Exchange Rate Exchange Rate Regimes of the WorldRegimes of the World

Exchange Rate RegimesExchange Rate Regimes• What is an exchange rate

regime?• “the exchange rate regime is the

way a country manages its currency in respect to foreign currencies and the foreign exchange market.”

• What are the most common types of exchange rate regimes?• Fixed Exchange Rate• Floating Exchange Rate• Pegged Exchange Rate

Fixed versus Floating Exchange Rate

To determine whether a regime is fixed or floating you have to decide where to draw the line between narrow and wide fluctuations.

A rule is to use annual variations in excess of +/- 2% and +/-1% as the sign of floating regime.

Fixed Exchange Rate Fixed Exchange Rate RegimesRegimesDefinition: in a fixed exchange rate system the

government or central bank intervenes in the currency market so that the exchange rate stays close to an ‘exchange rate target’.

The central bank is unable to affect the exchange rate through monetary policy. However, the central bank can use fiscal expansion to create an excess demand for the currency causing a rise in domestic output. The central bank will then purchase foreign assets to increase the money supply, and prevent the interest rate from rising causing an appreciation.

Due to these limitations the government of a country with a fixed exchange rate will want to control the amount of currency they let in and out. This will prevent any unwanted destabilization of the domestic currency.

Floating Exchange Rate Floating Exchange Rate RegimesRegimes Definition: a country’s “currency is set by the foreign-

exchange market through supply and demand for that particular currency relative to other currencies.”

In a floating exchange rate system the value of the currency is affected by everyday markets for supply and demand. Therefore trade and capital flows play a big role in determining the currency’s value.

There are two different types of floating exchange rate systems. Dirty Float and Clean Float and this depends on whether or not there is government intervention.

The exchange rate can be stabilized through both monetary and fiscal policy:◦ Through monetary policy when there is an excess in money

supply the government would purchase domestic assets to weaken the currency and push the interest rate down.

◦ Fiscal expansion causes an appreciation of the currency that forces the government to purchase foreign assets. This will increase the money supply preventing the currency appreciation.

Free FloatThe movements between peaks and troughs

may take months or years to occur.The exchange rate will show a great deal of

short-run volatility, with lots of up-and-down movement from day to day.

Examples between the U.S. dollar with all the three foreign countries:-the yen-the pound-the loonie

Free Float Cont.The range of variation is about

the same, with the maximum being about one and a half times the minimum:-The yen ranges from about $0.0065 to $0.010.-The pound from $1.3 to $1.95.-The loonie from $0.6 to about $0.85.

Pegged Exchange Rate Pegged Exchange Rate RegimesRegimes

This is most common under developing countries as well as communist countries. It’s somewhat similar to a fixed exchange rate however a pegged rate has a wider range of value versus the fixed exchange rate.

An example of a country with a pegged exchange rate would be China. China’s currency was pegged to the U.S. Dollar until 2005 as you can see in the graph.

Chinese Yuan to One USD

Type of PegCurrency Board- a type of fixed

regime that has special legal and procedural rules designed to make the peg harder which means more durable.

Crawling peg- when he exchange rate follows a simple trend and if there is any variation than it’s called a crawling band

American Dollars to 1 American Dollars to 1 Chinese YuanChinese Yuan

120 days latest (Apr 6) 0.146311

lowest (Mar 30) 0.145149

highest (Mar 26) 0.147596

American Dollars to 1 American Dollars to 1 JPYJPY  

120 days latest (Apr 6)

0.00992211 lowest (Oct 20) 0.00982898

highest (Dec 17) 0.0113843

American Dollars to 1 American Dollars to 1 CADCAD  

120 days latest (Apr 6) 0.810281

lowest (Mar 9) 0.765926

highest (Nov 4) 0.869414