Exchange rate regimes and the impossible trinity

An exchange rate regime is the rule that decides how a currency’s price is set. Pick a regime below and look at three things: who sets the rate, what the central bank does, and what is left of its monetary policy.

Some vocabulary, because examiners reuse it. A rate set by the market with no central bank intervention is flexible, also called floating. UOH 2014 asks which name fits a system with no intervention, and the key is that either does. A rate the government holds at a stated parity is fixed or pegged. When the government changes the parity it is a devaluation (the home currency is made cheaper) or a revaluation; when a market rate moves it is a depreciation or appreciation. A crawling peg is an automatic system for revising the rate in small steps, which UOH 2021 sets against a system of long constant periods punctuated by sharp devaluations. A currency union removes the rate between members altogether.

Even without a rate between them, two members of a currency union can have different real exchange rates, since the real rate depends on price levels as well as the nominal rate (JNU 2013). A regional inflation gap is a real appreciation for the dearer region, and it has no devaluation to undo it.

The regimes in use today are the result of three systems that broke. The timeline is short, and each step is the answer to at least one past-paper question.

Two of the questions are on how reserves were held. Under the gold exchange standard, foreign exchange reserves consist of gold plus convertible currencies (UOH 2013), which is what the Bretton Woods system did with the dollar. And between 1944 and 1971 the exchange rate between any two currencies was fixed within narrow boundaries (UOH 2015), unlike the period after, in which managed exchange rates have supported some restriction on fluctuations without fixing them (CUET 2020).

Suppose a currency is overvalued at its peg: at the fixed rate, people want to buy more foreign currency than others want to sell. The central bank has to fill the gap or the peg goes. The order of events is a UGC NET question, and the logic is a chain:

1. The fixed rate is lower than the market-clearing rate (the home currency is overvalued).
2. So the demand for foreign currency exceeds its supply.
3. The central bank sells foreign currency from its stock of reserves.
4. That closes the gap between supply and demand at the fixed rate.
5. But the bank’s stock of foreign currency is depleted.

That is B, A, E, C, D in the question, UGC NET Dec 2023. The last step is the weak point. If the pressure is temporary the bank can wait it out. If it persists, the reserves run down and the peg falls. Try it. The market is the one used on the exchange-rates page, where the rate clears at ₹80, and each year the demand for dollars grows by a little more.

With a shock of 6 a year and reserves of 100, the fixed rate holds until year 6, then jumps to ₹84.5. A float never runs out of anything, because it moves at once: ₹87.5 by year 10. A band is in between. The rate floats until it touches ₹84, and then the bank has to defend that edge, so by year 10 it has sold 80 and holds 20 (try 300 for reserves to see a defence that lasts).

Two lessons. A peg is only as strong as the reserves behind it relative to the pressure, and a shock that keeps growing beats any reserves. And the pain is not avoided by a peg; it is postponed, and arrives all at once. The speed of the fall is why governments dread a peg breaking.

The mirror image of defending a peg is holding one down during a capital inflow. Foreigners want the home currency, so it would rise. To stop it, the central bank buys foreign currency and pays in newly created home money. Look at the bank’s balance sheet. Its assets are net foreign assets (reserves) and domestic assets (bonds and loans); its liability is the monetary base. Buying foreign currency raises the first, and the base rises with it, so the money supply grows and the interest rate falls.

Sterilisation nullifies that effect on the money supply. The bank sells domestic bonds of the same value, which takes the new money back out. In the lab below, try both ends.

Unsterilised, buying 60 takes the base from 500 to 560. Fully sterilised, net foreign assets rise to 260, domestic assets fall to 240, and the base stays at 500. CUET 2023 asks for exactly this change: a rise in net foreign assets and a decline in domestic assets. A second CUET question tests the statement form. In an open economy, (A) sterilisation implies nullifying the impact of foreign-exchange transactions on the domestic money supply, and (B) in a sterilised intervention a purchase of foreign assets should be matched by a sale of domestic assets. Both are true. (C) is false, since a fixed rate with perfect capital mobility leaves no independent monetary policy, and (E) is false, since the real rate also moves with prices. So the key is A and B only.

Sterilisation is limited. It lets the bank keep its interest rate away from the world rate for a while, but it needs a supply of bonds to sell, it costs the bank the gap between what the bonds pay and what its foreign assets earn, and by keeping the home rate high it keeps attracting the inflow it is trying to stop.

Three goals look attractive together. A fixed exchange rate gives traders certainty. Free capital movement lets savings find the best use anywhere. An independent monetary policy lets the central bank fight home recessions and inflation. The trilemma says a country can hold any two, never all three. The proof is short, and it rests on the uncovered interest parity of the parity page.

The trilemma shows up in the effectiveness of policy. With free capital, the result of the Mundell-Fleming model (see the IS-LM-BP page) is a mirror:

Why does a floating rate help with monetary policy? Lower home rates cause a capital outflow, which depreciates the currency, which boosts exports. Under a fixed rate the same outflow forces the central bank to sell reserves and shrink the money supply back, undoing the cut.

Related, and asked twice by JNU, is the conflict of internal and external balance. Under a fixed rate, the goals can conflict: expansionary policy to cut unemployment lifts income, which raises imports and can open a trade deficit and a balance of payments problem (statements A and C of JNU 2019 are true; B is false). Greater flexibility eases that conflict, and means a recession abroad does not have contractionary effects at home, since the exchange rate absorbs it (JNU 2021, A and C). A more stable environment for trade and investment (B) is an argument for fixed rates, not flexible.

What a country gives up by sharing a currency, and when that is worth it, is the subject of the optimum currency area section of the integration page.

India’s own path, from a controlled rate to a market-determined one, is a short list of dates that the RBI records:

UOH 2015 asks what the rupee is. The answer, since August 1994, is fully convertible on the current account but not on capital account transactions. Current account convertibility means no restriction on buying foreign currency to pay for imports, services, travel or interest; capital account convertibility would mean the same for buying foreign assets. India has opened its capital account only part of the way. The rate itself is market-determined, with the RBI intervening, which is the managed float of the menu.

Facts on this page were read against these sources on 6 October 2026. India’s dates: the RBI chronology for 1991 to 2000 (July 1991 devaluation of about 18% against the dollar, LERMS in March 1992, a unified rate in March 1993, and rupee convertibility on the current account with acceptance of Article VIII in August 1994). Bretton Woods: Federal Reserve History (forty-four nations, $35 an ounce, lasted until 1971). The end of the par-value system in early 1973 and the Second Amendment: the IMF’s History 1972 to 1978. The SDR, created in 1969: IMF fact sheet. The euro: EU history, 1990 to 99. The first price of the model, ₹80 per dollar, is a stylised number, not a quotation.