The exchange rate regime is the way a country manages its currency in respect to foreign 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. The basic types are a floating exchange rate, where the market dictates the movements of the exchange rate, a pegged float, where the central bank keeps the rate from deviating too far from a target band or value, and the fixed exchange rate, which ties the currency to another currency, mostly more widespread currencies such as the U.S. dollar or the euro.

Float
Main article: Floating exchange rate Floating rates are the most common exchange rate regime today. For example, the dollar, euro, yen, and ritish pound all float. !owever, since central banks fre"uently intervene to avoid excessive appreciation or depreciation, these regimes are often called managed float or a dirty float. # floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency$s value is allowed to fluctuate according to the foreign exchange market. # currency that uses a floating exchange rate is known as a floating currency. It is not possible for a developing country to maintain the stability in the rate of exchange for its currency in the exchange market. There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. #s floating exchange rates automatically ad%ust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. !owever, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency &strong& or &high& relative to others, such as the U' or the Southeast #sia countries before the #sian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the (undell)Fleming model, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces. In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabili*e the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. # central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price &ceiling& and &floor&. (anagement by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.

[edit] Pegged float

!ere, the currency is pegged to some band or value, either fixed or periodically ad%usted. +egged floats are,

Crawling bands, the rate is allowed to fluctuate in a band around a central value, which is ad%usted periodically. This is done at a preannounced rate or in a controlled way following economic indicators. Crawling pegs, !ere, the rate itself is fixed, and ad%usted as above. Pegged with horizontal bands, The currency is allowed to fluctuate in a fixed band -bigger than ./0 around a central rate.

[edit] Fixed
Main article: Fixed exchange rate Fixed rates are those that have direct convertibility towards another currency. In case of a separate currency, also known as a currency board arrangement, the domestic currency is backed one to one by foreign reserves. # pegged currency with very small bands -1 ./0 and countries that have adopted another country$s currency and abandoned its own also fall under this category. # fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency$s value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. # fixed exchange rate is usually used to stabili*e the value of a currency, against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their 23+. It can also be used as a means to control inflation. !owever, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the (undell)Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. There are no ma%or economic players that use a fixed exchange rate -except the countries using the 4uro0.5citation needed6 The most recent such country to discontinue their fixed exchange rate was the +eople$s 7epublic of 8hina, which did so in 9uly :;;<.5.6

Maintenance
Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the opposite measures are taken. #nother, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black

market in foreign currency. =onetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the 8hinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the .>>;s, 8hina was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.5:65?6

[edit] Criticisms
The main criticism of a fixed exchange rate is that flexible exchange rates serve to automatically ad%ust the balance of trade.5@6 Ahen a trade deficit occurs, there will be increased demand for the foreign -rather than domestic0 currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic re)balancing does not occur. 2overnment also has to invest many)a)resources in getting the foreign reserves to pile up in order to defend the pegged exchange rate. (oreover the 2overnment, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand alance of +ayments doesn$t get to e"uilibrium automatically. Using reflationary tools to set the economy rolling -by decreasing taxes and in%ecting more money in the market0 the government risks running into a trade deficit as the purchasing power of a common household increases and so does inflation thus making imports relatively cheaper. #dditionally, the stubbornness of the 2overnment in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures -increased taxation and reduced availability of money0 which can lead to unemployment. Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate.

[edit] Fixed exchange rate regime versus capital control

The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. # fixed exchange rate regime should be viewed as a tool in capital control. For instance, 8hina has allowed free exchange for current account transactions since 3ecember ., .>>B. Cf more than @; categories of capital account, about :; of them are convertible. These convertible accounts are mainly related to foreign direct investment. ecause of capital control, even the renminbi is not under the managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners to purchase renminbi.

[edit] Currency board

Main article: Currency board

A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target.

Features of "orthodox" currency boards

The main "ualities of an orthodox currency board are,

A currency board's foreign currency reserves must be sufficient to ensure that all holders of its notes and coins (and all banks creditor of a eserve Account at the currency board! can convert them into the reserve currency (usually ""#$""%& of the monetary base M0!. A currency board maintains absolute' unlimited convertibility between its notes and coins and the currency against which they are pegged (the anchor currency!' at a fixed rate of exchange' with no restrictions on current(account or capital(account transactions. A currency board only earns profit from interests on foreign reserves (less the expense of note(issuing!' and does not engage in forward(exchange transactions. These foreign reserves exist ("! because local notes have been issued in exchange' or ()! because commercial banks must by regulation deposit a minimum reserve at the *urrency +oard. ("! generates a seignorage revenue. ()! is the revenue on minimum reserves (revenue of investment activities less cost of minimum reserves remuneration! A currency board has no discretionary powers to effect monetary policy and does not lend to the government. ,overnments cannot print money' and can only tax or borrow to meet their spending commitments. A currency board does not act as a lender of last resort to commercial banks' and does not regulate reserve requirements. A currency board does not attempt to manipulate interest rates by establishing a discount rate like a central bank. The peg with the foreign currency tends to keep interest rates and inflation very closely aligned to those in the country against whose currency the peg is fixed.

[edit] Consequences of adopting a fixed exchange rate as prime target

The currency board in "uestion will no longer issue fiat money but instead will only issue one unit of local currency for each unit -or decided amount0 of foreign currency it has in its vault -often a hard currency such as the U.S. dollar or the euro0. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as -initially0 higher deposits of the -net0 exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that e"uals additional hard foreign exchange reserves in the hands of the central bank.

[edit] Pros and cons

The virtue of this system is that "uestions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix

a country$s terms of trade, irrespective of economic differences between it and its trading partners. Typically, currency boards have advantages for small, open economies which would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.

[edit] Examples in recent history

-orldwide use of the ../. dollar and the euro0 .nited /tates 1xternal adopters of the ./ dollar *urrencies pegged to the ./ dollar *urrencies pegged to the ./ dollar w2 narrow band 1uro3one 1xternal adopters of the euro *urrencies pegged to the euro *urrencies pegged to the euro w2 narrow band 4ote that the +elarusian ruble is pegged
to the 1uro' ussian uble and ../. 5ollar in a currency basket.

!ong 'ong operates a currency board -!ong 'ong (onetary #uthority0, as do ulgaria and Dithuania. 4stonia established a currency board pegged to the 3eutsche (ark in .>>: after gaining independence, and this policy is seen as a mainstay of that country$s subse"uent economic success -see 4conomy of 4stonia for a detailed description of the 4stonian currency board0. #rgentina abandoned its currency board in 9anuary :;;: after a severe recession. To some, this emphasised the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. !owever, #rgentina$s system was not an orthodox currency board, as it did not strictly follow currency board rules ) a fact which many see as the true cause of its collapse. Cthers argue that #rgentina$s monetary system was an inconsistent mixture of currency board and central banking elements. They think misunderstanding of the workings of the system by economists and policymakers contributed to the #rgentine government$s decision to devalue the peso in 9anuary :;;:. The economy fell deeper into depression before a recovery began later in the year.5.6 The ritish Cverseas Territories of 2ibraltar, the Falkland Islands and St. !elena continue to operate currency boards, backing their locally printed currency notes with pound sterling reserves5:6. # gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency.

[edit] Examples against the Euro

+ulgarian lev 1stonian kroon +osnia and 6er3egovina convertible mark (Konvertibilna marka!

7ithuanian litas
o

8or complete listing' see currencies related to the euro

[edit] Examples against the U.S. dollar

6ong 9ong dollar +ermudian dollar *ayman :slands dollar 5jiboutian franc 1ast *aribbean dollar (Antigua and +arbuda' 5ominica' ,renada' /aint 9itts and 4evis' /aint 7ucia' and /aint ;incent and the ,renadines!
o

8or complete listing' see .nited /tates dollar

[edit] Examples against the pound sterling

8alkland :slands pound ,ibraltar pound /aint 6elena pound

[edit] Examples against other currencies

+runei dollar' against the /ingapore dollar <acanese pataca' against the 6ong 9ong dollar The 8aeroe :slands have a de jure currency board' but in fact the 5anish 4ational +ank serves as the lender of last resort and all bank accounts are denominated in 5anish kroner. The 5anish 4ational +ank refers to the 8aroese kr=na as a >special version> of the 5anish krone.

[edit]

istorical examples
:rish pound' pegged against pound sterling from independence until "?@?. Argentine peso' pegged against the .nited /tates dollar until )##). 6ong 9ong dollar' pegged against the .nited /tates dollar throughout Asian currency crisis of "??@ in spite of concerted speculative attacks.

[edit] Dollari ation

Main article: Dollarization Dollari ation occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency.

Cfficial dollari*ation has gained prominence as several countries have considered and implemented it as official policy. The ma%or advantage of dollari*ation is promoting fiscal discipline and thus greater financial stability and lower inflation. The biggest economies to have officially dollari*ed as of 9une :;;: are +anama -since .>;@0, 4cuador -since :;;;0, and 4l Salvador -since :;;.0. #s of #ugust :;;<, the United States dollar, the euro, the =ew Eealand dollar, the Swiss franc, the Indian rupee, and the #ustralian dollar were the only currencies used by other countries for official dollari*ation. In addition, the Turkish lira, the Israeli shekel, and the 7ussian ruble are used by internationally unrecognised but de facto independent states.

[edit] !easons
3ollari*ation can occur unofficially, when private agents prefer the foreign currency over the domestic currency. They hold for example deposits in the foreign currency because of a bad track record of the local currencyF semiofficially -or officially bimonetary systems0, where foreign currency is legal tender, but plays a secondary role to domestic currencyF or officially, when a country ceases to issue the domestic currency and uses only foreign currency. It adopts the foreign currency as legal tender