Every country must choose how to manage its exchange rate, and the choice shapes its whole macroeconomic policy. This module lays out the spectrum of regimes, applies the trilemma to the choice, and — crucially — distinguishes what countries say they do from what they actually do, which are often very different things.
The spectrum
- Hard pegs — the currency is rigidly fixed or abolished: dollarisation (adopting a foreign currency outright, e.g. Zimbabwe's dollarisation episode), a currency board (local currency fully backed by foreign reserves at a fixed rate), or a monetary union (a shared currency, e.g. the CFA franc, the euro). Maximum credibility and stability, zero monetary independence.
- Soft pegs — the currency is fixed but adjustable: a conventional peg, a crawling peg (the peg is adjusted gradually, e.g. to offset inflation), or a band (the rate floats within a fixed range). Some stability, some flexibility, vulnerable to attack.
- Floating — the rate is market-determined: a managed float (the central bank intervenes to smooth or guide it — what most 'floaters' actually run, the fear-of-floating point) or a free float (rare; the rate moves with the market and the bank rarely intervenes).
The trilemma and the regime choice
The choice is governed by the trilemma (from the Monetary Policy course): a country can have at most two of {fixed exchange rate, free capital mobility, independent monetary policy}. A hard peg with open capital sacrifices monetary independence (you import the anchor country's monetary policy — the CFA zone imports the ECB's). A float with open capital keeps monetary independence at the cost of exchange-rate stability. A peg with monetary independence requires capital controls. So the regime choice is fundamentally a choice about which corner of the trilemma to give up, and it follows from what the country values most: credibility and stability (peg), monetary autonomy (float), or insulation from capital flows (controls). There is no free lunch — every regime trades something away.
De jure versus de facto
What countries say vs what they do (Reinhart-Rogoff)
The single most important empirical fact about exchange-rate regimes: declared regimes are often not the regimes countries actually operate. Reinhart and Rogoff (2004) built a 'natural classification' based on what exchange rates ACTUALLY did, not what governments announced, and found pervasive discrepancies — many declared 'floats' were de facto managed or pegged (fear of floating), and many declared 'pegs' were de facto crawling or broken. They also documented the prevalence of dual/parallel (black-market) exchange rates that official classifications ignore. The lesson, recurring throughout this specialization: classify a regime by behaviour (how much the rate and reserves actually move), not by the label. An analyst who takes a central bank's declared regime at face value will misread its policy — the de jure/de facto distinction of the Governance course, applied to exchange rates. Most African 'floats' are managed floats, and the true regime is revealed by the data.
Choosing a regime
Which regime suits an economy depends on its circumstances. Considerations: the optimum-currency-area criteria (module 7 — openness, trade integration, shock symmetry favour fixing to a partner); the source of shocks (if shocks are mainly nominal/monetary, a peg helps; if real, e.g. terms-of-trade swings, a float that can absorb them is better — a commodity exporter benefits from a float that depreciates when commodity prices fall); the credibility need (a country with a history of high inflation may peg to import credibility); the level of financial development and capital openness (the trilemma constraint); and the degree of liability dollarisation (heavy foreign-currency debt makes depreciation dangerous, biasing toward stability — fear of floating). For many African economies — open, commodity-dependent, with shallow markets, some dollarisation, and credibility still being built — the de facto answer is a managed float (some flexibility to absorb terms-of-trade shocks, but heavy intervention to limit the inflationary and balance-sheet costs of large moves), which is exactly what the Reinhart-Rogoff lens reveals most of them to run, whatever they call it.
Exercise
A commodity-exporting country with a history of moderate inflation, shallow financial markets, significant foreign-currency corporate debt, and an officially 'floating' exchange rate is reviewing its regime. Its currency in fact moves very little, and the central bank holds large reserves and intervenes frequently. (1) Classify its true regime using the de jure/de facto distinction. (2) Apply the trilemma to its situation. (3) Given that it's a commodity exporter, argue for more genuine flexibility — and then give the countervailing fear-of-floating argument. (4) Recommend a regime stance and justify it.