Exchange Rate Regimes: What Do Countries Do?

Participating in a currency union is a choice about an economy's exchange rate regime. The exchange rate is fixed -supposedly irrevocably, but of course never say never- and the old currency is abandoned for the crispy notes and shiny coins of a new one.

That's what the eurozone countries chose to do a while back, partly for economical and partly for political reasons.

As economists know, the decision of what exchange rate regime to adopt is not straightforward. It depends on a variety of factors, such as

• what kind of shocks tend to hit the economy 
• what effects the variability of exchange rates has on trade 
• to what extent the country's monetary policy is credible 
• what trading partners and competitors do 
• and so on.

In turn, this decision will determine the effectiveness of particular macroeconomic policies, among other things.

What is interesting is that sometimes countries say that they operate a different exchange rate regime than they actually do. This is the difference between the official de jure regime and the actual de facto one.

So, what do countries actually do?

It turns out that almost everyone intervenes in the foreign exchange market either to maintain a peg, or to prevent the currency from moving too much. For the period, 1998-2007, only 4% of observations fall in the freely floating category.

In the chart above I have used data on de facto exchange rate regimes from Ilzetzki, Reinhart and Rogoff (2008) to show the percentage of observations in their sample that falls in different regimes. They assign a value from 1 to 6 to different types of exchange rate regimes followed by governments:

1. No separate legal tender, Pre announced peg or currency board arrangement, Pre announced horizontal band that is narrower than or equal to +/-2%, De facto peg                       

2. Pre announced crawling peg, Pre announced crawling band that is narrower than or equal to +/-2%, De factor crawling peg, De facto crawling band that is narrower than or equal to +/-2%

3. Pre announced crawling band that is wider than or equal to +/-2%, De facto crawling band that is narrower than or equal to +/-5%, Moving band that is narrower than or equal to +/-2% (i.e., allows for both appreciation and  depreciation over time), Managed floating

                       

4. Freely floating           

           

5. Freely falling                       

6. Dual market in which parallel market data is missing.