Ideal Currency Regime

Ideal Currency Regime

	The three properties of an ideal currency regime are as follows:

	1. The exchange rate between two currencies would be fixed credibly thus eliminating the uncertainty associated with respect to the prices of goods and services as well as real and financial assets.

	2. Currencies are made to exchange freely irrespective of the amount, thereby making it fully convertible. This would ensure an unrestricted flow of capital.

	3. Every country would be allowed to formulate its own monetary policy independently along with the fulfillment of domestic objectives.

	The three properties specified for the ideal currency regime are inconsistent. This is because; if the first two properties are fulfilled then there would be only a single currency in the world. As a result, the exchange of currencies would be insignificant and in no way each country would be able to undertake independent monetary policy. Thus, the concept of ideal currency regime is impossible.

	Some of the main impacts of currency regime on a country's ability of exercising independent monitory policy can be understood as follows:
		In case of perfect capital mobility if the central bank of a country fixes the exchange rate credibly and attempts to reduce the default-free interest rates lower than that of other countries so as to follow an independent expansionary monetary policy then this would certainly result in unlimited outflow of capital - in search of higher returns. In order to maintain the fixed exchange rates the central bank will be compelled to sell the foreign currency and buy domestic currency, which in turn will put an upward pressure on the interest rates, thus spoiling every attempt of decreasing the default interest rates. Similarly, the effects of the contractionary policy would be in opposite direction thus forcing. A fixed exchange rate thus poses a hindrance to independent monetary policy.
		On the other hand, if the exchange rates are freely floating they will help the central bank in addressing domestic macroeconomic objectives as any attempt to reduce (increase) the interest rates will result in demand shift towards (against) the domestic goods, leading to an increase (decrease) in exports and thus reinforcing the expansionary (contractionary) objective.