By Al-Fassel | 2025-08-14

As Nobel laureate Joseph Stiglitz aptly stated, "Exchange rates are not just economic indicators; they are the price of a nation's relative economic health."

Nations stabilize currencies through central banks using three systems: fixed exchange rates, floating exchange rates, and managed float regimes.

Fixed Exchange Rate System

A fixed exchange rate regime establishes a direct peg between a country's currency and another major currency, or a basket of currencies.

Central banks commit to maintaining this exchange rate, often through buying or selling their foreign reserve currencies.

This regime offers stability and predictability in trade and investment, appealing to countries with histories of inflation or political instability.

However, maintaining a fixed exchange rate is not without its challenges.

Maintaining a pegged currency demands large foreign reserves to manage market shocks, causing economic strain if it diverges from market value.

Consequently, If the fixed rate is too high or low, central banks may revalue currency, causing sudden, destabilizing economic adjustments.

The Iraqi dinar (IQD) is an example of a currency that uses a fixed exchange rate system where $1 equals 1,310 IQD, according to the official exchange rate.

Floating Exchange Rate System

In a floating exchange rate system, the currency value is determined by market forces without direct intervention from the central bank.

This system lets exchange rates fluctuate freely based on supply and demand, responding effectively to changes in the economic environment.

For instance, if a country's economic outlook improves, the value of its currency may rise due to increased investor confidence.

The floating regime can offer greater flexibility and reduced pressure on central bank resources.

However, it can lead to increased volatility, complicating business planning and allowing speculation to influence currency values heavily.

This unpredictability can deter international trade and foreign investment, particularly if the exchange rates are subject to rapid shifts.

Managed Float Regime

The managed float regime, or (hybrid regime), combines elements of both fixed and floating exchange rate systems.

In this framework, the central bank permits currency fluctuations in the market, occasionally intervening to stabilize or influence the exchange rate.

This approach provides a balance between the stability of fixed rates and the responsiveness of floating rates.

Central banks may engage in interventions through currency purchases or sales to smooth out excessive volatility or to achieve specific economic objectives.

This flexibility allows countries to mitigate short-term shocks while maintaining broader economic control.

Nevertheless, it can also raise questions about the central bank's commitment to market forces, and excessive intervention can lead to market distortions.

Central banks select exchange rate systems based on economic objectives and conditions.

Understanding these systems is critical for policymakers, investors, and businesses navigating global finance.