Lecture Notes

Exchange Rate Regimes

Prof. Metin Ercan

Exchange Rate Regimes
A- Floating Regimes
i)Independent float
ii)Lightly managed float
B- Intermediate Targets
i)Managed float
ii)Crawling broadband
C- Soft Peg Regimes
i) Crawling narrow band
ii) Crawling peg
iii) Pegged within bands
iv) Fixed peg
D- Hard Peg Regimes
i) Currency board
ii) Currency union (dollarization)

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A. Floating Regimes
i. Independent Float
• Exchange rate determined freely by demand
and supply
• Monetary authority does not intervene
• Monetary policy is independent of the exchange
rate regime

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A. Floating Regimes (cont’d)
ii. Lightly Managed Float
• Exchange rate determined essentially freely
• Occassional intervention to moderate excessive
fluctuations.
• Monetary policy is largely free (discretion)

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A. Floating Regimes (cont’d)
Where applicable and appropriate

• Medium and large industrialised countries

+
• Some emerging market economies relatively
closed to international trade but fully integrated
in global capital markets
+
• Diversified production and trade + deep and
broad financial sector + strong prudential
standards

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A. Floating Regimes (cont’d)
Advantages
• Absorb adverse shocks
• Not prone to currency
crisis
• High international
reserves not required
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Disadvantages
• High short-term volatility
(excessive fluctuations
may be eased in rightly
managed float)
• High possibility of
misalignment
• Discretion in monetary
policy may create
inflationary bias
B. Intermediate Regimes
i. Managed Float
• Monetary authority actively intervenes without
specifying or precommitting
• Intervention may be direct (buying and selling)
or indirect (through changes in interest rate)
• Monetary policy relatively free

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B. Intermediate Regimes (cont’d)
ii. Crawling broadband
• Exchange rate maintained within a broad band
around a central rate which is adjusted
periodically at a fixed preannounced rate to
keep exchange rate competitive.
• Common adjustment: Forward looking crawl
(based on difference between target inflation
and expected inflation in major trading partners)
• Constraints on monetary policy

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B. Intermediate Regimes (cont’d)

Where applicable and appropriate

• Emerging market economies and some other
developing countries with relatively stronger
financial sector and track record for disciplined
macroeconomic policy

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B. Intermediate Regimes (cont’d)

Advantages Disadvantages

• Partial absorption of • Lack of transparency

adverse shocks (criterion is not disclosed)
• If the regime credible, • High international
maintain stability and reserves required
competitiveness
• Low vulnerability to
currency crisis if the band
is not tight

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C. Soft Peg Regimes
i. Crawling Narrow Band

• Exchange maintained within a narrow band

around a central rate
• Limited discretion for monetary policy

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C. Soft Peg Regimes (cont’d)
ii. Crawling Peg

• Exchange is adjusted periodically around a

preannounced fixed rate at or below projected inflation
differentials (remember the Turkish practice in 2000)
• Constraints on monetary policy

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C. Soft Peg Regimes (cont’d)
iii. Pegged Within Bands

• Exchange rate allowed to fluctuate within a narrow band

around a formal or de facto central fixed peg
• Limited degree of monetary policy discretion

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C. Soft Peg Regimes (cont’d)
iv. Fixed Peg

• Exchange is pegged at a fixed rate to a major

currency or basket of currencies.
• Monetary authority not committed to the peg
indefinitely
• Peg is adjusted (devaluation) when misalignment
becomes unsustainable
• Monetary policy discretion limited

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C. Soft Peg Regimes (cont’d)
Where applicable and appropriate

• Developing countries with limited links to global

financial markets + less diversified products +
export structure + shallow financial markets +
lack of monetary discipline + credibility
• In countries stabilizing from very high level of
inflation

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C. Soft Peg Regimes (cont’d)
Advantages
• If peg credible, maintain
stability and
competitiveness
• Lower interest rates
• Provide clean+easily
monitorable nominal
anchor
• High inflation countries
can reduce inflation by
moderating inflation
expectations
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Disadvantages
• Prone to currency crisis if
the country open to
international capital
markets
• Foreign debt is
encouraged
• High international
reserves required
• Little shock absorption
capacity (shocks largely
absorbed by real sector)
D. Hard Peg Regimes
i. Currency Board
• Strict exchange rate regime supported by
legislative committment
• Domestic currency is issued only against F/X
• Almost no scope for independent monetary
policy
Where applicable and appropriate
• Countries with history of monetary disorder,
high inflation, low credibility of policymakers in
need of strong anchor for monetary stability
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D. Hard Peg Regimes (cont’d)
ii. Currency Union (Dollarization)

• Another country’s currency used as the only

tender
• Monetary authority fully surrendered
• No scope for independent monetary policy
Where applicable and appropriate
• Countries that have already developed
extensive trade and other economic ties
(European Monetary Union)
• Small countries already integrated in larger
neighboring countries
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D. Hard Peg Regimes (cont’d)

Advantages Disadvantages

• Maximum credibility to • No role as a lender of last

economic policy resort
• Good for disinflation • Low seignorage for
program currency board
• Not prone to currency • No seignorage for
crisis dollarization
• Low transaction costs + • No shock absorption
low and stable interest capacity, shocks fully
rates absorbed by economic
• No inflationary bias due to activities
lack of monetary • Exiting from dollarization
discretion very difficult

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