Question

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

Short answer

The difference between a floating exchange rate, a soft peg, a hard peg, and dollarization is as follows: - Floating exchange rate: The currency's value fluctuates according to market forces, such as the US Dollar, Euro, and Japanese Yen. - Soft peg: The currency's value is fixed to another currency or a basket of currencies within a narrow band, allowing for some flexibility. An example is China's Yuan. - Hard peg: The currency's value is fixed to another currency or a basket of currencies, and the central bank actively maintains the fixed rate, such as Hong Kong's Dollar pegged to the US Dollar. - Dollarization: A country adopts another country's currency as its official currency (official) or widely uses it alongside its domestic currency (unofficial), such as El Salvador adopting the US Dollar, and Zimbabwe's unofficial use of the US Dollar.

Step-by-step solution

Floating exchange rate

A floating exchange rate, also known as a flexible exchange rate, is a type of exchange rate regime where the value of a currency is determined by the foreign exchange market. It allows the currency's value to fluctuate according to supply and demand forces. Major currencies like the US Dollar, Euro, and Japanese Yen are examples of floating exchange rates.

Soft peg

A soft peg, also known as a crawling peg or adjustable peg, is an exchange rate regime where a currency's value is fixed to another currency or a basket of currencies, but it is allowed to fluctuate within a narrow band. This allows the country to have some degree of flexibility in its exchange rate policy while maintaining a stable exchange rate. For example, China's Yuan is currently under a soft peg system where the value of the currency is maintained within a certain range, set by the government, against a basket of currencies.

Hard peg

A hard peg, also known as a fixed exchange rate or currency board arrangement, is an exchange rate regime where a currency's value is fixed to another currency or a basket of currencies, and the central bank aims to maintain this fixed rate at all times. This means that the central bank intervenes in the foreign exchange market by buying or selling its own currency to keep its exchange rate constant. For example, Hong Kong's currency, the Hong Kong Dollar (HKD), is pegged to the US Dollar (USD) under a currency board arrangement.

Dollarization

Dollarization is a process where a country adopts the currency of another country, usually a more stable and internationally recognized one, as its official currency. This can happen either officially or unofficially. Official dollarization occurs when a government abandons its own currency and adopts the foreign currency as its legal tender. An example of this is El Salvador, which adopted the US Dollar as its official currency in 2001. Unofficial dollarization occurs when a foreign currency is widely used alongside the domestic currency for transactions, but it is not formally recognized as legal tender. This often happens in countries with high inflation or unstable currencies, such as Zimbabwe or Venezuela, where the population prefers to use stronger currencies like the US Dollar or the Euro for transactions.