An exchange rate regime refers to the framework or system used by a country to determine the value of its currency in relation to other currencies. It defines the rules and mechanisms for setting and adjusting exchange rates. Exchange rate regimes can vary from fixed exchange rates, where the value of the currency is pegged to a specific foreign currency or a basket of currencies, to floating exchange rates, where the value of the currency is determined by market forces. Hybrid exchange rate regimes, such as managed floats or crawling pegs, combine elements of both fixed and floating systems.
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An exchange rate regime is a way a monetary authority of a country or currency union manages the currency about other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors, such as economic scale and openness, inflation rate, the elasticity of the labor market, financial market development, and capital mobility.
There are two major regime types:
- Floating (or flexible) exchange rate regime exist where exchange rates are determined solely by market forces and often manipulated by open-market operations. Countries do have the ability to influence their floating currency from activities such as buying/selling currency reserves, changing interest rates, and through foreign trade agreements.
- Fixed (or pegged) exchange rate regimes, exist when a country sets the value of its home currency directly proportional to the value of another currency or commodity. For years many currencies were fixed (or pegged) to gold. If the value of gold rose, the value of the currency fixed to gold would also rise. Today, many currencies are fixed (pegged) to floating currencies from major nations. Many countries have fixed their currency value to the U.S. dollar, the euro, or the British pound.
There are also intermediate exchange rate regimes that combine elements of the other regimes.
This classification of exchange rate regime is based on the classification method carried out by GGOW (Ghos, Guide, Ostry and Wolf, 1995, 1997), which combined the IMF de jure classification with the actual exchange behavior so as to differentiate between official and actual policies. The GGOW classification method is also known as the trichotomy method.