What Is an Exchange Rate Regime? - dummies

What Is an Exchange Rate Regime?

By Ayse Evrensel

The exchange rate between two currencies may be determined in international foreign exchange markets or in a government office. If an exchange rate — say, the yen–dollar rate — is determined in international foreign exchange markets based on the demand for and supply of the yen, then the markets determine the exchange rate.

This situation is similar to the case of any other good, such as oranges, whose price is determined in the market based on the demand for and supply of oranges. If the exchange rate is mainly determined in international foreign exchange markets, it’s called a floating exchange rate regime.

Exchange rates involving developed countries’ currencies, such as the U.S. dollar, the euro, the pound, the yen, and the Swiss franc, are determined in foreign exchange markets — mostly. When referring to these currencies, you may hear the term dirty float because of occasional central bank interventions in foreign exchange markets.

If floating or dirty floating currencies are at one extreme of the foreign exchange regime spectrum, pegged exchange rate regimes are toward the other end of the spectrum. In a pegged exchange rate regime, governments either don’t allow their currency to be traded in international foreign exchange markets or impose restrictions on trade.

In fact, governments determine the exchange rate unilaterally and announce it to the world. Although a variety of pegged exchange rate regimes exist, you can think about pegged regimes in which the government determines the exchange rate. Governments have reasons to keep the exchange rate involving the domestic currency at a certain level.

Don’t think of pegging the exchange rate as an easy decision. As any other decision, the decision to peg implies tradeoffs. Governments that decide to peg their currency have to decide whether they want to allow foreign portfolio investment in and out of the country.

If governments allow foreign portfolio investment, this approach attracts foreign investors into the country and opens new sources of financing for the country. But it can also spark a currency crisis, as foreign investors cash out their investment in the fear of depreciation, leaving the country in desperate need of foreign currency.

Alternatively, a government may decide to peg the exchange rate without allowing foreign portfolio flows. This approach may prevent a currency crisis, but it also makes an additional financing opportunity unavailable.