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Concept
Exchange rate regime
Summary
An exchange rate regime is a way a monetary authority of a country or currency union manages the currency about other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors, such as economic scale and openness, inflation rate, the elasticity of the labor market, financial market development, and capital mobility.
There are two major regime types:
Floating (or flexible) exchange rate regime exist where exchange rates are determined solely by market forces and often manipulated by open-market operations. Countries do have the ability to influence their floating currency from activities such as buying/selling currency reserves, changing interest rates, and through foreign trade agreements.
Fixed (or pegged) exchange rate regimes, exist when a country sets the value of its home currency directly proportional to the value of another currency or commodity. For years many currencies were fixed (or pegged) to gold. If the value of gold rose, the value of the currency fixed to gold would also rise. Today, many currencies are fixed (pegged) to floating currencies from major nations. Many countries have fixed their currency value to the U.S. dollar, the euro, or the British pound.
There are also intermediate exchange rate regimes that combine elements of the other regimes.
This classification of exchange rate regime is based on the classification method carried out by GGOW (Ghos, Guide, Ostry and Wolf, 1995, 1997), which combined the IMF de jure classification with the actual exchange behavior so as to differentiate between official and actual policies. The GGOW classification method is also known as the trichotomy method.
There are many factors a country should consider before deciding on a fixed or floating currency, with pros and cons to both choices.
If a country chooses to fix its local currency to that of another country (like the US dollar) they achieve exchange rate stability.
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