Float

A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime
wherein a currency's value is allowed to fluctuate according to the foreign exchange
market. A currency that uses a floating exchange rate is known as a floating currency. It
is not possible for a developing country to maintain the stability in the rate of exchange
for its currency in the exchange market.

There are economists who think that, in most circumstances, floating exchange rates are
preferable to fixed exchange rates. As floating exchange rates automatically adjust, they
enable a country to dampen the impact of shocks and foreign business cycles, and to
preempt the possibility of having a balance of payments crisis. However, in certain
situations, fixed exchange rates may be preferable for their greater stability and certainty.
This may not necessarily be true, considering the results of countries that attempt to keep
the prices of their currency "strong" or "high" relative to others, such as the UK or the
Southeast Asia countries before the Asian currency crisis. The debate of making a choice
between fixed and floating exchange rate regimes is set forth by the Mundell-Fleming
model, which argues that an economy cannot simultaneously maintain a fixed exchange
rate, free capital movement, and an independent monetary policy. It can choose any two
for control, and leave third to the market forces.

In cases of extreme appreciation or depreciation, a central bank will normally intervene to

stabilize the currency. Thus, the exchange rate regimes of floating currencies may more
technically be known as a managed float. A central bank might, for instance, allow a
currency price to float freely between an upper and lower bound, a price "ceiling" and
"floor". Management by the central bank may take the form of buying or selling large lots
in order to provide price support or resistance, or, in the case of some national currencies,
there may be legal penalties for trading outside these bounds.

Fear of floating

A free floating exchange rate increases foreign exchange volatility. There are economists
who think that this could cause serious problems, especially in emerging economies.
These economies have a financial sector with one or more of following conditions:

• high liability dollarization

• financial fragility
• strong balance sheet effects

When liabilities are denominated in foreign currencies while assets are in the local
currency, unexpected depreciations of the exchange rate deteriorate bank and corporate
balance sheets and threaten the stability of the domestic financial system.

For this reason emerging countries appear to face greater fear of floating, as they have
much smaller variations of the nominal exchange rate, yet face bigger shocks and interest
rate and reserve movements.[1] This is the consequence of frequent free floating countries'
reaction to exchange rate movements with monetary policy and/or intervention in the
foreign exchange market.

The number of countries that present fear of floating increased significantly during the
nineties.[2]

Pegged float

Here, the currency is pegged to some band or value, either fixed or periodically adjusted.
Pegged floats are:

• Crawling bands: the rate is allowed to fluctuate in a band around a central value,
which is adjusted periodically. This is done at a preannounced rate or in a
controlled way following economic indicators.
• Crawling pegs: Here, the rate itself is fixed, and adjusted as above.
• Pegged with horizontal bands: The currency is allowed to fluctuate in a fixed
band (bigger than 1%) around a central rate.

Fixed

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange
rate regime wherein a currency's value is matched to the value of another single currency
or to a basket of other currencies, or to another measure of value, such as gold.

A fixed exchange rate is usually used to stabilize the value of a currency against the
currency it is pegged to. This makes trade and investments between the two countries
easier and more predictable, and is especially useful for small economies where external
trade forms a large part of their GDP.

It can also be used as a means to control inflation. However, as the reference value rises
and falls, so does the currency pegged to it. In addition, according to the Mundell-
Fleming model, with perfect capital mobility, a fixed exchange rate prevents a
government from using domestic monetary policy in order to achieve macroeconomic
stability.

There are no major economic players that use a fixed exchange rate (except the countries
using the Euro and the Chinese Yuan). The currencies of the countries that now use the
euro are still existing (e.g. for old bonds). The rates of these currencies are fixed with
respect to the euro and to each other. The most recent such country to discontinue their
fixed exchange rate was the People's Republic of China[citation needed], which did so in July
2005.[1] However, as of September 2010, the fixed-exchange rate of the Chinese Yuan has
only increased 1.5% in the last 3 months. [2]
Maintenance

Typically, a government wanting to maintain a fixed exchange rate does so by either

buying or selling its own currency on the open market. This is one reason governments
maintain reserves of foreign currencies. If the exchange rate drifts too far below the
desired rate, the government buys its own currency in the market using its reserves. This
places greater demand on the market and pushes up the price of the currency. If the
exchange rate drifts too far above the desired rate, the government sells its own currency,
thus increasing its foreign reserves.

Another, less used means of maintaining a fixed exchange rate is by simply making it
illegal to trade currency at any other rate. This is difficult to enforce and often leads to a
black market in foreign currency. Nonetheless, some countries are highly successful at
using this method due to government monopolies over all money conversion. This was
the method employed by the Chinese government to maintain a currency peg or tightly
banded float against the US dollar. Throughout the 1990s, China was highly successful at
maintaining a currency peg using a government monopoly over all currency conversion
between the yuan and other currencies.[3][4]

Criticisms

The main criticism of a fixed exchange rate is that flexible exchange rates serve to
automatically adjust the balance of trade.[5] When a trade deficit occurs, there will be
increased demand for the foreign (rather than domestic) currency which will push up the
price of the foreign currency in terms of the domestic currency. That in turn makes the
price of foreign goods less attractive to the domestic market and thus pushes down the
trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur.

Government also has to invest many resources in getting the foreign reserves to pile up in
order to defend the pegged exchange rate. Moreover a government, when having a fixed
rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free
hand. For instance, by using reflationary tools to set the economy rolling (by decreasing
taxes and injecting more money in the market), the government risks running into a trade
deficit. This might occur as the purchasing power of a common household increases
along with inflation, thus making imports relatively cheaper.

Additionally, the stubbornness of a government in defending a fixed exchange rate when

in a trade deficit will force it to use deflationary measures (increased taxation and
reduced availability of money) which can lead to unemployment. Finally, other countries
with a fixed exchange rate can also retaliate in response to a certain country using the
currency of theirs in defending their exchange rate.

Fixed exchange rate regime versus capital control

The belief that the fixed exchange rate regime brings with it stability is only partly true,
since speculative attacks tend to target currencies with fixed exchange rate regimes, and
in fact, the stability of the economic system is maintained mainly through capital control.
A fixed exchange rate regime should be viewed as a tool in capital control.

For instance, China has allowed free exchange for current account transactions since
December 1, 1996. Of more than 40 categories of capital account, about 20 of them are
convertible. These convertible accounts are mainly related to foreign direct investment.
Because of capital control, even the renminbi is not under the managed floating exchange
rate regime, but free to float, and so it is somewhat unnecessary for foreigners to
purchase renminbi.

Currency board

A currency board is a monetary authority which is required to maintain a fixed

exchange rate with a foreign currency. This policy objective requires the conventional
objectives of a central bank to be subordinated to the exchange rate target.

Features of "orthodox" currency boards

The main qualities of an orthodox currency board are:

• A currency board's foreign currency reserves must be sufficient to ensure that all
holders of its notes and coins (and all banks creditor of a Reserve Account at the
currency board) can convert them into the reserve currency (usually 110–115% of
the monetary base M0).
• A currency board maintains absolute, unlimited convertibility between its notes
and coins and the currency against which they are pegged (the anchor currency),
at a fixed rate of exchange, with no restrictions on current-account or capital-
account transactions.
• A currency board only earns profit from interests on foreign reserves (less the
expense of note-issuing), and does not engage in forward-exchange transactions.
These foreign reserves exist (1) because local notes have been issued in exchange,
or (2) because commercial banks must by regulation deposit a minimum reserve
at the Currency Board. (1) generates a seignorage revenue. (2) is the revenue on
minimum reserves (revenue of investment activities less cost of minimum
reserves remuneration)
• A currency board has no discretionary powers to effect monetary policy and does
not lend to the government. Governments cannot print money, and can only tax or
borrow to meet their spending commitments.
• A currency board does not act as a lender of last resort to commercial banks, and
does not regulate reserve requirements.
• A currency board does not attempt to manipulate interest rates by establishing a
discount rate like a central bank. The peg with the foreign currency tends to keep
interest rates and inflation very closely aligned to those in the country against
whose currency the peg is fixed.
Consequences of adopting a fixed exchange rate as prime target

The currency board in question will no longer issue fiat money but instead will only issue
one unit of local currency for each unit (or decided amount) of foreign currency it has in
its vault (often a hard currency such as the U.S. dollar or the euro). The surplus on the
balance of payments of that country is reflected by higher deposits local banks hold at the
central bank as well as (initially) higher deposits of the (net) exporting firms at their local
banks. The growth of the domestic money supply can now be coupled to the additional
deposits of the banks at the central bank that equals additional hard foreign exchange
reserves in the hands of the central bank.

Pros and cons

The virtue of this system is that questions of currency stability no longer apply. The
drawbacks are that the country no longer has the ability to set monetary policy according
to other domestic considerations, and that the fixed exchange rate will, to a large extent,
also fix a country's terms of trade, irrespective of economic differences between it and its
trading partners. Typically, currency boards have advantages for small, open economies
which would find independent monetary policy difficult to sustain. They can also form a
credible commitment to low inflation.

Examples in recent history

Worldwide use of the U.S. dollar and the euro: United States External adopters of the
US dollar Currencies pegged to the US dollar Currencies pegged to the US dollar w/
narrow band Eurozone External adopters of the euro Currencies pegged to the euro
Currencies pegged to the euro w/ narrow band Note that the Belarusian ruble is pegged to the Euro,
Russian Ruble and U.S. Dollar in a currency basket.

Worldwide official use of foreign currency or pegs: U.S. dollar users, including the
United States Currencies pegged to the US dollar Euro users, including the Eurozone
 Currencies pegged to the Euro
Australian dollar users, including Australia New Zealand dollar users, including New
Zealand South African rand users (CMA, including South Africa Indian rupee users and
pegs, including India Pound sterling users and pegs, including the United Kingdom
Special Drawing Rights or other currency basket pegs Three cases of a country using or
pegging the currency of a neighboor

Hong Kong operates a currency board (Hong Kong Monetary Authority), as do Bulgaria
and Lithuania. Estonia established a currency board pegged to the Deutsche Mark in 1992
after gaining independence, and this policy is seen as a mainstay of that country's
subsequent economic success (see Economy of Estonia for a detailed description of the
Estonian currency board). Argentina abandoned its currency board in January 2002 after
a severe recession. To some, this emphasised the fact that currency boards are not
irrevocable, and hence may be abandoned in the face of speculation by foreign exchange
traders. However, Argentina's system was not an orthodox currency board, as it did not
strictly follow currency board rules - a fact which many see as the true cause of its
collapse. Others argue that Argentina's monetary system was an inconsistent mixture of
currency board and central banking elements. They think misunderstanding of the
workings of the system by economists and policymakers contributed to the Argentine
government's decision to devalue the peso in January 2002. The economy fell deeper into
depression before a recovery began later in the year.[1]

The British Overseas Territories of Gibraltar, the Falkland Islands and St. Helena
continue to operate currency boards, backing their locally printed currency notes with
pound sterling reserves[2].

A gold standard is a special case of a currency board where the value of the national
currency is linked to the value of gold instead of a foreign currency.

Dollarization

Dollarization occurs when the inhabitants of a country use foreign currency in parallel to
or instead of the domestic currency. The term is not only applied to usage of the United
States dollar, but generally to the use of any foreign currency as the national currency.

Official dollarization has gained prominence as several countries have considered and
implemented it as official policy. The major advantage of dollarization is promoting
fiscal discipline and thus greater financial stability and lower inflation.

The biggest economies to have officially dollarized as of June 2002 are Panama (since
1904), Ecuador (since 2000), and El Salvador (since 2001). As of August 2005, the
United States dollar, the euro, the New Zealand dollar, the Swiss franc, the Indian rupee,
and the Australian dollar were the only currencies used by other countries for official
dollarization. In addition, the Turkish lira, the Israeli shekel, and the Russian ruble are
used by internationally unrecognised but de facto independent states.
Reasons

Dollarization can occur unofficially, when private agents prefer the foreign currency over
the domestic currency. They hold for example deposits in the foreign currency because of
a bad track record of the local currency; semiofficially (or officially bimonetary systems),
where foreign currency is legal tender, but plays a secondary role to domestic currency;
or officially, when a country ceases to issue the domestic currency and uses only foreign
currency. It adopts the foreign currency as legal tender.

U.S. dollar

• British Virgin Islands

• Cambodia (uses Cambodian Riel for many official transactions but most
businesses deal exclusively in dollars)
• East Timor (uses its own coins)
• Ecuador (uses its own coins in addition to U.S. coins)
• El Salvador
• Liberia
• Marshall Islands
• Federated States of Micronesia
• Palau
• Panama (uses its own coins)
• Turks and Caicos Islands
• Zimbabwe[1]

Euro
Main article: International status and usage of the euro

• Andorra (formerly French franc and Spanish peseta)

• Kosovo
• Monaco (formerly French franc; issues its own euro coins)
• Montenegro (formerly German mark and Yugoslav dinar)
• San Marino (formerly Italian lira; issues its own euro coins)
• Vatican City (formerly Italian lira; issues its own euro coins)

New Zealand dollar

• Cook Islands (issues its own coins and some notes)

• Niue
• Pitcairn Island
• Tokelau

Australian dollar

• Kiribati (issues its own coins)

 • Nauru
• Tuvalu (issues its own coins)

South African rand

Further information: Common Monetary Area

• Lesotho
• Namibia
• Swaziland

Zimbabwe

Due to the hyperinflation of the Zimbabwe dollar several currencies are used instead:

• British Pound Sterling

• Botswana pula
• Euro
• South African Rand
• United States Dollar

The US Dollar has been officially adopted for all transactions involving the new Power
Sharing Government.

Others

• Russian ruble: Abkhazia and South Ossetia (de facto independent states, but
recognized as part of Georgia by nearly all other states)
• Indian rupee: Bhutan and Nepal
• Swiss franc: Liechtenstein
• Israeli shekel: Palestinian territories
• Turkish lira: Turkish Republic of Northern Cyprus (de facto independent state,
but recognized as part of Cyprus by all states but Turkey)