What is a money band?
A currency band is a monetary regulation imposed by a government or a central bank that specifies both a minimum price and a maximum price for its national currency relative to other currencies. Between these two specified prices, the coin can float, but upon reaching those limits, the price of the coin will stop floating and remain fixed.
- A currency band is a range of upper and lower exchange rates acceptable for a national currency to fluctuate.
- Within these limits, the price can float and the exchange rate is dictated by the forces of supply and demand.
- A recent example of a working currency band can be found with the Chinese yuan.
How a money band works
A currency band can be understood as a managed exchange rate system that is a hybrid of a fixed exchange rate and a floating exchange rate. A country sets a range of values in which its currency can float or move, and the limits in which it will return to a fixed exchange rate. This allows for some revaluation, but generally stabilizes the price of the currency within the band.
For example, the central bank can bring the currency to the midpoint rate of the established band. However, if this move is too difficult or challenging, the bank will realign the band to create a new target exchange rate. The Chinese yuan is an example of a currency that moves within a currency band.
Example: China and the Yuan
China has a strictly controlled monetary policy that involves regulating the daily movements of the yuan in the foreign exchange market. Since introducing a currency band in 2005, the country has consistently allowed the Chinese yuan (CNY) band to widen against the US dollar over the years, starting at +/- 0.3% and eventually reaching +/- 2%, which was introduced in March 2014 and remains the same as in 2017. This allocation to widen and adjust the currency bands is known as moving parity.
The 2% band, for example, means that the yuan is allowed a 2% change up or down against the US dollar (its benchmark rate) each day. The daily limit suppresses the value of the currency and cheapens Chinese exports abroad.
Why use a money band
A currency band helps to impose discipline on monetary policy, but still provides flexibility if the country is affected by large capital inflows or outflows. The monetary policy of a country with a currency band depends on the behavior of its reference foreign currency because the central bank must make decisions that cause the value of the local currency to change in a way that approximates changes in the value of the currency. reference currency. .
The government uses the band to stabilize its currency in times of exchange rate volatility. Currency bands discourage speculation by currency traders looking to profit from changes in exchange rates. However, investors can use the band as a benchmark for expectations of future exchange rate movements.