a. An exchange rate regime is the policy framework for foreign exchange.
b. The ideal currency regime (which does not exist) would consist of the following circumstances:
i. The exchange rate is credible and fixed.
ii. All currencies are fully convertible.
iii. All countries are able to undertake independent monetary policy for domestic objectives.
The biggest problem with the ideal currency regime is that it would result in weak to no monetary policy effectiveness.
c. In reality, however, there is:
i. floating rate of exchange, resulting in exchange rate risk and uncertainty, and
ii. capital restrictions, resulting in inefficient allocation of capital.
This, however, results in effective monetary policy which is fully independent.
d. Historically speaking:
i. Up to the 1930s, most currencies across the world were linked to the gold standard. The money supply was tied to the trade balance’s surplus or deficit and the amount of gold available in the countries.
In order to protect their own economies, most countries abandoned global trade. Thus due to a drop in global trade during the 1930s, most countries abandoned the gold standards.
ii. After WWII, after the Bretton Woods conference, most countries opted for the fixed foreign exchange regime.
However, due to the inflation of the 1970s, most countries left the fixed rate for the floating exchange rate regime.
iii. The flexible foreign exchange, so adopted, is market-determined. However, the FX rates are much more volatile than expected.
iv. Later, some of the economies adopted midway between having limited flexibility. For example, most of the European countries formed the European Union and adopted a common currency, i.e. Euro so that they don’t have to worry about the interest rate volatility.
1.1. Major Exchange Rate Regimes
Thus different Exchange Rate Regimes across the world are:
a. No Separate Legal Tender: It is a fixed exchange rate regime, which involves dollarization, i.e. use of another nation’s currency as the medium of exchange (such as USD). This regime involves:
i. Countries making use of currency of other nations
ii. Imposition of fiscal discipline since countries cannot monetize debt
iii. This renders domestic monetary policies useless
b. Shared System: This is also a fixed exchange rate regime, which involves the formation of a monetary union, in order to use a currency of a group of countries as a medium of exchange.
c. Currency Board System: This is a fixed exchange rate regime, which involves the use of another currency in reserve as the monetary base, maintaining a fixed parity. This system involves:
i. Commitment to exchange domestic for foreign currency at a fixed rate
ii. Limits the printing press
iii. 100% foreign currency base against the monetary base
d. Fixed Parity or Fixed Rate System: This is a fixed exchange rate regime, which involves the use of another currency or basket of currencies in reserve, but with some discretion (parity bands). In this system:
i. There is no legislative commitment and can be abandoned anytime
ii. There is no need for 100% FX reserves
iii. There is some flexibility with the central banks
In this system, there are bands, within which the domestic currency can fluctuate, such that:
i. If excess demand results in inflation that leads to domestic currency rising out of that band, then the central banks must sell the domestic currency and buy the foreign currency to keep the peg.
ii. And if there are excess deflationary pressures, then the central banks must sell the foreign reserves and buy the domestic currency to maintain the peg.
b. Target Zone: This is also a fixed exchange rate regime, like the fixed-rate system but with fixed horizontal intervention bands.
c. Active Passive Crawling Pegs: This is the system of adjusting the exchange rate against a single currency, with adjustments for inflation (passive) or announced in advance (active). In this system, there are different types of pegs:
i. Static Peg: This is a fixed peg.
ii. Passive Peg: This is a peg adjusted to inflation (passive crawl).
iii. Active Peg: In this peg, the FX rate is pre-announced with changes in small steps. Rather than reacting to the inflation, the announcement is meant to influence expectations (active crawl).
d. Fixed Parity with Crawling Bands: This is also a peg system similar to the target zone, but here the bands can be widened.
e. Managed Float: It is a floating rate regime, which allows the exchange rate to float, but intervenes to manage it toward targets.
f. Independently Floating Rate: This is a floating rate system, of which there are:
i. Market-determined FX rates,
ii. The central bank enjoys full independence.
It should be noted that central banks do switch the regimes to suit their objectives.