Exchange rate flexibility

A flexible exchange-rate system is a monetary system that allows the exchange rate to be determined by supply and demand.

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.

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.

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Wikipedia