This freedom only exists as long as the countries involved do not care what exchange rate eventuates.
Choosing an Exchange Rate Regime: Goals, Priorities, and Policies (4)
For example, in the early 1980s, unemployment rates were very high in many European countries, but they did not attempt expansionary policies because their currencies were already weak against the dollar.
They actually tightened monetary policy to raise their interest rates to prevent their currencies from weakening further.
Choosing an Exchange Rate Regime: Inflation
An implication of PPP is that relative stable prices is a requirement for a fixed exchange rate.
The countries involved must have similar inflation rates over the long run.
Thus, fixed exchange rates may create a necessary price discipline on domestic policy to maintain low, stable inflation rates.
Argentina’s inflation rate dropped from 3000% to 4% per year after they fixed their peso to the U.S. dollar.
Inflationary expectations also lowered because of the credibility of the fixed-rate discipline.
Choosing an Exchange Rate Regime: Inflation (2)
This price discipline forces countries under fixed exchange rates to:
Keep their deficits small and similar,
Keep their money supply growth rates low and steady
This is the logic behind certain actions required of nations joining the European Union.
The result may be that a world under fixed exchange rates might enjoy lower global inflation rates.
Under a fixed system with a “lead country”, like the U.S. under Bretton Woods, all countries will have to match the inflation rate of the lead country.
When one country inflates, they all must inflate, which means that inflation can be “exported”.
Choosing an Exchange Rate Regime: Inflation (3)
No such pressures exist under floating exchange rates. Countries are free to conduct any domestic policies they wish.
Budget deficits may be financed by money creation.
This may lead to higher average global inflation rates.
Average inflation rates were higher after 1973 than before.
The real keys to lower inflation rates are policy discipline, resolve, and credibility of the monetary authorities in each country.
Choosing an Exchange Rate Regime: Exchange Rate Volatility
Floating exchange rates do float!
High variability of exchange rates can be a deterrent to trade and international investment because it raises exchange rate risk, affecting total expected returns. (Exchange rate risk is exchange rate variability.)
Exchange rate variability has real effects.
Those who favor fixed exchange rates claim that it reduces this variability, hence improves int’l trade and investment.
Choosing an Exchange Rate Regime: Exchange Rate Volatility (2)
Does exchange rate risk/variability actually reduce trade?
Early studies typically found no effect on the volume of international trade.
More recent studies found that exchange rate variability may affect trade volume, but the change is mostly negligible.
There is some concern that the dramatic swings due to overshooting may lead to significant long-term effects as capital formation is affected.
Choosing an Exchange Rate Regime: Exchange Rate Volatility (3)
Those who favor floating exchange rates argue that fixed exchange rates are just another form of price fixing or price controls. The market is not being allowed to work.
As with all markets, equilibrium exchange rates are prices that provide information (“send signals”) about the relative values of currencies. The question is whether or not the market might send “false signals” for some reason.
Price controls have been shown to be generally inefficient, while equilibrium rates are by definition optimal if they result from full information and full adjustment.
Those who argue against floating exchange rates argue that market exchange rates may be distorted by speculation, speculative bandwagons and bubbles, informational problems, and adjustment problems.
Extreme Fixes: Currency Boards
An “exchange rate only” monetary authority.
The board holds only foreign currency assets as official reserves.
It issues domestic currency liabilities only in exchange for foreign currency assets.
It holds no domestic currency assets, so cannot sterilize actions.
Because it focuses entirely on maintaining the fix, and not on domestic policy, and cannot sterilize, it has great credibility in terms of its commitment to the fixed exchange rate.
Extreme Fixes: Currency Boards (2)
Hong Kong established a currency board in 1973.
In the 1990s, Estonia, Lithuania, Bulgaria, and Bosnia/Herzegovina established currency boards.
Argentina set up a currency board in 1991, which it abandoned in 2002.
The creation of the board in 1991 was intended to increase the credibility of their anti-inflation stance.
Inflation fell dramatically, interest rates fell, and economic growth increased. Real growth was nearly 4% from 1992-1998.
But the fix made Argentina vulnerable to external shocks. Following the Mexico peso crisis hit in 1995, int’l investors started pulling out of Argentina. Defending its fix, Its money supply shrank and interest rates rose. This ultimately threw the country into recession in 1998.
Extreme Fixes: Currency Boards (3)
The Argentine government ultimately had to allow the exchange rate to float.
The currency board does not force a country to follow sensible fiscal and regulatory policies.
The fixed exchange rate leaves the country more exposed to adverse foreign shocks.
It is difficult to find a “graceful” exit strategy that allows the country to abandon the fix and allow rates to float.
Extreme Fixes: Dollarization
An extreme form of a fixed exchange rate is for a country to abolish its own currency and use the currency of some other country.
Because the “other currency” is often the U.S. dollar, this is called dollarization.
The government can still “de-dollarize” and reintroduce local currency.
Extreme Fixes: Dollarization (2)
In 1999, the president of Argentina talked about adopting the dollar, but did not follow through.
In 2000, Ecuador dollarized.
In 2001 El Salvador dollarized.
Dollarization makes it much harder for a country to retake control of its currency and devalue, so adds to its credibility.