Flexible exchange rate system
Encyclopedia
A flexible exchange-rate system is a currency
system that allows the exchange rate
to be determined by supply and demand
.
After the failure of Bretton Woods system
several currency regimes have emerged spanning the spectrum of rigidly fixed rate regime to independently flexible regimes.
Every country that has its own currency must decide what type of exchange rate arrangement to maintain. In academic discussions, the decision is often posed as a choice between a fixed or a flexible exchange rate. In reality however, there are different varieties of fixed and flexible arrangements, providing a range of alternatives. The different alternatives have different implications for the extent to which national authorities participate in the foreign exchange markets. According to their degree of flexibility, exchange rate regimes are arranged into three categories: currency unions, dollarized regimes, currency boards and conventional fixed pegs are defined as “fixed-rate regimes”; Horizontal bands, crawling pegs and crawling bands are grouped into “intermediate regimes”; Managed and independent floats are defined as flexible regimes.
Monetary union is a zone where a single monetary policy prevails and inside which a single currency or currencies, which are perfect substitutes, circulate freely. A monetary union has common monetary and fiscal policy to ensure control over the creation of high-powered money and the expansion of government debts; it has a central management of the common pool of foreign exchange reserves
, external debts and exchange rate policies. The monetary union has common regional monetary authority i.e. common regional central bank, which is the sole issuer of economy wide currency, in the case of a full currency union. The monetary union reduces the time inconsistency problem by requiring multinational agreement on policy and reduces real exchange rate volatility. The potential drawbacks are that member countries suffering asymmetric shocks lose a stabilization tool. The cost depends on the extent of asymmetric costs and the availability and effectiveness of alternative adjustment tools.
Dollarization/Euroization A foreign currency acts as legal tender. Dollarization is a summary measure of the use of foreign currency in its capacity to produce all types of money services in the domestic economy. Monetary policy is delegated to the anchor country. Dollarization/Euroization reduces the time inconsistency problem and real exchange rate volatility. Under dollarization exchange rate movements cannot buffer external shocks.
Currency board is monetary regime adopted by countries that intend to discipline their central banks, as well as solve their external credibility problems by “tying their hands” with institutionally binding arrangements. A currency board combines three elements: an exchange rate that is fixed to an “anchor currency”; automatic convertibility or the right to exchange domestic currency at this fixed rate whenever desired; and a long-term commitment to the system. The time inconsistency problem is reduced and real exchange rate volatility is diminished. A currency board system can be credible only if central bank holds official foreign exchange reserves sufficient to at least cover the entire monetary base. Exchange rate movements cannot buffer external shocks.
Fixed peg means fixed rate against a single currency or a currency basket. The time inconsistency problem is reduced through commitment to a verifiable target. Devaluation option provides potentially valuable policy tool in response to large shocks. It’s potential drawbacks are: provides a target for speculative attack
s, avoids real exchange rate volatility but not necessarily persistent misalignments, does not by itself place hard constrains on monetary and fiscal policy, the credibility effect depends on accompanying institutional measures and record of accomplishment.
Crawling peg A rule based system for altering the par value, typically at a predetermined rate or as a function of inflation differentials. It is an attempt to combine flexibility and stability. Often used by (initially) high inflation countries pegging to low inflation countries in attempt to avoid trend real appreciation. At the margins a crawling peg provides a target for speculative attacks. Among variants of fixed exchange rates, it imposes the least restrictions, and may hence yield the smallest credibility benefits. The credibility effect depends on accompanying institutional measures and record of accomplishment.
Bands exchange rate is flexible within a present band; endpoints are defended through intervention, typically with some intra-band intervention. An attempt to mix market-determined rates with exchange rate stabilizing intervention in a rule based system. It provides a limited role for exchange rate movements to counteract external shocks and partial expectations anchor, retains exchange rate uncertainty and thus motivates development of exchange rate risk management tools. On the margin a band is subject to speculative attacks. Does not by itself place hard constrains on monetary and fiscal policy, and thus provides only partial solution against the time inconsistency problem. The credibility effect depends on accompanying institutional measures, record of accomplishment and the characteristics of the band (firm or adjustable, secret or public, width, strength of intervention requirement).
Managed float Exchange rates are determined in the foreign exchange market. Authorities can and do intervene, but are not bound by any intervention rule. Often accompanied by a separate nominal anchor, such as inflation target. The arrangement provides a way to mix market-determined rates with stabilizing intervention in a non-rule-based system. Its potential drawbacks are that it doesn’t place hard constrains on monetary and fiscal policy. Absence of rule conditions credibility, gain on credibility of monetary authorities. Limited transparency.
Pure float The exchange rate is determined in the market without public sector intervention. Adjustments to shocks can take place through exchange rate movements. Eliminates the requirement to hold large reserves. This arrangement does not provide an expectations anchor. Exchange rate regime places no restrictions on monetary and fiscal policy; time inconvenience arises unless addressed by other institutional measures.
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
system that allows the exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
to be determined by supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
.
After the failure of Bretton Woods system
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...
several currency regimes have emerged spanning the spectrum of rigidly fixed rate regime to independently flexible regimes.
Every country that has its own currency must decide what type of exchange rate arrangement to maintain. In academic discussions, the decision is often posed as a choice between a fixed or a flexible exchange rate. In reality however, there are different varieties of fixed and flexible arrangements, providing a range of alternatives. The different alternatives have different implications for the extent to which national authorities participate in the foreign exchange markets. According to their degree of flexibility, exchange rate regimes are arranged into three categories: currency unions, dollarized regimes, currency boards and conventional fixed pegs are defined as “fixed-rate regimes”; Horizontal bands, crawling pegs and crawling bands are grouped into “intermediate regimes”; Managed and independent floats are defined as flexible regimes.
Monetary union is a zone where a single monetary policy prevails and inside which a single currency or currencies, which are perfect substitutes, circulate freely. A monetary union has common monetary and fiscal policy to ensure control over the creation of high-powered money and the expansion of government debts; it has a central management of the common pool of foreign exchange reserves
Foreign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...
, external debts and exchange rate policies. The monetary union has common regional monetary authority i.e. common regional central bank, which is the sole issuer of economy wide currency, in the case of a full currency union. The monetary union reduces the time inconsistency problem by requiring multinational agreement on policy and reduces real exchange rate volatility. The potential drawbacks are that member countries suffering asymmetric shocks lose a stabilization tool. The cost depends on the extent of asymmetric costs and the availability and effectiveness of alternative adjustment tools.
Dollarization/Euroization A foreign currency acts as legal tender. Dollarization is a summary measure of the use of foreign currency in its capacity to produce all types of money services in the domestic economy. Monetary policy is delegated to the anchor country. Dollarization/Euroization reduces the time inconsistency problem and real exchange rate volatility. Under dollarization exchange rate movements cannot buffer external shocks.
Currency board is monetary regime adopted by countries that intend to discipline their central banks, as well as solve their external credibility problems by “tying their hands” with institutionally binding arrangements. A currency board combines three elements: an exchange rate that is fixed to an “anchor currency”; automatic convertibility or the right to exchange domestic currency at this fixed rate whenever desired; and a long-term commitment to the system. The time inconsistency problem is reduced and real exchange rate volatility is diminished. A currency board system can be credible only if central bank holds official foreign exchange reserves sufficient to at least cover the entire monetary base. Exchange rate movements cannot buffer external shocks.
Fixed peg means fixed rate against a single currency or a currency basket. The time inconsistency problem is reduced through commitment to a verifiable target. Devaluation option provides potentially valuable policy tool in response to large shocks. It’s potential drawbacks are: provides a target for speculative attack
Speculative attack
A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...
s, avoids real exchange rate volatility but not necessarily persistent misalignments, does not by itself place hard constrains on monetary and fiscal policy, the credibility effect depends on accompanying institutional measures and record of accomplishment.
Crawling peg A rule based system for altering the par value, typically at a predetermined rate or as a function of inflation differentials. It is an attempt to combine flexibility and stability. Often used by (initially) high inflation countries pegging to low inflation countries in attempt to avoid trend real appreciation. At the margins a crawling peg provides a target for speculative attacks. Among variants of fixed exchange rates, it imposes the least restrictions, and may hence yield the smallest credibility benefits. The credibility effect depends on accompanying institutional measures and record of accomplishment.
Bands exchange rate is flexible within a present band; endpoints are defended through intervention, typically with some intra-band intervention. An attempt to mix market-determined rates with exchange rate stabilizing intervention in a rule based system. It provides a limited role for exchange rate movements to counteract external shocks and partial expectations anchor, retains exchange rate uncertainty and thus motivates development of exchange rate risk management tools. On the margin a band is subject to speculative attacks. Does not by itself place hard constrains on monetary and fiscal policy, and thus provides only partial solution against the time inconsistency problem. The credibility effect depends on accompanying institutional measures, record of accomplishment and the characteristics of the band (firm or adjustable, secret or public, width, strength of intervention requirement).
Managed float Exchange rates are determined in the foreign exchange market. Authorities can and do intervene, but are not bound by any intervention rule. Often accompanied by a separate nominal anchor, such as inflation target. The arrangement provides a way to mix market-determined rates with stabilizing intervention in a non-rule-based system. Its potential drawbacks are that it doesn’t place hard constrains on monetary and fiscal policy. Absence of rule conditions credibility, gain on credibility of monetary authorities. Limited transparency.
Pure float The exchange rate is determined in the market without public sector intervention. Adjustments to shocks can take place through exchange rate movements. Eliminates the requirement to hold large reserves. This arrangement does not provide an expectations anchor. Exchange rate regime places no restrictions on monetary and fiscal policy; time inconvenience arises unless addressed by other institutional measures.