4.2 Exchange Rate Regimes and Currency Markets

Exchange rate regimes shape how currencies interact globally. Fixed, floating, and managed systems each have unique features, impacting trade, investment, and economic stability. Central banks play a crucial role in managing these systems through various tools and strategies.

The choice of regime involves trade-offs between stability and flexibility. Factors like interest rates, inflation, and economic growth influence exchange rates. Central banks use interventions, monetary policy, and international cooperation to navigate these complex currency dynamics.

Exchange Rate Regimes

Types of exchange rate regimes

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• Fixed exchange rate regime
  • Pegs the exchange rate to another currency or a basket of currencies
  • Requires central bank intervention to maintain the fixed rate by buying or selling foreign currency reserves
  • Provides examples such as currency board system (Hong Kong), dollarization (Ecuador), and monetary union (Eurozone)
• Floating exchange rate regime
  • Allows the exchange rate to be determined by market forces of supply and demand
  • Involves minimal central bank intervention in the foreign exchange market
  • Includes examples like free float (United States) and clean float (Japan)
• Managed exchange rate regime
  • Combines elements of fixed and floating regimes
  • Enables the central bank to allow some exchange rate flexibility while intervening to keep it within a desired range
  • Offers examples such as crawling peg (China), dirty float (Singapore), and target zone arrangement (Denmark)

Determinants of exchange rates

• Interest rates
  • Attract foreign capital when higher, increasing demand for the domestic currency and causing appreciation
• Inflation rates
  • Reduce the purchasing power of a currency when higher, leading to depreciation
• Economic growth and stability
  • Boost confidence in a currency when stronger, resulting in appreciation
• Political stability and government policies
  • Can lead to currency depreciation when there is instability or unfavorable policies
• Balance of payments
  • Affects currency value through current account surplus (more exports than imports) and capital account surplus (more capital inflows than outflows), both contributing to appreciation
• Speculation and market sentiment
  • Cause short-term exchange rate fluctuations based on speculative activities and market sentiment

Pros and cons of exchange regimes

• Fixed exchange rate regime
  • Advantages
    • Offers stability and predictability for international trade and investment
    • Helps control inflation by anchoring domestic prices to a stable foreign currency (U.S. dollar)
  • Disadvantages
    • Demands large foreign currency reserves to maintain the fixed rate
    • Constrains the central bank's ability to conduct independent monetary policy
    • Risks overvaluation or undervaluation of the currency if the fixed rate is not adjusted appropriately
• Floating exchange rate regime
  • Advantages
    • Facilitates automatic adjustment to economic shocks and imbalances
    • Allows the central bank to conduct independent monetary policy
    • Lessens the need for large foreign currency reserves
  • Disadvantages
    • Introduces exchange rate volatility and uncertainty for international trade and investment
    • Exposes the currency to speculative attacks and currency crises (Asian Financial Crisis)
• Managed exchange rate regime
  • Advantages
    • Delivers some stability while permitting flexibility to adjust to economic conditions
    • Grants the central bank some control over the exchange rate
  • Disadvantages
    • Necessitates active and potentially costly intervention by the central bank
    • Challenges the central bank to maintain the desired exchange rate range when market pressures are strong

Central banks in currency management

• Intervention in foreign exchange markets
  • Involves central banks buying or selling foreign currencies to influence the exchange rate
  • Includes sterilized intervention, which offsets the impact on the domestic money supply, and non-sterilized intervention, which allows the intervention to affect the domestic money supply
• Monetary policy
  • Utilizes interest rate adjustments to influence capital flows and exchange rates, with higher rates attracting foreign capital and appreciating the currency, while lower rates discourage foreign capital and depreciate the currency
• Foreign currency reserves management
  • Requires maintaining adequate foreign currency reserves to support the exchange rate regime and intervene in the foreign exchange market when necessary
• Coordination with other central banks and international organizations
  • Involves collaborating with other central banks to address global economic imbalances and currency instability, as well as participating in international forums like the G20 and the International Monetary Fund (IMF) to promote global financial stability