When a country decides on an exchange rate regime, it needs to take several important things in account. Unfortunately, there is no system that can achieve every possible beneficial outcome; there is a trade-off no matter what regime a nation picks. Below are a few considerations a country needs to make when choosing a regime.
Stage of Economic Development
A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies . Developing economies often have the majority of their liabilities denominated in other currencies instead of the local currency. Businesses and banks in these types of economies earn their revenue in the local currency but have to convert it to another currency to pay their debts. If there is an unexpected depreciation in the local currency's value, businesses and banks will find it much more difficult to settle their debts. This puts the entire economy's financial sector stability in danger.
Developing Countries
The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating exchange rate. This is because sudden depreciation in their currency value poses a significant threat to the stability of their economies.
Balance of Payments
Flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs in an economy with a floating exchange rate, there will be increased demand for the foreign (rather than domestic) currency which will increase the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and decreases the trade deficit. Under fixed exchange rates, this automatic re-balancing does not occur.
Monetary and Fiscal Policy
A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. In general, fixed-rates are not established by law, but are instead maintained through government intervention in the market. The government does this through the buying and selling of its reserves, adjusting its interest rates, and altering its fiscal policies. Because the government must commit its monetary and fiscal tools to maintaining the fixed rate of exchange, it cannot use these tools to address other macroeconomics conditions such as price level, employment, and recessions resulting from the business cycle.