How can exchange rate policies promote environmental sustainability?

1 Fixed exchange rates

Some countries choose to fix their exchange rates to a certain level or a basket of currencies, usually by intervening in the foreign exchange market or by adopting a currency board or a monetary union. This can provide stability and predictability for trade and investment, but it can also limit the policy space for addressing environmental issues. For example, if a country faces a negative shock that reduces its export earnings or increases its import costs, it may have to adjust by cutting public spending, including on environmental programs, or by depleting its foreign reserves, which can reduce its ability to finance green projects. Moreover, a fixed exchange rate can create incentives for overexploitation of natural resources, especially if the currency is undervalued relative to its trading partners, as this can make exports more competitive and imports more expensive.

2 Flexible exchange rates

Other countries allow their exchange rates to fluctuate according to the market forces of supply and demand, with minimal or no intervention from the authorities. This can give more flexibility and autonomy for pursuing environmental objectives, as the exchange rate can act as a shock absorber and a policy instrument. For example, if a country faces a positive shock that increases its export earnings or reduces its import costs, it can use the appreciation of its currency to lower inflation, increase real incomes, and allocate more resources to environmental protection. Alternatively, if a country wants to discourage excessive consumption or pollution, it can use the depreciation of its currency to raise the relative prices of imported goods and services, especially those with high environmental footprints.

5 Here’s what else to consider

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