by A flexible exchange-rate system is a monetary system that allows the exchange rate to be determined by supply and demand.
Every currency area must decide what type of exchange rate arrangement to maintain. Between permanently fixed and completely flexible however some take heterogeneous approaches. They have different implications for the extent to which national authorities participate in foreign exchange markets. According to their degree of flexibility, post-Bretton Woods-exchange rate regimes are arranged into three categories: currency unions, dollarized regimes, currency boards and conventional currency pegs are described as “fixed-rate regimes”; horizontal bands, crawling pegs and crawling bands are grouped into “intermediate regimes”; and managed and independent floats are described as flexible regimes. All monetary regimes except for the permanently fixed regime experience the time inconsistency problem and exchange rate volatility, albeit to different degrees.
Flexible exchange rate
These systems do not particularly reduce time inconsistency problems nor do they offer specific techniques for maintaining low exchange rate volatility.
A crawling peg attempts to combine flexibility and stability using a rule-based system for gradually altering the currency’s par value, typically at a predetermined rate or as a function of inflation differentials. A crawling peg is similar to a fixed peg; however, it can be adjusted based on clearly defined rules. A crawling peg is often used by (initially) high-inflation countries or developing nations who peg to low inflation countries in attempt to avoid currency appreciation. At the margin 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.
Exchange rate bands allow markets to set rates within a specified range; edges of the band are defended through intervention. It provides a limited role for exchange rate movements to counteract external shocks while partially anchoring expectations. This system does not eliminate exchange rate uncertainty and thus motivates development of exchange rate risk management tools. On the margin a band is subject to speculative attacks. It does not by itself place hard constraints on policy, and thus provides only a limited solution to the time inconsistency problem. The credibility effect depends on accompanying institutional measures, a record of accomplishment and whether the band is firm or adjustable, secret or public, band width and the strength of the 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. They are often accompanied by a separate nominal anchor, such as an 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 does not place hard constraints on monetary and fiscal policy. It suffers from uncertainty from reduced credibility, relying on the credibility of monetary authorities. It typically offers limited transparency.
In a pure float, the exchange rate is determined in the market without public sector intervention. Adjustments to shocks can take place through exchange rate movements. It eliminates the requirement to hold large reserves. However, this arrangement does not provide an expectations anchor. The exchange rate regime itself does not imply any specific restriction on monetary and fiscal policy.
Fixed exchange rate regime
A fixed exchange rate regime, sometimes called a pegged exchange rate regime, is one in which a monetary authority pegs its currency’s exchange rate to another currency, a basket of other currencies or to another measure of value (such as gold), and may allow the rate to fluctuate within a narrow range. To maintain the exchange rate within that range, a country’s monetary authority usually needs to intervenes in the foreign exchange market. A movement in the peg rate is called either revaluation or devaluation.
Currency board
Currency board is an exchange rate regime in which a country’s exchange rate maintain a fixed exchange rate with a foreign currency, based on an explicit legislative commitment. It is a type of fixed regime that has special legal and procedural rules designed to make the peg “Harder that is, more durable”. Examples include the Hong Kong dollar against the U.S dollar and Bulgarian lev against the Euro.
Dollarisation
Dollarisation, also currency substitution, means a country unilaterally adopts the currency of another country.
Most of the adopting countries are too small to afford the cost of running its own central bank or issuing its own currency. Most of these economies use the U.S dollar, but other popular choices include the euro, and the Australian and New Zealand dollars.
Currency union
A currency union, also known as monetary union, is an exchange regime where two or more countries use the same currency. Under a currency union, there is some form of transnational structure such as a single central bank or monetary authority that is accountable to the member states.
Examples of currency unions are the Eurozone, CFA and CFP franc zones. One of the first known examples is the Latin Monetary Union that existed between 1865 and 1927. The Scandinavian Monetary Union existed between 1873 and 1905.
History:
The Bretton Woods Conference, which established a gold standard for currencies, took place in July 1944. A total of 44 countries met, with attendees limited to the Allies in World War II. The Conference established the International Monetary Fund (IMF) and the World Bank, and it set out guidelines for a fixed exchange rate system. The system established a gold price of $35 per ounce, with participating countries pegging their currency to the dollar. Adjustments of plus or minus one percent were permitted. The U.S. dollar became the reserve currency through which central banks carried out intervention to adjust or stabilize rates.
The first large crack in the system appeared in 1967, with a run on gold and an attack on the British pound that led to a 14.3% devaluation. President Richard Nixon took the United States off the gold standard in 1971.
By late 1973, the system had collapsed, and participating currencies were allowed to float freely.
Failed Attempt to Intervene in a Currency
In floating exchange rate systems, central banks buy or sell their local currencies to adjust the exchange rate. This can be aimed at stabilizing a volatile market or achieving a major change in the rate. Groups of central banks, such as those of the G-7 nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States), often work together in coordinated interventions to increase the impact.
An intervention is often short-term and does not always succeed. A prominent example of a failed intervention took place in 1992 when financier George Soros spearheaded an attack on the British pound. The currency had entered the European Exchange Rate Mechanism (ERM) in October 1990; the ERM was designed to limit currency volatility as a lead-in to the euro, which was still in the planning stages. Soros believed that the pound had entered at an excessively high rate, and he mounted a concerted attack on the currency. The Bank of England was forced to devalue the currency and withdraw from the ERM. The failed intervention cost the U.K. Treasury a reported £3.3 billion. Soros, on the other hand, made over $1 billion.
Central banks can also intervene indirectly in the currency markets by raising or lowering interest rates to impact the flow of investors’ funds into the country. Since attempts to control prices within tight bands have historically failed, many nations opt to free float their currency and then use economic tools to help nudge it one direction or the other if it moves too far for their comfort.
