Introduction
Exchange-rate flexibility
A flexible exchange-rate system is a monetary system that allows
theexchange rate to be determined by supply and demand.[1]
Every currency area must decide what type of exchange rate arrangement
to maintain. Between permanently fixed and completely flexible however,
are heterogeneous approaches. They have different implications for the
extent to which national authorities participate in foreign exchange markets.
According to their degree of flexibility, post-Bretton Woods-exchange rate
regimes are arranged into three categories: currency unions, dollarized
regimes, currency boards and conventional currency pegs are described as
fixed-rate regimes; Horizontal bands, crawling pegs and crawling bands
are grouped into intermediate regimes; Managed and independent floats
are described as flexible regimes. All monetary regimes except for the
permanently fixed regime experience the time inconsistency problem and
exchange rate volatility, albeit to different degrees.
Fixed Rate Programs[
In a fixed exchange rate system, the monetary authority picks rates of
exchange with each other currency and commits to adjusting the money
supply, restricting exchange transactions and adjusting other variables to
ensure that the exchange rates do not move. All variations on fixed rates
reduce the time inconsistency problem and reduce exchange rate volatility,
albeit to different degrees.
Under dollarization/Euroization, the US dollar or the Euro acts as legal
tender in a different country. Dollarization is a summary description of the
use of foreign currency in its capacity to produce all types of money
services in the domestic economy. Monetary policy is delegated to the
anchor country. Under dollarization exchange rate movements cannot
buffer external shocks. The money supply in the dollarizing country is
limited to what it can earn via exports, borrow and receive from emigrant
remittances.
A currency board enables governments to manage their external credibility
problems and discipline their central banks by tying their hands with
binding arrangements. A currency board combines three elements: an
exchange rate that is fixed to another, anchor currency; automatic
convertibility or the right to exchange domestic currency at this fixed rate
whenever desired; and a long-term commitment to the system. A currency
board system can ultimately be credible only if central bank holds official
foreign exchange reserves sufficient to at least cover the entire monetary
base. Exchange rate movements cannot buffer external shocks.
A fixed peg system fixes the exchange rate against a single currency or a
currency basket. The time inconsistency problem is reduced through
commitment to a verifiable target. However, the availability of
a devaluation option provides a policy tool for handling large shocks. Its
potential drawbacks are that it provides a target for speculative attacks,
avoids exchange rate volatility, but not necessarily persistent
misalignments, does not by itself place hard constraints on monetary and
fiscal policy and that the credibility effect depends on accompanying
institutional measures and a visible record of accomplishment.
Monetary union
A currency or monetary union is a multi-country zone where a single
monetary policy prevails and inside which a single currency or multiple
substitutable currencies, move freely. A monetary union has common
monetary and fiscal policy to ensure control over the creation of money and
the size of government debts. It has a central management of the common
pool of foreign exchange reserves, external debts and exchange rate
policies. The monetary union has common regional monetary authority i.e.
common regional central bank, which is the sole issuer of economy wide
currency, in the case of a full currency union.
The monetary union eliminates the time inconsistency problem within the
zone and reduces real exchange rate volatility by requiring multinational
agreement on exchange rate and other monetary changes. The potential
drawbacks are that member countries suffering asymmetric shocks lose a
stabilization toolthe ability to adjust exchange rates. The cost depends on
the extent of asymmetric costs and the availability and effectiveness of
alternative adjustment tools.
Flexible exchange rate regimes[edit]
These systems do not particularly reduce time inconsistency problems nor
do they offer specific techniques for maintaining low exchange rate
volatility.
A crawling peg attempt to combine flexibility and stability using a rulebased system for gradually altering the currency's par value, [2] typically at a
predetermined rate or as a function of inflation differentials. A crawling peg
is similar to a fixed peg, however it can be adjusted based on clearly
defined rules.[3] Often used by (initially) high-inflation countries or
developing nations who peg to low inflation countries in attempt to avoid
currency appreciation.[4] At the margin a crawling peg provides a target for
speculative attacks. Among variants of fixed exchange rates, it imposes the
least restrictions, and may hence yield the smallest credibility benefits. The
credibility effect depends on accompanying institutional measures and
record of accomplishment.
Exchange rate bands allow markets to set rates within a specified range;
endpoints are defended through intervention. It provides a limited role for
exchange rate movements to counteract external shocks while partially
anchoring expectations. This system does not eliminate exchange rate
uncertainty and thus motivates development of exchange rate risk
management tools. On the margin a band is subject to speculative attacks.
It does not by itself place hard constraints on policy, and thus provides only
a limited solution to the time inconsistency problem. The credibility effect
depends on accompanying institutional measures, a record of
accomplishment and whether the band is firm or adjustable, secret or
public, band width and the strength of the intervention requirement.
Managed float exchange rates are determined in the foreign exchange
market. Authorities can and do intervene, but are not bound by any
intervention rule. Often accompanied by a separate nominal anchor, such
as inflation target. The arrangement provides a way to mix marketdetermined rates with stabilizing intervention in a non-rule-based system.
Its potential drawbacks are that it doesnt place hard constraints on
monetary and fiscal policy. It suffers from uncertainty from reduced
credibility, relying on the credibility of monetary authorities. It typically offers
limited transparency.
In a pure float, the exchange rate is determined in the market without public
sector intervention. Adjustments to shocks can take place through
exchange rate movements. It eliminates the requirement to hold large
reserves. However, this arrangement does not provide an expectations
anchor. The exchange rate regime itself does not imply any specific
restriction on monetary and fiscal policy.