Contrast the various currency regimes
The idea
Regimes run along a spectrum. At one end a country abandons its own currency or fixes it rigidly through a currency board, buying credibility at the cost of an independent monetary policy. In the middle sit conventional pegs and crawling bands, which defend a rate within limits and must hold reserves to do so. At the other end a floating rate is set by the market, leaving policy free to target domestic conditions while the exchange rate absorbs shocks. The trilemma explains the trade-off: free capital movement, a fixed rate and independent monetary policy cannot all be had at once.
A practice question
What is the main cost of a rigidly fixed exchange rate?
- Loss of independent monetary policy — correct
- Higher inflation by constructionWhy not: A credible peg to a low-inflation currency usually imports that lower inflation, which is often the reason for adopting one.
- The inability to trade internationallyWhy not: Fixed rates are frequently adopted to make trade easier by removing currency uncertainty.
Defending the peg means setting interest rates to maintain it rather than to suit domestic conditions. The benefit bought is certainty and imported credibility.
A harder one
Under a floating regime, what absorbs an external shock?
- Foreign exchange reservesWhy not: Reserves are spent defending a peg. Under a float there is no rate to defend.
- The exchange rate itself — correct
- Government spending, by mandateWhy not: No mandate ties fiscal policy to external shocks, and fiscal responses are slow and discretionary.
A floating currency adjusts, which cushions the domestic economy and leaves monetary policy free. A fixed regime must absorb the same shock through reserves or domestic adjustment instead.
The hardest tier
A country with free capital movement wants both a fixed rate and its own monetary policy. What happens?
- It succeeds if its reserves are large enoughWhy not: Reserves buy time, not a resolution. Capital flows can exceed any reserve stock once the gap is clear.
- The peg comes under pressure — correct
- Its inflation rate falls to zeroWhy not: Nothing in the arrangement drives inflation to zero, and the conflict described is about the exchange rate rather than prices.
Capital moves to exploit the gap between domestic rates and the fixed rate. The trilemma is not a preference but a constraint, and the market enforces it.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →