Exchange Rate Regimes

With the world seeming to be one large marketplace, as the leader of the “free world”, which exchange rate would you favor?

Every country’s exchange rate regime varies according to the level of their development. For example developed nations favor a flexible/ floating exchange rate regime, developing nations favor a more managed float, and emerging markets prefer to use fixed exchange rate regime or peg their currency to the dollar or another stronger currency. Several other types of fixed exchange rate systems such as fixed currency within a band, crawling peg/band and dollarization etc., are used by a few countries. Our textbook also describes how the world went through changes of systems from gold standard to fixed and now to floating exchange rate system, mainly in developed countries. The world is becoming a more integrated marketplace and as the leader of the “free world”, the main focus is to analyze floating and fixed exchange rate systems. Each system had advantages and disadvantages.

According to supporters of a fixed exchange rate systems, economies worldwide benefit by stable international prices which then encourages trade. The fixed exchange rate regime promotes institutional credibility and signals discipline, which benefits mainly developing countries. Under this regime countries are required to adopt restrictive monetary and fiscal policies to prevent inflation. A pegged currency helps developing nations with unsophisticated capital markets to create a stable environment and greater confidence for investors.

On the other hand, the collapse of the Bretton Woods system of fixed exchange rates in 1973 is evidence that international trade became difficult. Also fixed exchange rate regimes are subject to destabilizing speculative attacks that could lead to destabilizing episodes, meltdown of financial systems and economic contraction especially in emerging market economies. This is the main weakness of this system. Additionally, determined fixed rates may be inconsistent with economic fundamentals and could cause a recession. Furthermore, a central bank is unable to respond to lowering the interest rate in the case of high unemployment.

Under the floating/flexible exchange rate system monetary policy, there is no central bank intervention and the exchange rate is market-determined. This regime is a simple set of international rules governing the setting of exchange rates.

An increase in import demand will increase demand for foreign exchange that will cause the quantity of imports demanded to decline as well exports to increase, eventually reaching the new equilibrium. An increase in import demand leads to a depreciation of the currency.

Many small emerging market economies/countries have a fear of using floating regimes because of higher exports, imports, and overall international capital flows, therefore large exchange