Exchange Rate Regimes

Published on June 24, 2020
Exchange Rates are a very crucial part of the economy, a small variation in the exchange rates makes a significant impact in the country’s financial position. The import and export are purely based on FX Rates and a variation in the rates varies the net revenue from exports and imports.
  • An increase in INR/USD rates depreciates the domestic currency INR which leads to increased revenue from exports, however, at the same time, it increases the cost of import as the payment to be done for imports increase in INR.
  • Similarly, a decrease in exchange rates decrease the revenue from exports, nut makes the imports cheaper, hence it is required that the Exchange Rate is properly regulated to maintain a balance in the economy.
  • A country must maintain an equilibrium between the exchange rates so that the exports earn good revenue and at the same time imports do not become too costly. When the country is in a net payable state, it is known as trade deficit and when the country is in a net receivable state, it is known as a trade surplus. It should always be noted that if one country is in the trade deficit, some other country is always a trade surplus, and this way trade deficit or trade surplus of the world becomes zero. (Balance of Payment)
  • An exchange rate regime is a system by which a country manages its currency with other currencies and the foreign exchange market. Each country is free to adopt the exchange-rate regime that it considers suitable.

Ideal Exchange Rate Regime

Before looking at the type of Exchange Rate Regimes, let us see the structure of an Ideal Exchange Rate Regime. The ideal exchange rate regime exhibits the following characteristics:
  1. The exchange rates between any two currencies would be credibly fixed. This implies that the rate would not depend on demand or supply, rather they would be fixed. This will remove the risk of currency-related risks between the countries.
  2. All Currencies will be fully convertible, this ensures that anyone could buy or sell any amount of currency without any limit or restriction. This will lead to the availability of capital.
  3. The countries associated will be able to take independent monetary and fiscal decisions in their respective countries.
The above points seem to be simple at first look but are difficult to achieve, let us see the reasons:
  1. If the FX rate between the currencies will be fixed, then there will be no FX market because there will be no speculation, appreciation, depreciation.
  2. If there will be no restrictions on the amount of currency sold or purchased, there will be no advantage of having two different currencies, it would rather be useful that both the countries use the same currency for trading.
  3. Independent monetary policies will not be possible if the exchange rates will be fixed and currencies are made fully convertible as the monetary policy will have a significant impact on other countries and currency as well.

Let us take an illustration to understand the same:

Illustration 1: Let us assume that India and the United States have decided to follow the Ideal Exchange Rate Regime between India and the US. The INR/USD is fixed at 75.
  1. There will be no logic for trading in the FX market as the rates are not market dependent and there is no scope for speculation or profit-making.
  2. There will be no logic for trading in the FX market as the currencies are fully convertible, there is no shortage that someone will approach the market to buy it. Moreover, India may stop printing INR and use USD as it is fully convertible in India.
  3. Indian and US cannot make individual monetary policies, if India tightens its monetary policy to control inflation, it would have a significant impact on INR supply in the economy and the clause of fully convertible will no longer exist.

Historical Perspective on Currency Regime

The world has seen various Currency Regimes since the growth of industrialization, each regime promised better characteristics than its previous one, but had an associate fault too, which led to new regimes, let us see few important milestones in this regard in chronological order:

I. Classical Gold Standard:

  • In this regime the price of each currency was set in gold, for example, USD 10 implied gold worth that amount. 
  • A country could only print that money for which it had gold reserves.
  • This regime operated in the price-specie-flow-mechanism, as gold was the ruling factor, a country with trade deficit paid the balance as Gold to other countries, and a country in the trade surplus received the payment in gold.
  • With time, the gold reserves of the countries began to deplete as they had to pay deficits in Gold
  • The price of Gold became very high that lead to the total collapse of the economy as in the absence of Gold countries could not pay the debt, could not issue currency, could not perform a trade, etc.

II. Fixed-Rate Regime:

  • The exchange rates were fixed with periodic reviews
  • Central Banks or Government fixed the Exchange Rates
  • Demand and Supply of currency had no impact on price.
  • Created opportunity for favourable exchange rates by paying a bribe to the deciding authorities. 

III. Market or Floating Rate Regime:

  • Market or the supply-demand decided the exchange rates
  • Highly Volatile Market
  • The government had no control over exchange rates.
  • Created difficulty in framing monetary policies as the change in exchange rates and its impact was not predictable.

IV. Limited Flexibility Rate Regime:

  • This was a combination of floating rate and fixed-rate regime.
  • The rate was floating but the government/central bank intervened periodically to maintain it at certain levels.

A Taxonomy of Currency Regime

Global markets are very diverse where each country has its regulations and hence, they cannot be controlled by a single regime. Let us discuss a few of them.
  1. Arrangements with No Separate Legal Tender: IMF identifies two types of regimes wherein two or more countries have the same legal tender (currency), they are as following:
    • Dollarization: A country chooses another country’s currency (mostly USD) as its legal tender, the country does not have legal tender of its own. This is practised in countries that lack fiscal discipline, e.g. Zimbabwe, Ecuador, Panama, etc.
    • Monetary Union with the same Legal Tender: Many countries form a monetary union together and follow on fixed legal tenders, a new country may also join an existing monetary union. The monetary policies of these countries are decided by the Monetary Union, e.g. the European Union.
  2. Currency Board System: Currency board is a type of fixed regime system with an additional fact that the central bank must keep large foreign exchange reserves.
    • The reserve maintenance is to ensure that the fixed exchange rate is credible and will be maintained indefinitely. The large reserve ensures that the entire population may convert their local currency to the foreign currency ta the fixed exchange rate.
    • This regime helps country’s to manage inflation well but at the same time eliminate the role of monetary policy as the central bank has to maintain forex reserves all the time so it cannot manipulate the money supply and the exchange rate. E.g. Hong Kong, Argentina, etc.
  3. Fixed Parity: It is a system wherein the value of the currency of a country is bound to a single or a basket of foreign currencies. Central Banks intervene in the market to maintain a balanced rate using foreign currencies. To maintain a healthy system, the Central Bank should have a healthy Forex Reserve, which is a key for effecting FX Regime in this system.
  4. Target Zone: A target zone regime is a fixed parity regime with a ±2% fluctuation in the exchange rates around the parity. In simple words, it is a fixed rate regime with Central Bank intervention limited to ±2% of the basket of currency. This allows central banks to use this band to design monetary policies that were lacking in the Fixed Parity system.
  5. Active and Passive Crawling Pegs: In this type of regime, the exchange rate as adjusted frequently (daily or weekly) to manage the inflation rate in the country, this was known as Passive Crawling Peg, when this process was made adaptive with the inflation it was referred to as Active Crawling Peg. The main effect of this regime was to control the level of inflation in the economy.
  6. Fixed Parity with Crawling Bands: This regime is a modified version of fixed parity regime wherein the country initially used the Fixed Parity regime to stabilize its economy and as the economy begins to stabilize the Central Bank can have small flexibility over the FX rates.
  7. Managed Float/Dirty Float: It is a flexible rate regime with the regular intervention of the Government or Central Bank to influence the FX Rates.
  8. Independently Floating Rates: This regime depends fully on market rates and allows the market to decide the FX rates, the Central Bank or Government does not intervene in FX Rates. The supply and demand of the currency are the key factors in determining the exchanger rates.

About me

ramandeep singh

My name is Ramandeep Singh. I authored the Quantitative Aptitude Made Easy book. I have been providing online courses and free study material for RBI Grade B, NABARD Grade A, SEBI Grade A and Specialist Officer exams since 2013.

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