Classification of exchange rate arrangements

1. Global Exchange Rate Arrangements
By
Mahir Mahtab Haque
ID: B17231042

2. What is Exchange Rate Regime?
• It is a system adopted by a country’s central bank to establish
the exchange rate of its own currency against other currencies.
• Each country is free to adopt the exchange-rate regime that it
considers optimal, and will do so using mostly monetary and
sometimes even fiscal policies.
• To determine the most appropriate exchange-rate regime for a
certain country is not a simple task as much will be at stake. A
country’s economy is hugely affected by this decision.
• The “impossible trinity”, also referred to as “trilemma”, states that
any exchange-rate regime will only have two of the following three
characteristics: free capital flow, fixed exchange rate regime &
sovereign monetary policy; thus, one is always left out.

3. Classification of Exchange Rate Arrangements
The figure shows the different regimes according to four different variables:
exchange rate flexibility, loss of monetary policy independence, anti-inflation
effect and credibility of the exchange rate commitment

4. Flexible Exchange Rates
Determined by
global demand &
supply of currency
Not pegged nor
controlled by
central banks
2 types
pure floating
regimes & managed
floating regimes
Milton Friedman
believed this exchange
rate would improve
global economy through
monetary independence
Robert Mundell and Marcus Fleming, as
demonstrated by the IS-LM-BOP
model, pointed out how hurtful fixed
exchange rates can be. All this relates to
the “impossible trinity” concept

5. Free Floating Exchange Rate
• Solely determined by market forces of demand
and supply of foreign and domestic currency
• Government intervention is totally nonexistent
Referred to as
clean/pure float
• Allows countries to retain their monetary
independence
• Controls inflation and unemployment without
having to worry about external aspects
Benefits
• External shocks can make it impossible to maintain a
purely clean floating exchange rate system
• Most developed countries maintain a managed float,
for some degree of support from their corresponding
central banks
Current
scenario
Countries: USA, Germany, France, UK, Japan, Canada, etc.

6. Managed Floating Exchange Rate
• Government/central bank may occasionally
intervene in order to direct the country’s
currency value into a certain direction
• Acts as a buffer against economic shocks and
hence soften its effect in the economy
Referred
to as Dirty
Float
• Mixture of a fixed & flexible exchange rate
• Can obtain the benefits of a free floating
system & still has the option to intervene and
minimize the risks associated with a free
floating currency
Benefits
Countries: Kenya, South Korea, Argentina, India, etc.

7. Crawling Peg
• A fixed par value of the currency which is frequently
revised and adjusted due to market factors
• A band of rates within which it is allowed to fluctuate
Defined by
2 main characteristics
•Currency is adjusted periodically in small amounts at a fixed
rate or in response to changes in selective quantitative
indicators, (past inflation differentials vis-à-vis major trading
partners, differentials between inflation target and expected
inflation in major trading partners)
According to IMF
• Crawling rate can be set in a backward-looking manner
(adjusting depending on inflation or other indicators),
or in a forward-looking manner (adjusting depending
on preannounced fixed rate and/or the projected
inflation)
Scopes
• Limits monetary policymaking, to a similar degree than for target zone
arrangements.
• These characteristics allow for progressive devaluation of the currency
which has a less traumatic effect in the country’s economy.
• This helps prevent, or at least soften, speculation over the currency.
Benefits
Countries: Nicaragua, Panama, Saudi Arabia (with US Dollar as anchor)

8. Target Zone
An agreed exchange rate system in which certain countries pledge to maintain their
currency exchange rate within a specific fluctuation margin or band. This margin can
be set vis-à-vis another currency, a cooperative arrangement (ERMII), or a basket of
currencies.
The spread of this
margin can however
vary, giving way to
Strong Version &
Weak Version.
Strong Version: Fluctuates
within margins of ±1% or less, and
is revised quite infrequently.
The monetary authority can
maintain the exchange rate within
margins through direct
intervention (purchasing and
selling domestic and foreign
currency in the market) or
through indirect intervention
(influencing on interest rates).
Weak Version: Fluctuates
more than ±1% around the fixed central
rate. Here, there is a limited degree of
monetary policy discretion.
Target zone arrangements can be seen as
being half way between fixed and flexible
exchange rates, this allows for relatively
stable trading conditions to prevail
between countries, and at the same time
allows some fluctuation in foreign
exchange rates depending on relative
economic conditions and trade flows .

9. Fixed Exchange Rate
Referred to as pegged exchanged rate
An exchange rate regime under which the currency of a
country is fixed, either to another country’s currency, a
basket of currencies or another measure of value, such as
gold
Central bank intervenes
in the foreign exchange
market and changes
interest ratesBrings stabilization to the real
economic activity as it
reduces volatility and
fluctuations in relative prices.
Also, eliminates the exchange
rate risk.
Monetary authority determines
the exchange rate and commits
itself to buy or sell the domestic
currency at that price
Main disadvantage is the
impossibility of adjusting
the balance of trade and the
need for governments to
have a foreign asset reserve
in order to defend the fixed
exchange rate

10. Currency Board
An exchange rate regime based on the full convertibility of a local currency into a
reserve one, by a fixed exchange rate and 100 percent coverage of the monetary
supply backed up with foreign currency reserves. Therefore, in the currency board
system there can be no fiduciary issuing of money.
To work properly, there has to be a long-term
commitment to the system and automatic
currency convertibility. This includes, but is not
limited to, a limitation on printing new money,
since this would affect the exchange rate.
Disadvantages include no monetary independence as monetary
policies will focus in maintaining the coverage of the reserve’s
monetary supply in detriment of other domestic
considerations.
The central bank will no longer act as a lender-of-last-resort,
and monetary policy will be strictly limited to that allowed by
the banking rules of the currency board arrangement.
Advantages include low inflation,
economic credibility, and lower
interest rates.
Countries: Hong Kong, Grenada, Dominica (with US Dollar as anchor)

11. No separate legal tender
Under an exchange arrangement
with no separate legal tender, “the
currency of another country
circulates as the sole legal tender, or
the member belongs to a monetary
or currency union in which the same
legal tender is shared by the
members of the union”.
Following this definition, we could
include every country in the Euro
zone.
The main implication for a country
to adopt an exchange arrangement
with no separate legal tender is that
it completely surrenders its control
over monetary policy. Therefore,
usually this regime is adopted by
governments that are considered as
non-reliable, substituting their
currency in favor of a currency of
another country considered to be
stable and with an effective
monetary policy.
Countries: Ecuador, El Salvador (with US Dollar as legal tender)

12. Monetary Union
•An exchange rate regime where two or more countries use the same
currency
•In some special cases there may also be a monetary union even if there is
more than a single currency, if the currencies have a fixed exchange
rate with each other. In that case, total and irreversible convertibility of the
currencies of those countries is required.
Also known as
currency union
• As explained by the impossible trilemma, in a monetary union there is exchange rate
stability and a full financial integration enjoyed among the countries in it, at the cost of
monetary independence.
• A common central bank should exist in order to coordinate the adequate monetary
policy to assure a correct functioning of the monetary union, independently from
national central banks,
Implications
•Disappearance of the uncertainty in the fluctuation of exchange rates,
lower transaction costs between countries, higher monetary stability
and inflation controlling by the national central bank.
Advantages
•Loss of monetary policy independence, the emergence of problems due to
the initial establishment of parities or the difficulties in establishing full
capital mobility.
Disadvantages

13. Thank You!