How do exchange rate policies evolve in regions pursuing monetary integration?

Exchange rate policies in regions pursuing monetary integration typically evolve towards fixed or unified exchange rates.

In the pursuit of monetary integration, regions often adopt policies that aim to stabilise exchange rates, reduce exchange rate risk, and promote economic stability. This evolution is usually a gradual process, involving several stages of policy changes and economic adjustments.

Initially, countries may adopt a managed float exchange rate system, where the value of the currency is allowed to fluctify within a certain range, but central banks intervene in the foreign exchange market to prevent excessive volatility. This system allows for some degree of monetary policy independence while also providing a measure of exchange rate stability.

As integration progresses, countries may move towards a fixed exchange rate system, where the value of the currency is pegged to another currency or a basket of currencies. This system provides greater exchange rate stability, but at the cost of monetary policy independence. Countries must maintain large reserves of foreign currency to defend the peg, and their monetary policy is effectively determined by the central bank of the currency to which they are pegged.

The final stage of monetary integration is the adoption of a common currency, such as the Euro in the European Union. This eliminates exchange rate risk entirely within the integrated region, but also means that countries have no independent monetary policy. Instead, monetary policy is determined by a central bank for the entire region, such as the European Central Bank.

The evolution of exchange rate policies in regions pursuing monetary integration is driven by the desire for greater economic stability and integration. However, it also involves trade-offs, particularly in terms of monetary policy independence. The choice of exchange rate system at each stage of integration depends on a variety of factors, including the degree of economic convergence among countries, the stability of their economies, and their willingness to surrender monetary policy independence.