Foreign Exchange Balance Policy

Foreign Exchange Balance Policy

1. Fixed exchange rate

   • The currency's value may fluctuate within a band (in the case of conventional 1% and intermediate 15%), be fixed by law (currency board) or directly adopt another currency but without right to decide anything (no separate legal tender).
     • By adopting a foreign currency (usually the dollar) a country can gain in credibility and even lower its inflation rate. It reinforces as well the commercial links and eliminates uncertainty, bringing new investors.
     • What is good for the country that has power over the currency may not be good for the adopters, shocks affect differently the countries. No possiblity of devaluate or appreciate the currency in response to shocks.

2. Flexible exchange rate

   • There may be intervention in the foreign exchange market in order to reduce the volatility of a currency exchange rate or it may be left completely free.
     • It allows the currency to have its real market value, allows the Central Bank to have an inflation target and to depreciate the currency if there is a need of improving the balance of payments.

3. The trilemma: incomptability between a fixed exchange rate, free capital flows and independent monetary policy