CFA Level I Exam · Capital Flows and the FX Market

Exchange Rate Regimes for CFA Level I

Updated 7 October 2026

An exchange rate regime is the system a country uses to set its currency's value. Regimes run from no own currency (dollarization) and currency boards, through fixed pegs, crawling pegs, target zones and managed floats, to independent floats. To solve questions, ask who controls the rate and how much monetary independence remains.

Understand Exchange Rate Regimes

A country must decide how its currency's price against others is set. The answer is its exchange rate regime. Think of a line. At one end the government gives up control and lets the market decide. At the other end it gives up its own currency entirely.

Start with the most rigid regimes. Formal dollarization means a country uses another country's currency as legal tender, such as the US dollar. It has no domestic currency and no monetary policy of its own, and it loses seigniorage (the profit from issuing money). A monetary union is similar: members share one currency, as in the euro area. A currency board keeps a domestic currency but commits to exchange it at a fixed rate for a foreign currency, and holds foreign reserves at least equal to the domestic money issued. The central bank cannot create money freely, so it cannot act as lender of last resort. A currency board can be abandoned, which is easier than leaving dollarization.

Next come the flexible-fixed middle regimes. In a conventional fixed peg, the country pegs to another currency or a basket and lets the rate move only within a narrow band, about ±1%, around the central rate. The central bank must buy or sell foreign exchange to defend it. In a target zone, the country lets the rate move within a wider band around the central rate, typically ±2% or more. Use the wording of the question: a narrow band of about ±1% around the peg points to a conventional peg, and a wider explicit band around a central rate points to a target zone. A crawling peg lets the peg change by small, pre-announced steps, for example to offset higher domestic inflation. A crawling band combines a band with a moving centre.

At the flexible end, a managed float lets the market set the rate, but the central bank intervenes at times without a stated target. An independent float lets the market determine the rate, and intervention is rare and only to calm disorderly markets.

The key trade-off: the more fixed the rate, the more the country gives up monetary policy independence, because it must keep interest rates and money supply consistent with the peg. A fixed rate gives stability and credibility for trade, but the country needs adequate reserves and can face speculative attacks. Floating rates absorb shocks and leave policy free, but can be volatile.

Key formulas to remember

Spectrum of regimes (most fixed to most flexible): Dollarization / monetary union → currency board → fixed peg → target zone / crawling peg → managed float → independent float; Learn this order. Exam items often ask which regime is more or less rigid than another.
Currency board backing rule: Foreign reserves ≥ domestic monetary base issued (at the fixed rate); Every unit of domestic currency is backed by foreign currency at the fixed rate.
Trade-off rule: More fixed rate → less monetary policy independence; more flexible → more independence, more rate volatility; This is the logic behind most conceptual questions.
Band deviation (simple helper): Deviation % = (market rate − central rate) ÷ central rate × 100; This is a simple helper, not a named curriculum formula. Use it to test whether a rate is inside a stated band.

How to solve Exchange Rate Regimes questions

Use this method for any regime question, whether it asks you to classify a regime or judge its effects.

1Read the stem for the clue: does the country have its own currency, a stated rate or band, a changing peg, or market determination?
2Place the regime on the spectrum from dollarization to independent float.
3If no domestic currency exists, choose dollarization or a monetary union. If the domestic currency is fully backed by foreign reserves at a fixed rate, choose currency board.
4If a rate is defended, use the wording of the stem to choose between a conventional fixed peg (the rate moves only within a narrow band of about ±1% around the peg) and a target zone (a wider band around the central rate, typically ±2% or more). If the peg moves in pre-announced steps, choose crawling peg.
5If the market sets the rate but the central bank sometimes intervenes with no target, choose managed float. If intervention is rare, choose independent float.
6Apply the trade-off: the more fixed the regime, the less monetary independence and the more need for reserves.
7Eliminate options that contradict the clue, then pick the best match.

Quickest way: Keyword matching on the rigidity ladder

When to use it: Use for conceptual classification questions where you have about 90 seconds.

Spot the keyword: 'another country's currency' = dollarization; 'backed by reserves' = currency board; 'narrow band (about ±1%)' around a peg = conventional fixed peg; 'target zone' or a wider explicit band (typically ±2% or more) around a central rate = target zone; 'pre-announced adjustments' = crawling peg; 'intervenes occasionally' = managed float.
Rank the regime on the ladder and decide whether the question asks about more or less independence.
Remember: fixed means low policy freedom, high credibility; floating means high freedom, more volatility.
Remove the two options that do not fit, and answer.

Common mistakes in Exchange Rate Regimes

Treating a currency board as the same as dollarization
Both fix the rate to a foreign currency and limit monetary policy.
Fix: A currency board keeps its own currency, backed by reserves. Dollarization has no domestic currency at all, so exit is harder.
Confusing a crawling peg with a managed float
Both involve a rate that moves over time.
Fix: A crawling peg moves by announced, rule-based steps. A managed float has no announced path; the market sets the rate with occasional intervention.
Saying a fixed peg keeps full monetary independence
Students focus on the central bank still existing.
Fix: To defend the peg, the central bank must set rates and money supply to match it. Independence is largely lost.
Thinking an independent float means the central bank never acts
'Independent' sounds absolute.
Fix: Intervention is possible but rare, and aims to calm disorderly markets rather than target a level.
Assuming a target zone is the same as a conventional fixed peg
Both use a defended central rate and a band.
Fix: A conventional peg allows only a narrow band of about ±1% around the central rate. A target zone allows a wider band around the central rate, typically ±2% or more.

Worked examples

Example 1

A country has its own currency, but the central bank may issue it only when it receives foreign currency, and it exchanges at a fixed rate with full reserve backing. Which regime is this? (A) Managed float (B) Crawling peg (C) Currency board

Show the solution

The country has its own currency, so it is not dollarization.
Issuing money only against foreign currency at a fixed rate with full backing is the definition of a currency board.
A managed float has no fixed rate, and a crawling peg adjusts in steps with no full-backing rule.
So A and B are eliminated.

Answer: C. Currency board.

Example 2

A country operates a target zone. Its central bank allows the currency to trade within a band of ±2% around a central rate of 1.2000 per USD. What are the lower and upper limits of the band? (A) 1.1760 to 1.2240 (B) 1.1800 to 1.2200 (C) 1.2000 to 1.2240

Show the solution

Band width: 2% × 1.2000 = 0.0240.
Lower limit: 1.2000 − 0.0240 = 1.1760. Upper limit: 1.2000 + 0.0240 = 1.2240.
Option B uses a band of 0.0200, which is about 1.67%, so it is wrong.
Option C starts at the central rate and covers only the upside, so it is wrong.

Answer: A. The band runs from 1.1760 to 1.2240.

Exam tips

Memorise the spectrum order. Many questions reduce to ranking regimes by rigidity.
Link every regime to monetary policy independence: fixed means little, floating means a lot.
Watch the wording: 'pre-announced steps' signals a crawling peg, and 'occasional intervention without target' signals a managed float.
Currency board questions often test reserve backing and loss of lender-of-last-resort ability.
Band calculations are simple percentages; compute limits before choosing among three options.

Practice questions from Capital Flows and the FX Market

Exchange Rate Regimes: frequently asked questions

What is the difference between fixed and floating exchange rates?

In a fixed regime, the government or central bank commits to a set rate and defends it with reserves and policy. In a floating regime, supply and demand set the rate. Fixed gives stability but costs policy independence; floating gives independence but more volatility.

What is the difference between a currency board and dollarization?

Under a currency board, the country keeps its own currency but backs it fully with foreign reserves at a fixed rate. Under dollarization, the country uses a foreign currency as legal tender and has no domestic currency. A currency board is easier to abandon.

What is a crawling peg?

A crawling peg is a fixed rate that is adjusted gradually in small, pre-announced steps. It is often used to offset higher domestic inflation. It differs from a managed float because the path of change is set in advance.

Which regime gives the most monetary policy independence?

An independent float gives the most independence, because the central bank does not need to defend any exchange rate level. It can set interest rates for domestic goals such as inflation.