Exchange Rates in a Fiat Money System - dummies

Exchange Rates in a Fiat Money System

By Ayse Evrensel

A fiat currency has no intrinsic value. In other words, its value is not based on a precious metal. Monetary policy determines the purchasing power of the currency. The exchange rate regime involving fiat currencies is called a flexible or floating exchange rate regime, where the exchange rate is determined in international foreign exchange markets.

An international monetary system in a fiat currency world is characterized by floating exchange rates. In fact, most developed countries’ exchange rates are characterized as such. There is the possibility of government as well as central bank intervention in exchange rates under the floating exchange rate regime.

Fiat currencies do not necessarily lead to a flexible exchange rate regime. Although almost all developed countries adopted a floating exchange rate regime starting in 1973, most developing countries adopted pegged exchange rate regimes, where governments unilaterally decide what the exchange rate is going to be.

There were different types of pegged regimes during the post–Bretton Woods era. Dollarization and currency board are examples of hard pegs. Dollarization involves replacing the domestic currency with another country’s currency. A currency board indicates the commitment of a central bank to a certain exchange rate by being willing to trade domestic currency for foreign currency at a fixed rate.

In the pure case, a currency board keeps 100 percent reserves of the foreign currency. In this case, the central bank doesn’t conduct monetary policy to address the country’s economic problems; monetary policy maintains the peg. In addition to hard pegs, countries can implement soft pegs that overvalue or undervalue the domestic currency, in an attempt to make either imports or exports cheaper or attract foreign portfolio investment.