What are the different exchange rate regimes and why do countries choose fixed vs. floating rates?

Exchange rate regimes sit on a spectrum from fully fixed to freely floating. Understanding the trade-offs is a core CFA Level I Economics concept.

The Spectrum of Regimes

1. Hard Peg (Currency Board / Dollarization)

• Country either adopts another currency entirely (dollarization, e.g., Ecuador uses USD) or maintains a currency board that guarantees conversion at a fixed rate (e.g., Hong Kong's 7.75–7.85 HKD/USD band)
• Advantage: Maximum exchange rate stability, very low inflation
• Cost: Complete loss of independent monetary policy

1. Conventional Fixed Peg

• Central bank sets a target rate and intervenes in FX markets to maintain it
• Example: Saudi Arabia pegs the riyal at 3.75 SAR/USD
• Requires large foreign exchange reserves

1. Crawling Peg

• The peg is adjusted periodically (often to account for inflation differentials)
• Provides some stability while allowing gradual adjustment

1. Managed Float

• No explicit target, but the central bank intervenes to smooth volatility or prevent excessive moves
• Many emerging markets operate this way (India, China until recently)

1. Free Float

• Exchange rate determined entirely by market forces
• USD, EUR, GBP, JPY, AUD all float freely (mostly)
• Central bank focuses monetary policy on domestic objectives

The Impossible Trinity (Trilemma)

A country cannot simultaneously have all three of:

1. Fixed exchange rate
2. Free capital flows
3. Independent monetary policy

It must give up one. This is the fundamental framework for understanding regime choice.

Example:

• US: Chooses free capital flows + independent monetary policy → must allow floating exchange rate
• Hong Kong: Chooses fixed rate + free capital flows → sacrifices independent monetary policy (must follow the Fed)
• China (historically): Chose fixed rate + independent monetary policy → restricted capital flows

When Fixed Pegs Break:

Hawkshire Capital (fictional) was long Thai baht in 1997 when Thailand's fixed peg broke. The government ran out of reserves trying to defend the peg while running a current account deficit. When the peg broke, the baht fell 40% in months — a classic speculative attack pattern.

CFA Exam Tip: If a vignette describes a country with a fixed exchange rate, large capital account openness, and rising inflation, expect questions about the trilemma — the country will either need to abandon the peg or restrict capital flows.

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