3 prevalent ways to determine an exchange rate
Countries worldwide have dealt differently with determining the value of their local currencies. Here are 3 prevalent models.
 
 
 

What is currency floatation and how does it differ from currency management? Does a fully-fledged floatation mean leaving the exchange rate completely up to supply and demand without any state intervention?

We explain here the different ways of setting an exchange rate. Such methods encompass a wide spectrum of strategies, from standard government intervention in pegging an exchange rate, all the way to free floatation. We refer to the quarterly Finance and Development report and the Exchange Rate Regimes: Fix or Float? report, published by the International Monetary Fund in 2014.

Pegging the exchange rate

This means a local currency is anchored to a foreign one, and is permitted to increase or decrease along with its foreign counterpart in a free manner known as “full dollarization.” The state can also manage foreign currency reserves through what is known as a currency board, in a way that guarantees that their value will always equal the value circulating in the market.

When pegging an exchange rate, the state loses the independence of its monetary policies, as its rate is then determined through the changes in value of the anchor currency. Bank interest rates will be determined according to the changes in the anchor currency too. But this system guarantees a degree of security for international financial dealings because of its relative stability.

While Panama applies full dollarization, Hong Kong uses a currency board to manage its foreign reserves. According to International Monetary Fund statistics, the percentage of its 189 member states that anchored exchange rates between 2008 and 2014 increased from 12.2 to 13.3.

Fixing the exchange rate

This means that a local currency is fixed against an anchor currency or composite of currencies, such that the price of the local currency moves within a margin of 1 to 30 percent of the value of its foreign counterpart(s). This is determined by a management decision based on a reading of inflation rates, which indicate the local currency’s purchasing power.

Although this system determines a nominal value for a currency’s exchange rate to curtail inflation, it also allows for a limited degree of flexibility in monetary policies — especially in dealing with financial shocks. The IMF reports that this system is subject to financial shocks, which can lead to a violent decrease in the price of a local currency or the collapse of an entire exchange system.

Costa Rica, Hungary and China use this system. Egypt did too until 2003.  Between 2008 and 2014, the percentage of IMF member states using it increased from 39.9 to 43.5.

Free floatation of the exchange rate

Before devaluing the pound, Egypt adopted what is known as a managed floatation, which is different from a full-fledged floatation, only in the extent to which the Central Bank intervenes in the market. Before Thursday’s devaluation, the Central Bank continued to defend an official rate for the pound and imposed several restrictions to control the exchange market in the absence of a sufficient supply of foreign currencies and prevalence of black market dealings.

In the free floatation Egypt adopted on Thursday, these restrictions were removed in order to seek one price for the pound in the market. Floatation enthusiasts say forces of supply and demand are best able to set a realistic price.

In a free floatation system, the local currency is primarily but not exclusively subject to the mechanisms of supply and demand. Even in that system, there is a margin for state intervention through the Central Bank buying and selling foreign currency to control changes in the currency market in the short term. The rate of intervention differs from one state to another. In a small number of states, such as New Zealand, Sweden, Iceland and the USA, central banks do not intervene to determine the exchange rate except within the narrowest of limits.

The percentage of IMF member states using this system decreased from 39.9 to 34 between 2008 and 2014. The percentage of states adopting fully-fledged floatation, where only very limited intervention is allowed, also decreased in the same period from 19.5 to 12.2.

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