Alternative Exchange Rate Regimes - dummies

Alternative Exchange Rate Regimes

By Ayse Evrensel

In addition to the fixed and flexible exchange rate regimes, intermediate foreign exchange regimes also have appeared in the post–Bretton Woods era. Pegged exchange rates, especially the soft or crawling pegs, have the characteristics of the fixed and flexible exchange rate regimes without the metallic standard. After 1971, unlike the Bretton Woods system, many developing countries adopted a unilateral peg.

These pegs have been implemented to improve the trade position of countries (making either exports or imports cheaper). Starting in the mid-1980s, emerging markets pegged their exchange rates to attract foreign portfolio flows into their countries and improve their hard currency receipts. These pegs fulfilled their objectives for a while.

When developing countries wanted to affect the prices of their exports and imports, they certainly could do that. When pegs were introduced to attract foreign investors, this happened as well.

However, substantial costs were associated with these soft pegs. The sort of pegs aiming to favorably affect developing countries’ exports and imports distorted relative prices in these countries, which led to inefficient use of scarce resources. The kind of pegs implemented to attract foreign investors proved to be extremely harmful when investors became suspicious that the pegs couldn’t be maintained for long.

Countries with these kinds of pegs either weren’t careful with their fiscal and monetary policy, which put the credibility of the peg in danger, or didn’t have the necessary stability and strength in their political environment and financial structure. In either case, speculative attacks on pegged currencies had extremely harmful effects on some emerging countries.

The table illustrates the undeniable presence of tradeoffs. Especially during times of uncertainty, policymakers and people alike desire stability. If the understanding of stability is that an international monetary system has inherent mechanisms that ensure stability, then reality has shown that stabilizing mechanisms inherent in any system work a lot better on paper than in reality.

Therefore, selecting an international monetary system among the alternative systems doesn’t entail selecting one without a price — it involves selecting one whose price countries are willing to pay.

Advantages and Disadvantages of Alternative Exchange Rate Regimes
Exchange Rate Regimes Pro Con
Fixed No sudden changes in ER; no need to forecast future exchange
Import of other countries’ domestic economic problems,
such as inflation and unemployment
Flexible Insulation of countries from other countries’ economic
problems, such as inflation and unemployment
Excessive volatility in exchange rates
Pegged Stability provided by a nominal anchor Prone to speculative attack
Financing economic development through incoming portfolio
Hot money leaving the country fast if investors doubt the
credibility of the peg