Exchange regimes: One hand, the other hand, both hands

There are three types of exchange rate regimes: fixed, floating and pegged.

Fixed exchange rate: A regime in which the value of a currency remains constant against other currencies. Under such a system, increases in the money supply must be backed by equal amounts of some tangible asset (like gold under the Bretton Woods fixed regime from the 1940s to 1970s). Such a regime allows government to manage exchange rates but puts monetary policy on autopilot, as the supply of money is determined by the balance of trade payments between countries.

Floating exchange rate: A regime in which a currency's exchange rate fluctuates according to market supply and demand and (hypothetically, at least) is free from intervention by governments or central banks. Such a regime requires a central bank or government to manage only the domestic money supply, while exchange rates are on "market autopilot."

Pegged exchange rate: A regime in which the government or central bank establishes an official "range" value for its currency and then attempts to maintain value by intervening in foreign exchange markets, buying and selling currency as necessary. Such a regime requires government to manage both exchange rates and money supply simultaneously.

Each regime has its pros and cons, though most experts dismiss the pegged system as unusable.

Previous to the current floating regime, the world was on a fixed exchange rate. Back in 1944, developed countries got together in Bretton Woods, N.H., to discuss the post-World War II economy. It was decided that the currencies of other countries would be fixed against the U.S. dollar, which itself held a fixed price for gold. For every dollar in circulation, the United States was required to back (warehouse, really) a proportional amount of gold.

This so-called Bretton Woods system held for nearly 30 years. A rapidly growing U.S. economy became attractive to foreign investors, and more dollars made their way overseas. In order to remain true to the fixed rate regime (which mandated that the supply of one currency remain stable against other currencies), foreign countries importing dollars had to similarly expand the supply of the home currency. In essence, foreign countries were importing inflation because the domestic money supply was growing without a reciprocal increase in demand for domestic output.

Recognizing this inflation trap, countries began to return dollars in exchange for the gold assets backing the dollar. The outflow of gold was so strong, and gold reserves so low, that President Richard Nixon closed the so-called gold window and took the United States—indeed, the world—off the gold standard.

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