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Understanding Exchange Rate Regimes

Understanding Exchange Rate Regimes

Almost every exchange rate regime has its flaws, virtues, and particularities. Since exchange rates in different currencies fluctuate due to the influence of market forces, some nations peg their currencies on other currencies. Others, still, have market-determined floating rate regimes. That said, exchange rate arrangements are mainly used by developing economies.

Floating Exchange Rate

Most medium-sized nations have successfully managed to maintain floating exchange rate regimes over long periods of time. Floating exchange rate regimes use the market forces to dictate their currencies’ exchange rates.

Pegged Currencies

The monetary systems of some nations, for example, China, use pegged exchange rate regimes. This means exchange rates are fixed to other currencies for a certain period of time. In the case of China, the yuan is pegged on the US dollar. The cornerstone of China’s economic policy is managing the yuan exchange rate to benefit its exports.

Dollarization

Dollarization refers to a case in which a foreign currency is used as legal tender in addition to or instead of the domestic currency. This is mostly the case for small (and sometimes unstable) countries such as Ecuador, El Salvador, the British Virgin Islands, and Zimbabwe, which use the U.S. dollar instead of their own currency. Other examples include Kosovo and Montenegro, which use the Euro without being part of the Eurozone.

Question

If the fluctuation of a country’s currency is exactly in tune with the US dollar because of central bank interventions, it would most likely be an example of:

A. dollarisation.

B. a pegged currency.

C. a floating exchange rate regime.

Solution

The correct answer is B.

If a country has it’s own currency and its fluctuation is in tune with the US dollar, then it’s an example of a currency that is pegged on the US dollar. China is a good case in point.

A is incorrect. Dollarization refers to a case in which a foreign currency is used as legal tender instead of the domestic currency.

 C is incorrect. Floating exchange rate regimes simply use the forces of the market to dictate their currencies’ exchange rates.

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