2.3 Exchange rate regimes and their implications

Exchange rate regimes shape global finance, influencing trade, investment, and economic stability. From fixed to floating systems, each approach offers unique benefits and challenges. Understanding these regimes is crucial for grasping how currencies interact and impact international markets.

Central banks play a pivotal role in managing exchange rates, using tools like interventions and monetary policy. Their actions affect trade competitiveness, foreign investment, and overall economic health. Exploring these dynamics reveals the complex interplay between currencies and global economics.

Exchange Rate Regimes and Their Implications

Types of exchange rate regimes

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• Fixed exchange rate regime
  • Exchange rate pegged to another currency or basket of currencies maintains stability
  • Central bank intervenes buying or selling foreign currency to maintain fixed rate
  • Provides certainty for international trade and investment (Hong Kong dollar to US dollar, CFA franc to euro)
• Floating exchange rate regime
  • Exchange rate determined by market forces of supply and demand fluctuates freely
  • Minimal central bank intervention allows automatic adjustment to economic shocks
  • Offers monetary policy independence and flexibility (US dollar, euro, Japanese yen)
• Managed exchange rate regime (dirty float)
  • Combination of market forces and central bank intervention balances stability and flexibility
  • Exchange rate allowed to fluctuate within specified band provides limited flexibility
  • Central bank intervenes when rate moves beyond desired range maintains some control
  • Compromise between fixed and floating regimes (Singapore dollar, Chinese yuan)

Factors in exchange rate regime selection

• Economic structure
  • Size and openness of the economy influences vulnerability to external shocks
  • Degree of economic diversification affects ability to absorb currency fluctuations
• Political considerations
  • Desire for monetary policy independence shapes regime choice
  • Regional integration goals may favor fixed rates or currency unions
• External factors
  • International trade patterns impact currency demand and supply
  • Capital flows and financial market integration affect exchange rate stability
• Macroeconomic objectives
  • Inflation control may prioritize exchange rate stability
  • Economic stability goals influence regime choice
• Historical context
  • Past experiences with different regimes inform policy decisions
  • Currency crises or hyperinflation episodes shape risk perception

Exchange rates and international economics

• Trade competitiveness
  • Currency appreciation makes exports more expensive reduces competitiveness
  • Currency depreciation makes exports cheaper boosts competitiveness
• Foreign direct investment (FDI)
  • Exchange rate volatility may deter long-term investments increases uncertainty
  • Currency depreciation can attract foreign investors seeking cheaper assets
• Portfolio investments
  • Short-term capital flows influenced by expected currency movements cause volatility
  • Carry trade strategies based on interest rate differentials exploit rate differences
• Pricing strategies
  • Exchange rate pass-through to import prices affects domestic inflation
  • Firms decide on local currency pricing vs producer currency pricing impacts profit margins
• Trade balance
  • J-curve effect shows short-term worsening before long-term improvement after depreciation
  • Marshall-Lerner condition states sum of export and import elasticities > 1 for depreciation to improve trade balance

Central banks in exchange rate management

• Foreign exchange interventions
  • Direct market operations buying or selling foreign currency influence exchange rates
  • Verbal interventions signaling future policy intentions shape market expectations
• Monetary policy tools
  • Interest rate adjustments influence capital flows affect exchange rates
  • Open market operations manage liquidity impact currency value
• Reserve management
  • Maintaining adequate foreign exchange reserves ensures intervention capacity
  • Diversification of reserve assets reduces risk exposure
• Currency swap arrangements
  • Bilateral agreements between central banks provide emergency liquidity
  • Providing liquidity in times of market stress stabilizes exchange rates
• Macroprudential policies
  • Capital controls manage volatile short-term flows reduce exchange rate pressure
  • Regulations on foreign currency borrowing and lending mitigate currency mismatch risks
• International coordination
  • Participation in global financial institutions (IMF, BIS) enhances policy effectiveness
  • Coordinated interventions during crises amplify impact on exchange rates