In the previous chapter, we reviewed arguments for and against extreme exchange rate regimes. Under such regimes, whether they involve a currency board or a clean float with monetary targeting, the authorities have no need to make day-to-day decisions about how the exchange rate should be managed. All decisions about the exchange rate are made at the time that the regime is adopted. It may indeed be optimal for a country to adopt a regime of one of these types, and the last chapter reviewed some of the considerations involved in deciding whether to do so. But as we saw at the end of the last chapter, for many countries, the conditions that would make an extreme exchange rate regime appropriate are not likely to be met. When such a regime is not adopted, the exchange rate will have to be managed in some fashion, whether through intervention in the foreign exchange market or through using monetary policy to influence the exchange rate.

This chapter examines some basic principles of exchange rate management in such “intermediate” regimes. We will use as an organizing framework the assumption that a country maintains an exchange rate band, since all the exchange regime options available to an emerging economy can be thought of as variations on such a band. An exchange rate band essentially involves the announcement of a central parity for the domestic currency, together with fluctuation margins around that parity that commit the central bank to buy or sell the domestic currency in unlimited amounts whenever its value reaches previously specified lower or upper bounds.