Question

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

Short answer

The difference between the four exchange rate systems is as follows: 1. Floating exchange rate: The value of a currency is determined by supply and demand in the foreign exchange market, with no central bank intervention. It provides flexibility in responding to economic changes (e.g., US dollar to euro exchange rate). 2. Soft peg: The currency's value can fluctuate within a certain range, but the central bank may intervene if it deviates too far from its target value. It offers a mix of flexibility and stability (e.g., Chinese yuan). 3. Hard peg: The currency's value is fixed to another currency, a basket of currencies, or a commodity, and the central bank maintains the fixed rate through intervention. It provides stability but reduces response to economic changes (e.g., Hong Kong dollar pegged to the US dollar). 4. Dollarization: A country adopts a foreign currency as its official legal tender, ensuring stability and reducing inflationary pressures but losing control over monetary policy (e.g., Ecuador adopting the US dollar).

Step-by-step solution

1. Floating Exchange Rate

A floating exchange rate, also known as a flexible exchange rate, is an exchange rate system in which the value of a currency is determined by the supply and demand of the currency in the foreign exchange market. With no central bank intervention, the currency can freely fluctuate in value against other currencies. This system allows for more flexibility in responding to changes in the economy and global market forces. For example, the US dollar to euro exchange rate fluctuates daily due to market forces and economic factors.

2. Soft Peg

A soft peg, also known as a managed float, is an exchange rate system in which a currency's value is generally allowed to fluctuate within a certain range, but the central bank may intervene to stabilize the currency if it moves too far from its target value. This system offers a mix of flexibility and stability, as it allows for some fluctuation but also prevents extreme changes in value that could hurt the economy. An example of a soft peg is the Chinese yuan, where the People's Bank of China intervenes if the currency value deviates too much from its target range.

3. Hard Peg

A hard peg is an exchange rate system in which a currency's value is fixed to another currency, a basket of currencies, or a commodity (such as gold). In this system, the central bank commits to maintain the fixed exchange rate by intervening in the foreign exchange market, buying or selling its own currency as needed. This system provides stability in exchange rates but reduces a country's ability to respond to economic changes and may require the central bank to maintain large reserves of foreign currency. An example of a hard peg is the currency board arrangement between Hong Kong and the US, in which the Hong Kong dollar is pegged 7.8 to the US dollar.

4. Dollarization

Dollarization occurs when a country decides to abandon its own currency and adopt a foreign currency (usually the US dollar) as its official legal tender. This system ensures stability in exchange rates and can reduce inflationary pressures in the adopting country, but it also means the country loses control over its monetary policy and has limited tools to respond to economic shocks. A prominent example of dollarization is Ecuador, which adopted the US dollar as its official currency in 2000 to combat hyperinflation and stabilize its economy.