Exchange Rate Regime

Exchange Rate Regime Definition

The exchange rate regime of a country is basically the foreign exchange policy of that country. The term “exchange” for most of the time refers to foreign exchange. The exchange rate regime therefore is the way a country manages its foreign exchange policy.

How efficiently a country manages its currency in relation to foreign currencies is directly proportional to how strong the economy of that particular country is. There are three types of exchange rates:

Floating Exchange Rate:

The most common type of exchange rate regime is the Floating Exchange Rate. The most well known currencies like the British Pound and Yen both have floating rates. As central banks intervene from time to time to monitor depreciation or appreciation in the market, floating rates are further classified as “managed floats” or “dirty floats”, depending on whether the central bank of that country is monitoring the rates or not.

Pegged Exchange Rate:

In this case, the currency is “pegged” to a particular value or band and the rates are adjusted from time to time to enable them to keep within the defined or pegged range. Here also, there are further sub-categories such as crawling bands, crawling pegs and rates which are pegged with horizontal bands.  

  1. Crawling bands: In this case, the value is fixed, but the rate is enabled to rise and fall within the band. This is done at regular intervals and the extent of fluctuation in rates depends on the situation in the economy. 
  1. Crawling Pegs: This is usually linked to fixed exchange rate regimes where appreciation or depreciation is allowed gradually. A few central banks apply a formula for the movement of rates, but others do not use this method as they believe that it gives rise to speculations.
  1. Pegged with Horizontal Bands: In such a system, the currency can fluctuate around the central rate but within a predetermined horizontal band, usually set at a value of more that 1%.

Fixed Exchange Rate:

These rates can be directly converted into other currencies. This rate is also known as pegged exchange rate. Here, the currency is tallied with another one or a group of them, or it may be linked to the value of gold.

Within reasonable limits, fixed exchange rates can be used by the governments to control inflation of their respective countries, but due to the frequent rising and falling of the reference value, it becomes difficult for a government to use its domestic monetary policy to have any major influence in the world market. Today, there are few countries that still use fixed exchange rates. The Peoples’ Republic of China has discontinued using the fixed exchange rate recently. 

Currency Board:

This is a very important aspect of exchange rate regimes as it is the main prime mover for setting up of exchange rates in a particular country. The currency board must see that the central bank adheres to the objectives set by the board.

Features of Currency Boards

  • The first and foremost condition that has to be met by a national currency board is that the reserves of foreign currency which it holds should be enough to convert all notes and coins held by them into at least 110% to 115% of the base value.
  • The board has an absolute control over the convertibility foreign currency in coins and notes at a fixed exchange rate in relation to the domestic rates, and there may be no restriction in the case of current or capital account transactions.
  • The board can earn profit through interest only from foreign currency held by it.
  • The currency board does not have any discretionary power and it cannot lend any money to the government. Likewise, the government cannot print extra money for its expenses and has to acquire this through taxes or borrowing.
  • Finally, the currency board cannot manipulate interest rates by applying discounts to certain banks. The pegging system is what controls the rates and keeps them closely aligned with the countries concerned.  

Dollarization

It is worthwhile to say a few words about the concept that has come to be known as “dollarization”. This happens when a foreign currency is used in parallel with the domestic currency. It need not only apply to the use of dollars, but it is most commonly used, hence the word “dollarization” is used. The stability of the dollar has tempted several countries to adopt it as their official policy. Some of the major countries which adopt this policy are Panama, Ecuador and El Salvador.

Dollarization may take place unofficially also, wherein private parties favor foreign currency for their transactions. This is likely to occur in countries where the local currency is weak.

Conclusion

The exchange rate regime of a particular country by and large defines the economic capability of that country. By studying the details of the exchange rate regime, we can get a clear picture of how economically stable a country is.