An exchange rate regime is a way a

monetary authority A central bank, reserve bank, national bank, or monetary authority is an institution that manages the monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monet ...

of a country or currency union manages the

currency A currency is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general definition is that a currency is a ''system of money'' in common use within a specific envi ...

about other currencies and the

foreign exchange market The foreign exchange market (forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. By trading volume, ...

. It is closely related to

monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to affect monetary and other financial conditions to accomplish broader objectives like high employment and price stability (normally interpreted as a low and stable rat ...

and the two are generally dependent on many of the same factors, such as economic scale and openness,

inflation rate In economics, inflation is an increase in the average price of goods and services in terms of money. This increase is measured using a price index, typically a consumer price index (CPI). When the general price level rises, each unit of curre ...

, the elasticity of the

labor market Labour economics seeks to understand the functioning and dynamics of the Market (economics), markets for wage labour. Labour (human activity), Labour is a commodity that is supplied by labourers, usually in exchange for a wage paid by demanding ...

financial market A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial marke ...

development, and capital mobility. There are two major regime types: * ''Floating (or flexible) exchange rate'' regimes exist where exchange rates are determined solely by market forces, and often manipulated by open-market operations. Countries do have the ability to influence their floating currency from activities such as buying/selling currency reserves, changing interest rates, and through foreign trade agreements. * ''Fixed (or pegged) exchange rate'' regimes exist when a country sets the value of its home currency directly proportional to the value of another currency or commodity. For years, many currencies were fixed (or pegged) to gold. If the value of gold rose, the value of the currency fixed to gold would also rise. Today, many currencies are fixed (pegged) to floating currencies from major nations. Many countries have fixed their currency value to the U.S. dollar, the

euro The euro (currency symbol, symbol: euro sign, €; ISO 4217, currency code: EUR) is the official currency of 20 of the Member state of the European Union, member states of the European Union. This group of states is officially known as the ...

, or the

British pound Sterling (Currency symbol, symbol: Pound sign, £; ISO 4217, currency code: GBP) is the currency of the United Kingdom and nine of its associated territories. The pound is the main unit of account, unit of sterling, and the word ''Pound (cu ...

. There are also intermediate exchange rate regimes that combine elements of the other regimes. This classification of exchange rate regime is based on the classification method carried out by GGOW (Ghos, Guide, Ostry and Wolf, 1995, 1997), which combined the

IMF The International Monetary Fund (IMF) is a major financial agency of the United Nations, and an international financial institution funded by 191 member countries, with headquarters in Washington, D.C. It is regarded as the global lender of la ...

de jure classification with the actual exchange behavior so as to differentiate between official and actual policies. The GGOW classification method is also known as the trichotomy method.

Fixed versus floating

There are many factors a country should consider before deciding on a fixed or floating currency, with pros and cons to both choices. If a country chooses to fix its local currency to that of another country (like the US dollar) they achieve exchange rate stability. This means that any time that country trades with the United States or conducts trade denominated in US dollars, there is certainty around how much the local currency will be worth in terms of US dollars. Businesses enjoy this certainty and pegging a currency can often lead to foreign direct investment (FDI). However, when a country decides to fix their currency they give up monetary autonomy. They are not able to set their own exchange rates, and thus the relative strength or weakness of their currency is fully dependent on the strength or weakness of the currency they have chosen to fix their local currency to. If a country chooses to be free-floating like the US dollar, they are monetarily independent- however they lose the exchange rate stability that fixed currencies have. Notice you can not achieve a currency that is monetarily independent yet also has an exchange rate stability. This inability to have both is part of a concept known as the incompatible trinity. When deciding upon a currency regime countries can achieve two out of three things: full financial integration, exchange rate stability, or monetary independence. A country can never have a currency that achieves all three.

Exchange rate regimes

Floating exchange rate regime

A floating (or flexible) exchange rate regime is one in which a country's exchange rate fluctuates in a wider range and the country's monetary authority makes no attempt to fix it against any base currency. A movement in the exchange is either an appreciation or depreciation. Free float (or floating exchange rate) Under a

free float In the context of stock markets, the public float or free float represents the portion of Share (finance), shares of a corporation that are in the hands of public investors as opposed to locked-in shares held by promoters, company officers, control ...

, also known as clean float, a currency's value is allowed to fluctuate in response to foreign-exchange market mechanisms without government intervention. Managed float (or dirty float) Under a

managed float A managed float regime, also known as a dirty float, is a type of exchange rate regime where a currency's value is allowed to fluctuate in response to foreign-exchange market mechanisms (i.e., supply and demand), but the central bank or monetary ...

, also known as dirty float, a government may intervene in the market exchange rate in a variety of ways and degrees, in an attempt to make the exchange rate move in a direction conducive to the economic development of the country, especially during an extreme appreciation or depreciation. A monetary authority may, for example, allow the exchange rate to float freely between an upper and lower bound, a price "ceiling" and "floor".

Intermediate rate regime

The exchange rate regimes between the fixed ones and the floating ones. Band (or target zone) There is only a tiny variation around the fixed exchange rate against another currency, well within plus or minus 2%. For example, Denmark has fixed its exchange rate against the euro, keeping it very close to 7.44 krone = 1 euro (0.134 euro = 1 krone). Crawling peg A crawling peg is when a currency steadily depreciates or appreciates at an almost constant rate against another currency, with the exchange rate following a simple trend. Crawling band Some variation about the rate is allowed, and adjusted as above: for example, see

Colombia Colombia, officially the Republic of Colombia, is a country primarily located in South America with Insular region of Colombia, insular regions in North America. The Colombian mainland is bordered by the Caribbean Sea to the north, Venezuel ...

from 1996 to 2002 and

Chile Chile, officially the Republic of Chile, is a country in western South America. It is the southernmost country in the world and the closest to Antarctica, stretching along a narrow strip of land between the Andes, Andes Mountains and the Paci ...

in the 1990s. Currency basket peg A currency basket is a portfolio of selected currencies with different weightings. The currency basket peg is commonly used to minimize the risk of currency fluctuations. For example, Kuwait shifted the peg based on a currency basket consists of currencies of its major trade and financial partners.

Fixed exchange rate regime

A fixed exchange rate regime, sometimes called a pegged exchange rate regime, is one in which a monetary authority pegs its currency's exchange rate to another currency, a basket of other currencies or to another measure of value (such as gold), and may allow the rate to fluctuate within a narrow range. To maintain the exchange rate within that range, a country's monetary authority usually needs to intervene in the foreign exchange market. A movement in the peg rate is called either

revaluation Revaluation is a change in a price of a good or product, or especially of a currency, in which case it is specifically an official rise of the value of the currency in relation to a foreign currency in a fixed exchange rate system. In contrast, ...

devaluation In macroeconomics and modern monetary policy, a devaluation is an official lowering of the value of a country's currency within a fixed exchange-rate system, in which a monetary authority formally sets a lower exchange rate of the national curre ...

. Currency board

Currency board In public finance, a currency board is a mechanism by which a monetary authority is required to maintain a fixed exchange rate with a foreign currency by fully backing the commitment with foreign holdings, or reserves. This policy objective requ ...

is an exchange rate regime in which a country's exchange rate maintain a fixed exchange rate with a foreign currency, based on an explicit legislative commitment. It is a type of fixed regime that has special legal and procedural rules designed to make the peg "harder—that is, more durable". Examples include the Hong Kong dollar against the U.S. dollar and Bulgarian lev against the Euro. Dollarisation Dollarisation, also ''currency substitution'', means a country unilaterally adopts the currency of another country. Most of the adopting countries are too small to afford the cost of running its own central bank or issuing its own currency. Most of these economies use the U.S. dollar, but other popular choices include the euro, and the

Australian Australian(s) may refer to: Australia * Australia, a country * Australians, citizens of the Commonwealth of Australia ** European Australians ** Anglo-Celtic Australians, Australians descended principally from British colonists ** Aboriginal Aus ...

and

New Zealand dollar The New Zealand dollar (; currency sign, sign: $; ISO 4217, code: NZD) is the official currency and legal tender of New Zealand, the Cook Islands, Niue, the Ross Dependency, Tokelau, and a British territory, the Pitcairn Islands. Within New Zeal ...

s. Currency union A currency union, also known as monetary union, is an exchange regime where two or more countries use the same currency. Under a currency union, there is some form of transnational structure such as a single central bank or monetary authority that is accountable to the member states. Examples of currency unions are the

Eurozone The euro area, commonly called the eurozone (EZ), is a Monetary union, currency union of 20 Member state of the European Union, member states of the European Union (EU) that have adopted the euro (Euro sign, €) as their primary currency ...

, CFA and

CFP franc The CFP franc (French language, French: , called the ''franc'' in everyday use) is the currency used in the France, French overseas collectivity, overseas collectivities (, or COM) of French Polynesia, New Caledonia, and Wallis and Futuna. The i ...

zones. One of the first known examples is the

Latin Monetary Union The Monetary Convention of 23 December 1865 was a unified system of coinage that provided a degree of monetary integration among several European countries, initially Belgium, France, Italy and Switzerland, at a time when the circulation of bank ...

that existed between 1865 and 1927. The Scandinavian Monetary Union existed between 1873 and 1905.

References

* Robert C. Feenstra, Alan M. Taylor, 2014, International Economics-Worth Publishers * Ye Shujun, 2009, International Economics,Tsinghua University Press,79 * Andrea, Inci, 2002, The Evolution of Exchange Rate Regimes Since 1990: Evidence from De Facto Policies, 8