Instructor: Patrick M. Crowley
Issue 15: To fix or to float?

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Some history
Fixed rates – what do they entail?
Floating rates – what do they entail?
Other variations on a theme….
Intervention
Economic policy and exchange rate regimes

Before WWI: Gold standard
Inter-war years: Flexible exchange rates – led to “competitive depreciation/devaluations” or “beggar thy neighbor” policies
Post WWII: Bretton Woods system – based on dollar, which in turn was pegged to price of gold (at $35/oz)
Canadian episode: 1950s-60s – Canada floated – not a disaster
Vietnam war: late 1960s – US increased spending, threatening
US$ gold peg, so in 1971, Smithsonian agreement, whereby
US$ gold peg was maintained, but greater fluctuation allowed
1973: Germans complained that Bretton Woods was unsustainable, and Nixon cut US$ link to gold
Post 1973: Floating rates the norm – except in Europe where
“the Snake” used
1984 – Plaza agreement: central banks agreed to coordinated intervention to depreciate the US$
1987 – Louvre accord: central banks agreed to stabilize the US$ within a certain range against DM and Yen

Fixed exchange rates still popular today – e.g. HK$, many smaller developing countries, CEECs
Fixed exchange rates entail making sure that the exchange rate remains fixed against another currency
This means that the central bank has to be ready to sell or buy the domestic currency in the forex market so as to keep the price fixed – it means that foreign exchange reserves become key
But as the value of currency depends on how much there is in circulation, what does this tell us about how monetary policy and exchange rate policy?
So here, exchange rate often used as a means of “anchoring” economic policy

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Pros:
- more certainty for exporters and importers
- potentially anchors monetary policy
- can always devalue/revalue to another rate
- can bestow credibility
Cons:
- can lead to crises if policy not credible
- ties monetary policy to anchor country
- could choose inappropriate rate to peg at
- choice of currency might not be obvious

With a fully flexible exchange rate regime, market forces fully determine the value of a country’s currency.
Economic policy can be independent of another country’s policies
Foreign exchange markets though can be unstable in 2 ways:
- misalignment: pushing currencies far away from their “equilibrium” values – e.g. US$ in ‘84
- volatility: causing currencies to move around a lot, creating market “nervousness” and erratic currency movements – e.g. US$ in ‘87
Central banks often “intervene” if forex markets are thought to be unstable

 Pros:
- economic policy can focus on internal economic situation
- forex market movements can be seen as indication of quality of economic policy
 Cons:
- exchange rate movements create shocks in the economy
- exporters and importers have little certainty
- can encourage bad economic policy as no “anchor”

Other intermediate exchange rate regimes:
Dirty/managed floating - intervention
Shadow target zone – specific zone for currency known by policymakers only, e.g. UK pound before ERM
Explicit target zone – e.g. ERM
Crawling peg
Currency boards
Dollarization/Euroization

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Unsterilized intervention
Sterilized intervention
Efficacy – “leaning against the wind”…
Short-term vs long term effects

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Many developed countries use floating rate policies
Many developing countries still use fixed rate policies
The line has become blurred though, as the EU now essentially has gone to a one (fixed) currency regime
Credibility matters but it is a 2-way street…