A country can choose from a variety of exchange rate regimes. At one end of the spectrum, the currency floats freely, while at the other end it is pegged to another currency through a hard peg. Below we have divided this spectrum into two broad categories - floating and pegged - although within these categories finer distinctions can also be made.
Floating is a common type of exchange rate regime as it promotes macroeconomic stability, shielding the economy from shocks and allowing monetary policy to focus on targeting internal economic conditions. In a floating regime, exchange rates are usually determined by market forces of supply and demand for foreign currency. For many years, the floating exchange rate has been the regime used for major world currencies, namely the US dollar, the euro of the eurozone, the Japanese yen, and the British pound sterling.
In the long run, the theory of purchasing power parity states that floating bilateral exchange rates should be set at a level where goods and services cost the same amount in both countries, although this is hard to see in historical data. In the medium term, changes in the exchange rate reflect factors such as changes in interest rate differentials, international competitiveness, and relative economic prospects in each economy. Daily fluctuations in exchange rates may reflect speculation or news and events affecting the economies of the respective countries.
The floating option currency exchange can lead to more significant and frequent fluctuations of the currency compared to pegged regimes. In a free-floating regime, monetary authorities intervene to influence the exchange rate level only in rare cases when market conditions are disorderly. In contrast, some floating rate regimes are more managed, and monetary authorities intervene more frequently to limit exchange rate volatility.
Under a pegged regime (sometimes referred to as a fixed regime), the monetary authority pegs its official exchange rate to the currency of another country. In most cases, this will take the form of a target currency or a target range against the US dollar, euro, or a basket of currencies. The goal provides visible peg and currency stability, although the target may shift over time.
The monetary authority manages its exchange rate by intervening (buying and selling currency) in the foreign exchange market to minimize fluctuations and keep the currency close to the target (or within the target range). The pegged exchange rate regime limits the independence of monetary policy as it restricts the use of interest rates as a policy tool and requires monetary authorities to maintain significant reserves in foreign currency for intervention purposes.
Thus, exchange rate regimes can either float freely or be rigidly pegged, but in both ways, economic prospects for the country are visible.