So much of barbarism, however, still remains in the transactions of most civilized nations, that almost all independent countries choose to assert their nationality by having, to their inconvenience and that of their neighbors, a peculiar currency of their own.
John Stuart Mill
The breakdown of the international monetary system of fixed exchange rates that had prevailed until March 1973 under the Bretton Woods (1944–1971) and the short-lived Smithsonian (1971–1973) agreements ushered the world economy into uncharted territory. The new international financial order that has emerged in its stead is commonly characterized as a system of floating exchange rates. Such a characterization, however, is misleading since it applies to only a handful of major currencies that float independently, such as the U.S. dollar ($), the Japanese yen (¥), and the euro (€). Most other currencies are actually closely managed by their respective central banks when they are not pegged to or tightly controlled vis-à-vis the U.S. dollar, the euro, or a basket of currencies.
This chapter develops a framework for understanding how exchange rates are determined and how different exchange rate regimes have developed in each country. It sheds light on the conceptual foundations of the three major systems of exchange rate determination within which actual exchange rate forecasts have to be made. In the companion Chapter 3 we illustrate how exchange rates regimes have been implemented ...