Chapter 15: Problem 21

What is the difference between a floating exchange rate, a soft peg, a hard peg, and dollarization?

Short Answer

Expert verified

The difference between a floating exchange rate, a soft peg, a hard peg, and dollarization lies in the level of government or central bank intervention in determining a currency's value. In a floating exchange rate system, the currency's value is determined by market forces without government intervention. A soft peg allows the currency to fluctuate within a predetermined range and may involve limited central bank intervention. A hard peg directly links a currency's value to another currency or a basket of currencies, with the central bank maintaining this fixed exchange rate. Dollarization involves a country abandoning its own currency and adopting a foreign currency as its official legal tender.

Step by step solution

1. Floating Exchange Rate System

A floating exchange rate system is a type of exchange rate regime in which a currency's value is determined by the foreign exchange market without any government or central bank intervention. The market forces of supply and demand dictate the exchange rate fluctuations against other currencies. Some examples of countries with floating exchange rate systems include the United States, Canada, and Japan.

2. Soft Peg

A soft peg exchange rate system, also known as a managed float or dirty float, lies between a floating exchange rate and a fixed exchange rate system. In a soft peg system, a currency's value is allowed to fluctuate within a narrow band or range, and the central bank or government may intervene in the foreign exchange market to maintain the currency value within this predetermined range. Examples of countries with soft peg exchange rate systems include China and Singapore.

3. Hard Peg

A hard peg exchange rate system is a type of fixed exchange rate regime where a currency's value is directly linked to another currency or a basket of currencies. The central bank or government maintains this fixed exchange rate by buying or selling its own currency in the foreign exchange market. Hard peg systems can take various forms, such as a currency board arrangement, where a country's central bank holds foreign currency reserves to back up the entire supply of the domestic currency. Examples of countries with hard peg exchange rate systems include Hong Kong (which pegs its currency to the US dollar) and Denmark (which pegs its currency to the euro).

4. Dollarization

Dollarization is an exchange rate system in which a country formally abandons its own currency and adopts the currency of another country, usually a more stable and internationally recognized currency like the US dollar or the euro. In a dollarized economy, the foreign currency becomes the official legal tender for all transactions. Dollarization can be either full, where the domestic currency is completely replaced, or partial, where the foreign currency is used alongside the domestic currency. Examples of fully dollarized countries include Panama and Ecuador, while countries like Cambodia and Zimbabwe have partially dollarized economies.

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