Chapter 10
Fixed or Flexible
Exchange Rates?
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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
If the exchange
country has
rate is flexible it
high inflation
will depreciate;
because of
this adds to
excess supply
aggregate
of money.
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)
Greater confidence in the system promotes
higher rates of
trade
investment growth
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%.
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, and
managed 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.
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