www.themegallery.com

Chapter 10

Fixed or Flexible Exchange Rates?

Learning Objectives Describe the differing impacts of fixed and

flexible exchange rates on international trade, international investment, and resource allocation.

Discuss how the macroeconomic responses to foreign and domestic shocks are influenced by the exchange rate system in place.

Explain the advantages and disadvantages of a currency board.

Compare and contrast the strengths and weaknesses of exchange rate systems that combine elements of both fixed and flexible exchange rates.

Do Fixed or Flexible Exchange Rates Provide Greater

“Discipline?”

Some argue for fixed exchange rates:

As we’ve seen, with a fixed rate system, there should be no tendency for greater inflation in one country than in the world as a whole.

The “vicious circle hypothesis”: flexible exchange rate systems may aggravate

inflationary tendencies.

Suppose a

country has

high inflation

because of

excess supply

of money.

If the exchange

rate is flexible it

will depreciate;

this adds to

aggregate

demand and

worsens

inflation.

In response the following have been suggested:

The inflation is a signal to monetary authorities to reduce Ms – with fixed exchange rates this signal may not be noticed.

Is the alleged discipline of a fixed exchange rate system really desirable? There may be other goals (such as generation of employment and economic growth) that may have to be sacrificed in a fixed system.

Would Fixed or Flexible Exchange Rates Provide Greater

Growth in Trade and Investment?

Some argue for fixed exchange rates: Flexible exchange rates vary – this introduces

risk into trade decisions. Hedging options exist, but these are costly. Foreign direct investment may be less under

flexible exchange rates due to exchange rate risk.

• This means that world resource allocation may be sub-optimal under flexible exchange rates.

In response the following have been suggested:

If there is exchange rate risk, FDI may occur more frequently, rather than producing at home and exporting.

Under fixed rate systems, dealing with BOP deficits requires internal macroeconomic adjustments (e.g., contracting national income) that many countries have been unwilling to tackle.

Would Fixed or Flexible Exchange Rates Provide Greater

Efficiency in Resource Allocation?

Some argue for fixed exchange rates: With fluctuating exchange rates there are

constantly changing incentives to producers. A depreciation induces labor and capital to flow

into the tradeable goods sector and out of the nontradeable goods sector.

An appreciation has the opposite effect. This may create waste, since factors are

temporarily displaced and workers may need to be retrained.

In response the following have been suggested:

Efficient resource allocation depends on not fixing prices such as the exchange rate – economic agents react optimally when prices reflect true scarcity values.

Fixed exchange rate systems require that resources be tied up in the form of international reserves – flexible exchange rate systems don’t.

Is Policy More Effective at Influencing National Income

Under Fixed or Flexible Systems?

Argument for fixed exchange rates: Fiscal policy is largely ineffective under

a flexible exchange rate system. Fiscal policy can be very effective

under a fixed exchange rate system.

In response the following have been suggested:

Monetary policy is more effective in a flexible exchange rate system.

Flexible rate systems allow monetary and fiscal policies to be directed solely towards attainment of internal goals.

Will Destabilizing Speculation in Exchange Markets Be Greater

Under Fixed or Flexible Systems?

Argument for fixed exchange rates: When a currency depreciates, speculators may

project this forward and decide their best strategy is to sell the currency, thereby worsening the depreciation.

When a currency appreciates, speculators may project this forward and decide their best strategy is to buy the currency, thereby worsening the appreciation.

In response the following have been suggested:

Speculative purchases may in fact be stabilizing.Fixed rate systems may actually invite speculation if central banks are unable to enforce ceiling and floor limits.

Will Countries Be Better Protected from External Shocks

Under Fixed or Flexible Systems?

Argument for flexible exchange rates: Business cycles may be transmitted

from one country to another under fixed exchange systems.

This may be less likely under a flexible system, since the exchange rate helps mitigate the transmission.

Fixed vs. Flexible

Most countries relied on fixed exchange rate systems in the 1950s and 1960s.

There has been a movement since 1973 toward more flexible systems.

There are some hybrid systems, however.

Currency Boards A relatively new arrangement that is a

form of fixed exchange system has emerged – the currency board.

A currency board is a monetary authority that is allowed to issue domestic currency that can be exchanged for a foreign currency (the “anchor”) at a fixed exchange rate.

The currency board is not allowed to change the monetary base.

Governments cannot monetize budget deficits under this system

Currency Boards: Advantages

Convertibility is ensured. Macroeconomic discipline is instilled –

currency boards cannot finance budget deficits, so governments must either maintain budgetary discipline or borrow from the public.

A guaranteed payment adjustment mechanism is provided, increasing confidence in the system.

Currency Boards: Advantages (cont’d)

trade investment growth

Greater confidence in the system promotes higher rates of

Currency Boards: Disadvantages

The seigniorage problem Currency boards earn interest on

foreign currency holdings, but those holdings could have been used to make investments at home.

The difference in yield could represent a loss.

The startup problem It’s not easy to gather enough reserve

currency to back the monetary base 100%.

The seigniorage problem Currency boards earn interest on

foreign currency holdings, but those holdings could have been used to make investments at home.

The difference in yield could represent a loss.

The startup problem It’s not easy to gather enough reserve

currency to back the monetary base 100%.

Currency Boards: Disadvantages

The transition problem The local currency may become

overvalued in a high inflation economy. The fixed exchange rate will eventually

bring inflation under control – how long will the transition last?

The adjustment problem It’s costly to correct BOP imbalances –

adjustments would be automatic under a flexible rate system.

The management problem The normal monetary policy tools are off

the table.

Currency Boards: Disadvantages

The crisis problem The currency board cannot serve as the

lender of last resort, so banking crises may be difficult to head off.

The political problem Will the government actually balance its

budget? Currency boards have no authority to force them to do so.

The monetary sovereignty problem The normal monetary policy tools are off

the table – the “anchor” economy may have much influence.

Optimum Currency Areas

An optimum currency area is an area that has fixed exchange rates among member countries, but flexible exchange rates with external trading partners.

For example, the European Union fixed exchange rates among 11 countries beginning in 1999.

Optimum currency areas may make macroeconomic policy more effective and assist with BOP adjustments.

Optimum Currency Areas

Relatively open countries may do better with a fixed exchange rate.

Relatively closed economies may do better with flexible exchange rates.

Therefore, open economies that have a high degree of factor mobility between them may be the best candidates for an optimum currency area.

Hybrid Systems

Several arrangements attempt to incorporate the attractive features of each exchange rate system while minimizing the unattractive features.Examples include

wider bands,crawling pegs, andmanaged floating.

Wider Bands Basic idea: let exchange rates vary

around parity values to a much greater extent (say 10% instead of 1%).

Some BOP adjustment can take place via changes in the exchange rate.

Still, if countries have consistently different inflation rates, the system will break down.

There will be additional risks from exchange rate fluctuations that aren’t present with a fixed system.

Crawling Pegs Basic idea: allow small variation around

parity, but adjust the parity value regularly.

That is, periodically devalue or revalue according to circumstances.

In principle, the ceilings and floors may instill some monetary discipline.

However, a major change in the BOP position due to an external or external shock may require major changes in the exchange rate.

Managed Floating Basic idea: some interference with

exchange rate movements are permitted, but the intervention is discretionary on the part of the central bank.

That is, there are no announced rules or guidelines, but monetary authorities intervene when they judge it to be in the country’s best interests.

However, without any rules nations may be working at cross-purposes.

www.themegallery.com

Add your company slogan