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:
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.
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.
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.
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.
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.
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.