Question

Discuss the key factors that need to be considered when choosing the appropriate exchange rate regime for a currency. Give examples of at least four different regimes chosen by countries and justify why that regime was chosen. [HINT: choose examples from the full range between fully fixed and fully floating exchange rates]

Answer 1

The ikey ifactors ithat ineed ito ibe iconsidered iwhen ichoosing ithe iappropriate iexchange irate iregime ifor ia icurrency iare:

• The iFiscal iPolicy iof ia iCountry: iThis ikey ifactor iintroduced iin ichoosing ia irate iof iexchange iis ia ifiscal ipolicy iof ia icountry. iIf ia icountry ichooses ito iuse ia ifixed irate iof iexchange, iit iadjusts iits iinterest irates iand ichange icertain ifiscal ipolicies. iIt ican ialso ibe isaid ithat ianother irate iof iexchange imay ibe ibetter ias ian ientity icannot iuse ithis itype iof iexchange iif iit iwants ito iaddress ieconomic iconditions, isuch ias iprice ilevel, ibusiness icycle irecessions, ior iemployment.
• The iBalance iof iTrade: iWhen iflexible iexchange irates iare iused iby icountry iit imaintain ito ibalance ithe itrade iin ia icountry ialong iwith ipayments ireceived. iIf ia ifloating iexchange irate iis iused iand ia itrade ideficit ioccurs ithen ia idemand iin iforeign icurrency iwill iincrease. iDue ito iincrease iin idemand iof iforeign icurrency ithat ilead ito iincrease iin ithe iprice iof iforeign icurrencies iwhen icompared ito ithe ilocal icurrency. iThis iresult ithat iforeign iproducts ibecome iless iattractive iin ithe ilocal imarketplace iwhich iimpacts ion ireducing ideficit. iIn icase iof iusing ifixed irate iof iexchange iwhere irebalancing idoes inot ihappen.
• Influence iof iCentral iBank ion iRates: iWhile iusing imanaged ifloat iregimes, iit ican ibe isaid ithat iit iis iused ito iconvert icurrencies. iThis ifactor iaffects ion ithe imodels iof iexchange iwhich ipermit ifluctuations iof iexchange irates iwith ithe iinfluence iof ia icentral ibank ior ibanking isector ithat isupported iby ithe ipurchase iand isales iof icurrencies. iFurther, ithe iworth iof icurrencies iare imanaged iby ithe iintervention iof igovernments ior icentral ibanks iof ia icountry iwhich iusually irefers ito ia imanaged ifloat.
• The iEconomic iDevelopment iStage iof ia iCountry: iThe iuse iof ithis iexchange irate idepends iupon ia istage iof iprogress ieconomically iof ia icountry. iIn icase iof ia ifree-floating itype iof irate iof iexchange iwhich iincreases ivolatility ithat ican ilead ito inegative iimpact ion ideveloping inations. iThe imoney ivalue iof imost iof ithe ideveloping ieconomies ihave imanaged ion ithe ibasis iof iother icountry’s icurrencies iinstead iof itheir ilocal icurrency. iThe idepreciation iof ilocal icurrency iwill ibe ichallenging ifor ia ibank ior ibusiness iin ia ideveloping icountry ito isettle iany icurrent iobligations.

The ifour idifferent iregimes ichosen iby icountries iwith ijustification ihave ibeen imentioned ibelow:

1. iExchange iRate iRegimes ifor iMajor iCurrencies i-

Prior ito ithe iintroduction iof ithe ieuro iin iJanuary i1999, i iexchange irates iregimes ifor imajor icurrencies iamong ithe imajor icurrencies isuch ias ithe iU.S. idollar, ithe iJapanese iyen iand ithe ideutsche imark iwere ipartnered icurrencies iin ithe iexchange irate imechanism iof ithe iEuropean iMonetary iSystem ithat ilead ito ithe icurrencies iof iother ilarge iindustrial icountries icurrencies ihave iexhibited isubstantial ishort-term ivolatility iin inominal iand ireal iterms. iTherefore, ithe ivolatility iconsidered ihigher ithan iit iwas iunder ithe iBretton iWoods isystem, imedium-term iswings ihave ibeen iquite ilarge i(i.e., iappreciation iof ithe idollar iand ithe iyen) iand ithese iswings iwidely iimpacted ion iexchange irates iwhich iwas irelated ito ieconomic ifundamentals. iFurther, ifor istabilization iin ithe iexchange irates iof imajor iindustrial icountries ibelieve ithat iexchange irates ialways ireflect ifundamentals iand ithat igovernments iand icentral ibanks ido inot ipossess iknowledge isuperior ito ithat iof ithe imarket iin isuch imatters, ito iproposals ifor ithe iintroduction iof ia isingle iworld icurrency. iThis iproposals iinclude itarget izones, ia iquasi-fixed iexchange irate iregime iamong ithe imajor icurrencies ito ibe iachieved iby imonetary ipolicy irules iaimed iat ithe iexchange irate ialong iwith ivarious ischemes ifor ipolicy icoordination.

2. iPegged iExchange iRate iRegimes iby iDeveloping iCountries i- i

It irefers ito ian iexplicit ior iimplicit icommitment iby ithe ipolicy iauthorities ito ilimit ithe iextent iof ifluctuation iof ithe iexchange irate ito ia idegree ithat iprovides ia imeaningful ifor iprivate iexpectations iabout ithe ibehavior iof ithe iexchange irate ifor isupporting imonetary ipolicy. iThe icurrency iborad iis ia ihardest iform iof ia ipegged iexchange irate iregime iwhere imonetary ipolicy iis ientirely isubordinated ito ithe iexchange irate iregime. iThis iimpact idirectly ion ithe iadjustments iin ithe ireal iexchange irate ithrough ichanges iin ithe inominal iexchange irate. iAccordingly, iadjustments ito ichanging iconditions imust ibe imade iby iother imeans, iincluding ithrough idomestic iprices iand icosts, iand ieconomic iactivity iand iemployment.

3. iExchange iRate iRegimes iof iMedium-Sized iIndustrial iCountries i-

The iexchange irate iregimes iof imedium-sized iindustrial icountries ihave isuccessfully imaintained ifloating iexchange irate iregimes isince ilong iperiod iof itime. iThese icountries iaccepted ithat irates iwill imove iregularly iand isometimes iquite isubstantially iin iresponse ito imarket iforces. iThese icountries iinitially iadopted ia ifloating iregime iand ithen ireturned ito ifloating ibefore iending iof ithe iBretton iWoods isystem. iSome icountries isuch ias iSwitzerland iand iAustralia iand iNew iZealand iwere idiversified itrade ipartners iwho iwere idependent ion icommodity iexports. iIn ithe iabsence iof ian iexchange irate ipeg, ithese icountries ihave ineeded ito iestablish itheir imonetary ipolicies ithrough ia icredible icommitment ito ilow iinflation, iwhich ibecame iinflation itarget ifor ithe icentral ibank.

4. iExchange iRate iArrangements iof iDeveloping iand iTransition iCountries i-

The iexchange irate iregimes iare iused iin idiversified ifor ideveloping iand itransition icountries iwhere ivery ihard icurrency ipegs iconvert iinto irelatively ifree ifloats iwith imany ivariations. iThis idefines ithe iview iof ithe iwide idifferences iamong ithese icountries ion ithe ibasis iof ieconomic iand ifinancial icircumstances. iTherefore, ithese icountries ihave iadapted ito iexpand iopportunities iarising ifrom ideeper iinvolvement iin ian iincreasingly iintegrated iglobal ieconomy iwhich ichanges iin itheir iown ieconomic isituations ithat ilead ito ishift itoward igreater iflexibility. iThe ireason ibehing iit ithat igross icapital iflows ito ideveloping icountries ihave irisen iconsiderably isince ithe iearly i1980s, iincreasing ithe ipotential ifor ilarge iand isudden ichanges iin inet iflows ithat iwould imake ipegged irates imore idifficult ito imaintain. iAdditionally, ithe iconsistency iwith ithe itrend itoward iglobalization, ipresently imany ideveloping ieconomies iare itrading iwith ia iwider irange iof ipartner icountries. iIt ican ibe isaid ithat ithe icountries iwho ihave isingle icurrency ipegs iare iexposed ito ithe iwide ifluctuations iamong imajor icurrencies.