Lesson 5 of 9 · All lessons in this module
- The FX market: functions and participants
- Reading exchange rate quotes
- Percentage changes in exchange rates
- Nominal and real exchange ratesVideo lesson
- Why no currency regime is ideal
- The menu of exchange rate regimes
- Exchange rates, the trade balance and capital flows
- Capital restrictions
- Integrated cases: reading an FX and capital-flow brief
Lesson 5 of 9 · 12 min
Why no currency regime is ideal
No country can have credibly fixed exchange rates, full convertibility and independent monetary policy all at once, and the history of currency systems is a series of choices between those goals.
In short
- The ideal regime would combine credibly fixed rates, full convertibility and independent monetary policy. The three are inconsistent.
- With a fixed rate and free capital, a rate cut triggers outflows; defending the peg drains reserves and money until rates return: monetary policy is powerless.
- With a floating rate, a rate cut weakens the currency, which boosts net exports and reinforces the policy.
- The more a rate floats and the tighter convertibility is controlled, the more effective domestic monetary policy, at the cost of FX risk and capital misallocation.
- History: gold standard → Bretton Woods fixed but adjustable parities → floating from 1973 → European ERM → the euro (1999).
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