What is an Exchange Rate Regime?
The exchange rate regime is the way in which a country controls how its currency relates to those of other countries. The most common types of exchange rate regime are floating, pegged and fixed rate. Each has its advantages and disadvantages in terms of a country's control over its own economy and its global financial position.
The most common exchange rate regime in developed countries today is the floating rate. In its purest form, this means the exchange rate between a country's currency and those of other countries is decided entirely by the free market. In reality, many countries have a policy of having their treasury or central bank buy and sell currency when it believes it is necessary to do so to avoid extreme fluctuations in the exchange rate which would otherwise be created by the free market. This policy is known as a managed or dirty float.
A variation on this exchange rate regime is the pegged float. This is where a country allows the market to determine the exact rate, but limits the movement to within a certain level above or below a fixed point. In most cases this fixed point is revised from time to time, which gives the government some control over the big picture movement of the currency. This has been used when a government wants to make significant changes to the exchange rate without doing so in one step or letting the free market make the adjustment too rapidly and causing the government to lose control.
Another exchange rate regime is the fixed or pegged rate. This is where the exchange rate does not float on the market and is instead fixed at a certain rate against one or more currencies or commodities. For example, a country might fix the rate so that its unit of currency is permanently worth two US dollars. This is usually only possible where a country has the ability to control trading in its currency.
The best known example of a fixed rate system was the Bretton Woods system. This was a scheme introduced after the Second World War by which the countries from the Allied side fixed their exchange rates so that each unit of currency was worth a set amount of gold. With the price of gold fixed, each participating country's currency was then also fixed against the dollar, giving them stability and protecting them against sudden increased or decreases in the worth of their money worldwide. The scheme ended in the early 1970s when the price of gold was allowed to float freely.
This article is the one which has helped me to know and understand the exchange rate regimes and background to the International Monetary System - The Gold Standard and the Bretton Woods Agreement.
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