Unit 7 Macroeconomic policy in the global economy
7.6 Fixed and flexible exchange rate regimes in practice around the world
Read Choosing an Exchange Rate Regime for the advice that the International Monetary Fund gives to countries on which exchange rate to choose.
Our three benchmark regimes are helpful for thinking about the wide range of exchange rate regimes we actually observe. We can compare regimes by comparing both the degree of ‘fixedness’ of exchange rates and the outcomes in terms of inflation and depreciation.
‘Dollarization’ and ‘euro-ization’
The eight countries are Ecuador, El Salvador, the Federated States of Micronesia, Marshall Islands, Palau, Panama, Timor-Leste, and Zimbabwe.
As a candidate for president of Argentina, Javier Milei (Section 7.1) proposed to formally ‘dollarize’ the Argentine economy, by abolishing the national currency, the peso, and replacing it with the US dollar. If dollarization were to proceed, Argentina would join a small group of eight countries which have legally adopted the US dollar as their currency. Similarly, four very small European economies that are not officially members of the eurozone nonetheless do not have their own currency, and simply use the euro (Andorra, Monaco, San Marino, and the Vatican City).
The only substantive difference is that the decision to join the eurozone is part of a treaty negotiation and is said to be ‘irrevocable’. This is not the case for a dollarized economy, in which the government could in principle introduce a new domestic currency at any time.
How different is a dollarized or ‘euro-ized’ economy from a country in a common currency area? In relation to monetary policy, the answer is: barely at all. In the eurozone, it is true that each national central bank has some say in collective decision-making of the ECB; whereas a dollarized or euro-ized economy simply has to accept the monetary policy that has been set for the US or eurozone. But in practice, a small country in the eurozone has very little influence on ECB decisions.
Fixed exchange rate regimes in practice
An important historical example of such regimes was the Bretton Woods agreement in the decades after the Second World War, in which a large number of countries agreed to maintain a fixed exchange rate against the US dollar, sometimes for decades at a time.
A common currency area is the most extreme case of a fixed exchange rate. In most fixed exchange rate regimes, as conventionally defined, individual countries continue to have their own currency but hold their exchange rates constant against either one, or sometimes multiple, currencies. This category covers a much larger share of the global population.
Normally we would only refer to a ‘fixed’ exchange rate as such if the government and central bank both commit to, and actually maintain a nominal exchange rate that is either completely fixed, or moves by only very small amounts.
Within a common currency, dollarized, or euro-ized area, it must be the case that any individual country completely gives up any autonomy in monetary policy. The power to set the policy interest rate is simply handed over to the central bank that controls monetary policy for the shared currency—whether it is the ECB or the Federal Reserve. This is also the case for a country that still has its own currency, and a central bank that controls it, but fixes its exchange rate. A good example is Denmark, which fixes its exchange rate to the euro.
The only real difference between a truly fixed exchange rate regime and a common currency is that, for as long as a separate currency exists, there is always the possibility that it will cease to be fixed. The extension to Section 7.10 shows that this difference can sometimes have quite important implications.
Example: The eurozone is (a lot) bigger than you thought
While the eurozone is the most prominent common currency area in the world, it is not the only one.
Strictly speaking, there are two currencies—the West African CFA franc and the Central African CFA franc—but they are, in practice, interchangeable.
Another, distinctly older, major common currency area is made up of the 14 African countries, with a combined population of over 200 million, which all use the same currency, the CFA franc.
Before that, for multiple decades (between 1948 and 1994), the CFA franc had a fixed value against the French franc, and even today the value of the CFA franc is effectively guaranteed by the French finance ministry. The explanation for this lies in the history of the countries using the CFA franc, which were mostly previously French colonies.
However, while the CFA franc officially circulates as a currency in its own right, in practice, the exchange rate of the CFA franc against the euro has been fixed at exactly €1 = 655.957, since the inception of the eurozone.
As a result, the CFA zone is euro-ized in practice. And, although not officially part of the common currency area, its monetary policy is determined by the ECB.
Therefore, the eurozone in effect contains 14 more countries, and roughly 200 million more people, than you thought. But unlike the members of the eurozone, these other countries have no influence at all on ECB monetary policy.
Figure 7.14 illustrates the feature that, when fixed exchange rates are truly fixed, as has been the case for the CFA franc, the outcome for inflation is indeed close to what you would expect in a common currency area. It compares the CPI inflation rate for Senegal, one of the members of the CFA common currency, with the CPI inflation rate of France, its former colonial power, since the beginning of the eurozone in 1999.
Figure 7.14 CPI inflation rates in Senegal and France (1999–2022).
Senegal is still a very poor country, with a GDP per capita (at purchasing power parity) only just over $4,000, compared to a figure for France of nearly $60,000. Its economy, and its consumers, are still highly dependent on local agricultural production. For this reason, it is not surprising that its CPI inflation is distinctly more volatile than France’s. But since 1999, its average inflation rate has been just under 2%—hence closer to the ECB’s target inflation rate than France’s figure of 1.6%. But the figures are strikingly similar.
If we go further back in time, to the period from 1963 to 1993 when the CFA franc maintained a constant fixed exchange rate against the French franc, rather than the euro, this provides another clear illustration. This was a period when French inflation was distinctly higher, averaging 7% per year. And the Senegalese inflation rate over the same period? Very similar, at 6.2%.
‘Managed’, ‘target’, and ‘shadow’ exchange rate regimes
A wide range of countries at least attempt, with greater or lesser degrees of success, to limit changes in exchange rates. Such regimes are referred to by different titles but have similar features.
We discussed one example in Figure 7.10. In the last five years before joining the euro, Spain, along with a number of other European countries (including the UK), followed a ‘shadow’ (or ‘target’) regime called the Exchange Rate Mechanism or ERM, by which they attempted to maintain their exchange rates within a relatively narrow range against the Deutsche Mark. For Spain, as Figure 7.10 shows, this was effectively a dry run for adopting the euro.
By virtue of having the option to let the exchange rate change, such countries retain at least some national monetary policy autonomy.
Take the case of a country that has fixed its exchange rate to the dollar for a number of years and where the US is one of its major export markets. Suppose that inflation in the home country has been higher than in the US over this period, causing a progressive loss of competitiveness for home producers. With factories closing and unemployment rising, home’s government decides that a more competitive exchange rate would help. To achieve this rapidly, it can take back temporary control of its monetary policy and allow the exchange rate to depreciate. It can then fix it at a ‘more competitive’ level against the dollar. This will only be successful if the government addresses the roots of its inflation (and competitiveness) problem.
There are also situations in which a country wants to manage its exchange rate to prevent the nominal exchange rate from appreciating. An important example of a country with a managed exchange rate is China. Between 1994 and 2005, the Chinese renminbi was fixed against a basket of currencies that was dominated by the US dollar. Had the renminbi exchange rate been flexible, the consensus view was that it would have appreciated against the dollar. The reason is that China became a major source of US imports during this period. The Chinese government sought to prevent the renminbi from appreciating relative to the US dollar in order to further encourage exports, especially in the manufacturing sector, and drive long-term economic growth. Since 2005, the exchange rate regime has become somewhat more flexible, but is still carefully managed.
Question 7.14 Choose the correct answer(s)
Read the following statements and choose the correct option(s).
- Monaco is an example of a euro-ized country, which has adopted the euro. It has not adopted the US dollar.
- The CFA franc is held constant against the euro at a rate of €1 = 655.957.
- The exchange rate of the Chinese renminbi to the US dollar is not completely flexible, nor is it held completely fixed. It is an example of a managed exchange rate.
- This has been true since the euro was introduced, and previously, when the CFA franc maintained a constant fixed exchange rate against the French franc.
Exchange rate regimes across the world
Figure 7.15 summarizes the wide range of exchange rate regimes around the world, in pie charts that show shares of the global population living in different regimes.
The pie charts divide up the world using two different approaches. The first shows population shares living in different countries, classified by the way the exchange rate regime is described by the IMF. The second approach focuses on outcomes: namely how much the exchange rate has actually changed (or not changed) against the benchmark of either the dollar or the euro (depending on which is most relevant) in the period 2017–2022.
In each case, working clockwise around the pie corresponds to an increase in national monetary policy independence, starting from the benchmark case of members of a currency union, which have no control over monetary policy at all.
Figure 7.15 Exchange rate regimes and national monetary policy autonomy across the world.
Countries without national monetary policy autonomy
Countries with fixed exchange rate commitments
Countries with crawling or managed pegs
Countries with floating exchange rates
Countries with no change in the nominal exchange rate (2017–2022)
Countries with slight changes in the nominal exchange rate (2017–2022)
Countries with modest changes in the nominal exchange rate (2017–2022)
Countries with changes of 2–5% in the nominal exchange rate (2017–2022)
Countries with large changes in the nominal exchange rate (2017–2022)
The key messages from Figure 7.15 are:
- Approximately half of the world’s population lives in countries with exchange rates that are either fixed (sometimes irrevocably) or systematically managed.
- The outcome of these controls meant that just under half of the world’s population live in countries where, over the five years to 2022, the exchange rate changed by less than 1% per year against either the dollar or the euro.
- This group of countries either entirely gave up any national control over monetary policy (as in the eurozone) or it was tightly constrained.
- The remainder of the world’s population lives in countries with a flexible exchange rate. But within this group, there are important contrasts.
- Only around one quarter of the world’s population currently live in countries where monetary policy roughly corresponds to the model of a FlexIT economy we set out in Unit 5. In this group of countries, independent central banks systematically (and largely successfully) pursue stable inflation targets, and changes in the exchange rate significantly increase the power of monetary policy.
- For just under a quarter of the world’s population, national control over monetary policy (and the flexible exchange rate that goes with it) has often been associated with poor macroeconomic performance. In these countries, the exchange rate is frequently both volatile, and has a strong tendency to a combination of rapid depreciation and high inflation.
Exercise 7.3 Exchange rate regimes
Choose a country that is not mentioned in Section 7.6 and find out which exchange rate regime it has (for example, check the central bank’s website). Then, find an example of a policy action that was taken (for example, in response to a macroeconomic shock) that demonstrates a commitment to this regime.
