An exchange-rate regime is the way an authority manages its currency in relation to 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.
The basic types are a floating exchange rate, where the market dictates movements in the exchange rate; a pegged float, where a central bank keeps the rate from deviating too far from a target band or value; and a fixed exchange rate, which ties the currency to another currency, mostly more widespread currencies such as the U.S. dollar or the euro or a basket of currencies.
Floating rates are the most common exchange rate regime today. For example, the dollar, euro, yen, and British pound all are floating currencies. However, since central banks frequently intervene to avoid excessive appreciation or depreciation, these regimes are often called managed float or a dirty float.
Pegged floating currencies are 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
- the rate itself is fixed, and adjusted as above.
- Pegged with horizontal bands
- the rate is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate.
Fixed rates are those that have direct convertibility towards another currency. In case of a separate currency, also known as a currency board arrangement, the domestic currency is backed one to one by foreign reserves. A pegged currency with very small bands (< 1%) and countries that have adopted another country's currency and abandoned its own also fall under this category.
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. Zimbabwe is an example of dollarization since the collapse of the Zimbabwean dollar.
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