Exchange rate regimes and the long run
Exchange rates can be loosely split into two major types of systems, which are commonly called exchange rate regimes.
This century, most major currencies are examples of floating exchange rates. For example, the US dollar, the British pound, the Japanese yen, and the Australian dollar.
The euro, which is a currency union, is technically a form of a fixed exchange rate regime. Countries in the Eurozone use the same paper money, with slightly different coins made by each.
Another present day example is the Danish krone, which is fixed to the euro at a rate of one euro per 7.46038 Danish krone. The Danmarks Nationalbank is officially required to holds the the exchange rate within 2.25% of this value.
A final case of a special fixed exchange rate system is dollarization, sometimes called dollarisation. This refers to situations where a foreign currency is used as an official currency. Sometimes the foreign currency is accepted alongside the home currency, often at a fixed exchange rate. In the extreme, only the foreign currency is used.
| Arrangement | Currency | Country Examples |
|---|---|---|
| Exclusive use | Euro | Andorra |
| At par with home currency | US Dollar | Panama |
| South African rand | Namibia | |
| Other fixed rate with home currency | US Dollar | Belize |
| At par, only produces coins | US Dollar | Ecuador |
| Australian dollar | Nauru | |
| New Zealand dollar | Cook Islands |
There are also two regions in Africa that are working towards formal currency unions similar to the Euro, with further plans for them to join together.
The details of how any of these fixed exchange rate arrangements are maintained are not of concern to us at this level, but the consequences are.
The trilemma (impossible trinity)
There is an inherent trade-off with regards to capital flows, monetary policy and exchange rates. This is referred to as the trilemma or the impossible trinity. What it says if that of these three international factors,
- Free capital flows
- Independent monetary policy (control of money supply)
- Fixed exchange rate
that only two can be true at the same time. Put another way, a country has to give up one in order to choose the other two.
So for example, countries that have a floating exchange rate instead of a fixed exchange rate must have free capital flows and have the option of independent monetary policy. This case includes most of the major economies of the world, the United States, the Eurozone and Great Britain.
Countries with fixed exchange rates generally give up independent monetary policy and control of their own money supply. In fact, Panama does not even have a central bank at all! This case covers all of the arrangements mentioned as examples above.
The final case is when countries restrict flows of international funds, either in or out. Countries with this arrangement include China and North Korea. Capital controls have also been used during crisis situations in order to stabilize floating exchange rates or financial markets and to raise government revenue.
The law of one price
The law of once price states that with flexible prices, competitive markets and no trade frictions, such as transportation costs and tariffs, then specific goods should have the same price when adjusting for exchange rates. Put in different terms, this is the same as have a real exchange rate of exactly 1 for any tradeable good…
To explore this concept, the table below presents values for a half liter (500 mL) bottle of Coca-Cola.
| Currency | Price | Nominal Exchange | RER |
|---|---|---|---|
| US dollar | 2.99 USD | 1 | 1 |
| Euro | 2.5 EUR | 0.8694 EUR/USD | |
| Indian Rupee | 30 INR | 88.814 INR/USD | |
| South African Rand | 80 ZAR | 17.095 ZAR/USD |
At first this might seem like a product that should be relatively identical, so it might be natural to question why there are such significant differences in the real exchange rate. However, even for a good that is so similar across countries there are differences in production costs (energy, sweeteners, packaging), costs of transportation, taxes, and retailer markups (profits at point of final sale).
Additionally the exchange rate is a reflection of wider interactions beyond a single good, and it is unlikely that a half liter bottle of Coca-Cola is the key product traded for any of these countries.
Exchange rates in the long run
Over the long run, real exchange rates should have some relationship to the real purchasing power of the currency.
A first thought is to apply the law of one price. The Economist magazine created the “Big Mac Index” to allow for an objective measure of how “overvalued” or “undervalued” a currency is by using exchange rates and the price of a Big Mac. The reasoning is that a Big Mac is the closest thing to an identical good across countries.
Expanding to law of one price to a basket of goods is called purchasing power parity (PPP). Just like with the CPI, the details of finding this basket are not our concern, but understanding the relevance and applications of the concept are.
PPP is at the center of two theories for the long run behavior of exchange rates.
We will now briefly expand on each.
Absolute PPP
Absolute PPP implies that all currencies should eventually have equal purchasing power. Realistically we should see this if a few assumptions hold. Every good in the two countries must be perfectly identical, there must be no trade frictions and every good and service must be tradeable. In short, the law of one price should hold for every good.
These are not realistic conditions. Goods are often not identical and trade involves transportation costs and sometimes even tariffs. Perhaps most importantly, not every good is traded. For example. services are often not realistic to trade.
You may be able to import avocados from Mexico, but you cannot import a haircut. If you live near the border someone could drive across to cut your hair, but that is not an option for everyone. Even in that case whatever service was provided would not strictly be an import and would count for US GDP and not Mexico’s.
Relative PPP
In contrast to absolute PPP, relative PPP says that changes in the real exchange rate should be approximately equal to the difference in the inflation rate. So if a country has a consistently higher inflation rate than the United States, and everything else stays equal, the currency of that country should get weaker.
As a quick example, let us look at Argentina compared to the United States, using monthly data from 2017 through September of 2025. The reason for the awkward stopping point is data availability, October 2025 is missing in the US data due to a government shutdown.
Comparatively, we can see that while the values look similar the currency seems to move more than relative inflation. In particular, the inflation spike in 2024 was accompanied by a larger exchange rate movement. This becomes more clear when we calculate the relative PPP deviation
which will be zero if relative PPP holds exactly.
The currency movements are more wild because in this situation everything else was not equal. In Argentina there was an election and significant policy changes in terms of government spending and getting inflation under control. The continued depreciation of the Argentine peso could reflect expectations that these policies will not last.
This example shows what happens to be a general result. Relative PPP generally fits real life bettter than absolute PPP, but neither gives an exact relationship.