Exchange rate regime

An exchange rate regime is the system that a country’s monetary authority, -generally the central bank-, adopts to establish the exchange rate of its own currency against other currencies. Each country is free to adopt the exchange-rate regime that it considers optimal, and will do so using mostly monetary and sometimes even fiscal policies.

The distinction amongst these exchange rates regimes is generally just made between fixed and flexible exchange rate regimes, but we find there are many other different regimes, some of which are in between these extreme cases:

-Monetary Union, with a shared currency, such as the Eurozone;

-No separate legal tender, where the use of the currency of another country takes place;

-Currency Board, an explicit agreement on a fixed exchange rate between two or more currencies;

-Target zone arrangement, where the exchange rate is allowed to fluctuate within certain bands;

-Crawling Peg, with a periodically adjusted exchange rate;

-Managed (dirty) float, a flexible exchange rate regime with some government intervention;

-Free (clean) float, the exchange rate is market determined.

The “impossible trinity”, also referred to as “trilemma”, states that any exchange rate regime will only have two of the following three characteristics: free capital flow, fixed exchange rate, and sovereign monetary policy; and thus, one is always left out.

Every exchange rate regime obviously has its particularities, virtues and flaws. To determine the most appropriate exchange-rate regime for a certain country is not a simple task as much will be at stake. A country’s economy is hugely affected by this decision. The following figure shows the different regimes according to four different variables: exchange rate flexibility, loss of monetary policy independence, anti-inflation effect and credibility of the exchange rate commitment:

Exchange rate regimes