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Exchange Rate Regimes
(Backgrounder)

Finance Ministers and Central Bank Governors Meeting
Berlin, Germany, December 15 & 16, 1999

Why Are Exchange Rate Regimes Important?

A currency crisis can entail significant costs – not only for the country in which it originates, but also for the entire global economy. Recent emerging market financial crises and the general increase in international capital mobility have led to a re-evaluation of the role of exchange rate arrangements in reducing vulnerability to economic crises.

Background

Choices of exchange rate regimes include, in order of diminishing flexibility:

  1. flexible exchange rates, which fluctuate constantly in response to market forces;
  2. target bands, under which authorities intervene to keep the exchange rate within a pre-arranged range;
  3. crawling pegs, in which the exchange rate is regularly adjusted in the same direction by a pre-arranged amount;
  4. conventional pegs, in which the authorities intervene to keep the exchange rate at a pre-arranged level;
  5. currency boards, under which the only role of monetary policy is to keep the domestic currency’s value constant relative to a particular foreign currency; and
  6. monetary unions or dollarization. Under a monetary union, such as the European Monetary Union, several countries adopt a common currency. Dollarization involves one country unilaterally adopting the currency of another.

The circumstances of individual countries vary, and the choice of exchange rate regime will depend on a number of considerations.

"Intermediate" exchange rate regimes – those in between fully flexible rates and very rigid arrangements like currency boards or monetary unions – may be difficult to sustain in a world of large-scale capital flows, requiring at a minimum very large international reserves. Fixed rates require countries to direct their monetary policy exclusively to defending the exchange rate. This means that the tool of monetary policy is not available to them to promote domestic objectives such as economic growth and job creation.

During the last two years, a number of emerging market economies have moved from fixed to flexible exchange rates. One interpretation of this is that these countries place a high value on an ability to conduct an independent monetary policy.

At the same time, flexible exchange rates are sometimes prone to volatility. Moreover, the freedom to pursue an independent monetary policy can sometimes be abused. In this regard, fixing the exchange rate can allow a country to "borrow" monetary policy credibility from a low inflation partner.

A Role for the G20

G20 finance ministers and central bank governors will discuss the role of exchange rate arrangements in reducing countries’ vulnerability to economic crises.

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Source: Department of Finance, Canada


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