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A Guide to Exchange Rate Regimes
Economists often use words such as fixed, flexible, pegged, and floating to describe the way one nation’s currency is exchanged—how it is bought or sold and at what price—for another nation’s currency. But they just as often fail to explain exactly what these terms mean.
Take the example of a country where the peso is the national currency. A fixed or pegged exchange rate between the peso and the dollar, say at a rate of one-to-one as in the case of Argentina, is a promise of the central bank to exchange one U.S. dollar to any holder of one Argentine peso that wants to make the trade or to exchange one peso for any holder of one dollar that wants to convert the dollar to pesos. In practice, of course, the central bank is not a party to every transaction. Rather it is a buyer or seller of “last resort”: If there is an excess demand in the foreign exchange (or “forex”) market for dollars at the one-to-one exchange rate, the central bank must sell dollars and buy pesos. If there is an excess demand for pesos, it must sell pesos and buy dollars.
In a flexible exchange rate system, by contrast, the central bank does not commit to supply dollars or pesos at a predetermined price. Swings in forex market supply and demand may therefore shift the price of the peso in terms of the dollar. If there is an excess demand for dollars, the number of pesos needed to buy one dollar (“the cost of foreign exchange” from the point of view of peso holders) goes up. If there is an excess demand for pesos, the cost of foreign exchange (pesos per dollar) goes down. A rise in the price of foreign exchange is known as a currency depreciation, and a fall in the price is a currency appreciation.
In a pegged exchange rate system, the central bank uses its foreign exchange reserves to make the intervention in the market. Herein lies the rub. If there is a persistent excess demand for dollars, the central bank must sell dollars. Its forex reserves therefore fall. If the central bank’s reserves run low, and it is not able to secure financing from private markets, it may have to let the exchange rate depreciate, even if it has promised to defend the national currency. Thus, a fixed or pegged exchange rate is really a conditional promise, not an unconditional commitment. It says that the central bank will use its foreign exchange reserves to defend the currency (that is, to keep the rate from depreciating), but it will do so only so long as it has foreign exchange reserves to use for this purpose. If it runs out of reserves, the currency will collapse whether it has been pegged or not. The term “fixed,” therefore, is rather optimistic; many fixed rates end up in collapse. The alternative usage of “pegged” exchange rate is probably more accurate in the final analysis, as it seems less definitive.
Some monetary arrangements aim to bolster the commitment to a pegged rate. In a currency board, the central bank may not issue domestic credit to its own banking system or to the government. It may only exchange domestic currency for international currencies at the pegged exchange rate. Moreover, the value of the exchange rate is often set by law. The combination of no credit expansion plus a legally bound exchange rate often strengthens market confidence in the currency peg. It may, however, severely limit the flexibility of economic management.
Under a managed float, governments and central banks intervene in the market with the aim of achieving a specific exchange rate without making any public commitment to a desired target (which would constitute a peg). This system is currently favored by Great Britain and Japan. But when Japan intervened in the currency markets in the 1980s to keep down the value of the yen—thus boosting Japanese exports and making imports more expensive—it was described as a dirty float. Many governments try to have it both ways: to run a monetary policy aimed at domestic economic conditions while intervening in the forex market to influence the exchange rate. These two goals are often at odds or even mutually incompatible.
Virtually every conceivable variant between fixed and floating has been tried. Some currencies operate in a band— the central bank does not commit to a single price for foreign exchange, but rather to a range of upper and lower prices for the currency. Sometimes the pegged rate changes on a preset scale, in which case there is a crawling peg; sometime an entire band moves over time, in which case the system is a crawling band. The peg may be to a basket of currencies—not to a single counterpart—so that the national currency keeps its value relative to an average of the dollar, the euro, and the yen. Floats may be clean or dirty. In the end, the only thing truly fixed about exchange rates has been the capacity of nations to innovate and to improvise them.
—FP