Types of exchange-rate regimes:
Flexible (floating) exchange rate: A government allows market forces to determine the exchange rate. The value of a country’s currency fluctuates with the demand for and supply of the currency (Grieco and Ikenberry, 65).
How this regime functions: • If country A’s currency appreciates appreciates against country B’s currency (causing depreciation of country B’s currency), those in country A desire more goods from country B, where goods and services will be relatively cheaper. This increases the demand for country B’s currency and increases supply of country A’s currency. • Changes in taste, income, or investment returns are major reasons one country might suddenly change its supply of currency (residents are willing to offer more of their currency, increasing its abundance on the foreign exchange market).
Fixed (pegged) exchange rate: A government announces that the currency will trade at a government-specified rate against a key currency or group of currencies and intervenes to maintain those rates. They attempt to “maintain the integrity of the peg” (Grieco and Ikenberry, 67) by intervening in the currency market or changing the country’s fiscal, and especially monetary, policy (Grieco and Ikenberry, 65).
How this regime functions: • Devaluation: In the case of increased demand for a country’s currency, the government must meet this demand by exchanging its reserves with those willing to buy them. The government therefore builds up foreign currency holdings. • Revaluation: In the case of increased supply for a country’s currency, the government must use its reserves of foreign currency to buy up its own excess currency.
Why countries choose different regimes:
A country’s desire to appear attractive to foreign investors often affects its decision to implement a fixed-rate regime; if the government has a history of domestic price inflation, investors could drive down the currency’s value by selling it in reaction to any slight negative development in the country’s domestic economy. By fixing to a country with a low inflation rate, a country signals that it is “committed to achieving domestic price stability as a precondition to sustainable economic growth” (Grieco and Ikenberry, 68).
Sources: Grieco, Joseph M. and G. John Ikenberry. State Power and World Markets. New York: W.W. Norton and Company, 2003.