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Chapter 24 National and Global Choices: Floating Rates and the Alternatives Overview This chapter provides a capstone to the discussion of international finance and international macroeconomics by examining the choice between fixed and floating exchange rates. Much of the discussion examines this choice from the point of view of a single country, but the discussion also examines some issues related to the functioning of the entire system. The text examines five key issues that can influence a country's choice. Figure 24.1 presents a summary of implications of the key issues for the advantages of each policy choice. First, different types of shocks have different effects, depending on which exchange rate policy is chosen. Internal shocks, especially domestic monetary shocks, are less disruptive to the domestic economy with a fixed exchange rate. External shocks, especially international trade shocks, are less disruptive with a floating exchange rate. If a country believes that it is mainly hit with internal shocks, it would favor a fixed rate; if it believes that it is mainly hit by external shocks, it would favor a floating rate. Second, monetary policy is less effective as an independent policy influence on the domestic economy with a fixed exchange rate (compared to its effectiveness with a floating rate). Differences in the effectiveness of fiscal policy depend on the responsiveness of capital flows to interest rate changes. The key conclusion is that a country that desires to use monetary policy to address domestic objectives will favor a floating exchange rate. Third, countries that have their currencies linked through fixed exchange rates must achieve consistency in their macroeconomic policies, so that the fixed rate can be defended and maintained. If countries have different goals, priorities, and policies, then they will favor floating exchange rates. Fourth, the choice of exchange rate policy is linked to inflation rates in several ways. Countries that have fixed exchange rates between their currencies are committed to having similar inflation rates in the long run (an important specific example of the third point). Proponents of fixed rates argue that this imposes a discipline effect on countries that otherwise would tend to have high inflation rates. If the price discipline is stronger on countries that would tend to inflate and run payments deficits, then the overall average global inflation rate is likely to be lower with fixed rates. On the other hand, countries that might prefer to have even lower inflation rates (than the lead country in the fixed rate system) are likely to "import inflation" as their inflation rate tends to rise toward that of the lead country. Floating rates simply allow countries to have different inflation rates. In the 1970s it seemed that the average global inflation rate was higher with floating exchange rates, but the experience since the early 1980s indicates that the tendency toward higher inflation with floating rates is not that serious. What really matters is the resolve of the national monetary authorities. Fifth, floating rates have been highly variable. The variability can increase exchange rate risk, which can discourage international transactions, especially trade in goods and services. In addition, overshooting can create signals for resource reallocations that are too strong. The defenders of floating rates indicate that this is a market doing what it is supposed to do-setting a market clearing price given demand and supply conditions at each time. The opponents of floating exchange rates believe that the variability is excessive, at least from the point of view of its effects on the macroeconomy. Each country must make its own decision about its exchange rate policy. Several of these key issues seem to be important for most countries. Strong arguments in favor of a country's choosing a floating exchange rate are the use of changes in the floating exchange rate to achieve external balance, so that monetary policy can be used to pursue domestic objectives, the ability to set its own goals and policies, and the reduced need to hold official international reserves to defend against speculative attacks on the fixed rate. The strong argument in favor of a fixed rate is that floating rates are disturbingly variable. Many countries have shifted to a floating exchange rate during the past several decades. Even for countries that float, the government authorities typically use some form of management of the float. A managed floating exchange rate seems to be a reasonable compromise choice for many countries. A number of countries maintain fixed exchange rates, but a fixed rate that is adjustable (called a "soft peg") sometimes seems to invite speculative attack. In response, some countries are adopting exchange rate arrangements (called "hard pegs") in which the fixed exchange rate value is very difficult to change. A currency board, such as that adopted by Hong Kong and several other countries, requires the country's monetary authority to focus almost completely on defending the fixed exchange rate through intervention, with almost no possibility for sterilizing the effects of any intervention. The case of Argentina illustrates some of the advantages of a currency board, as well as the disadvantages and problems of an exit strategy. With "dollarization," used by El Salvador, Ecuador, Panama and few other very small countries, the country's government abolishes its own currency and uses the currency of some other country (e.g., the U.S. dollar). The members of the European Union (EU) are pursuing an international fix-a monetary union in which exchange rates are permanently fixed among the currencies of the countries in the union and a single monetary authority conducts a unionwide monetary policy. As mentioned previously in Chapter 19, in 1979 the EU countries established the European Monetary System, and most became members of its Exchange Rate Mechanism (ERM), an adjustable pegged rate system among its members' currencies. By mid-1992 all EU members except Greece were members of the ERM, and most maintained their currencies within a band of plus or minus 2.25 percent around the central rates. Then a series of speculative attacks weakened the ERM-Britain and Italy left it in 1992, the bands for nearly all currencies were widened to plus or minus 15 percent in 1993, and several realignments were necessary for the central rates of the currencies of some other countries. After 1993 the exchange rates within the ERM were generally steady, and a number of countries joined or re-joined the ERM. The ERM experience provides examples of several points from earlier in the chapter. The ERM exchange rates generally were steadier than floating rates, and inflation rates in other ERM members decreased to the low levels of Germany. But differences in priorities and policies led to the strains that weakened the system in the early 1990s. At the same time as the turmoil in the ERM, the EU countries drafted and approved the Maastricht Treaty, which called for creation of European Monetary Union in 1999, for countries that met five criteria contained in the treaty. In 1998 eleven countries were deemed to meet the criteria and chose to join. On January 1, 1999, the union began, with the euro as a new common currency and the European Central Bank (ECB) conducting monetary policy for the union. Greece joined in 2001, and the euro replaced all national currencies of the twelve member countries in 2002. The Euro area is now a monetary union with a single common currency. Key gains from European Monetary Union are the elimination of exchange rate risk and the elimination of the transaction costs of exchanging currencies. Key risks include questions about how effective the ECB will be in its conduct of monetary policy and the loss of national use of exchange rate changes and monetary policy to address shortcomings in national economic performance. Fiscal policy remains available, but may be constrained both by national politics and by limits imposed by the Stability and Growth Pact. Labor mobility between member countries is low. Thus, a key challenge for the member countries is finding effective mechanisms for national adjustments when economic shocks affect different countries in different ways (for instance, Germany and Ireland during 2000-2002). Objectives of the Chapter One of the key decisions that each country has to make is what exchange rate policy it should use. Although there is a clear trend toward floating exchange rates today, some countries still adhere to fixed exchange rates. Others choose a regime between the two extremes of a pure float and a permanently fixed rate. As you have seen in the previous two chapters, whatever exchange rate system a country chooses, it will have implications for domestic stability and domestic policymaking. After studying Chapter Twenty-four you should be able to discuss the advantages and disadvantages of fixed and floating exchange rates relative to policy issues such as: 1. The impact of domestic shocks on income levels. Key Terms
. True or False? Explain 1. T / F If demand for a country's exports is highly variable, that country will be more stable under a fixed exchange rate than a floating one.
2. T / F Proponents of flexible exchange rates believe that a fixed-rate system generates widespread price distortions and gives misleading; signals.
3. T / F An important argument for a flexible exchange rate regime is that, in such a system, business cycles are not easily transmitted from one country to another.
4. T / F If a government wants to maximize its flexibility and independence while still announcing a commitment to keeping its exchange rate constant, it should choose to dollarize rather than institute a currency board.
5. T / F Island nations always choose a floating exchange rate while continental nations choose a fixed exchange rate.
Multiple Choice 1. Inflation was relatively lower under the:
2. One advantage of a fixed exchange rate system is that:
3. Which of the following statements is most correct:
4. If a country moves from a fixed exchange rate to a floating exchange rate system:
5. Which of the following sequences characterizes the progress of exchange rate arrangements in Europe during the twentieth century?
Problems 1. You are an impartial economist who has noticed that Leinster is much more internally stable than Saxony. a. If you are hired by the government of Leinster to suggest the
exchange rate regime that will keep income in the country constant,
would you suggest a fixed rate or a floating rate? 2. Suppose that our imports were completely unaffected by our level of national income (i.e., our marginal propensity to import were zero) and suppose our income also has no effect on our exports. Under these assumptions compare the effects of expansionary fiscal policy under the following exchange rate regimes: a. Fixed rates with sterilization. 3. Try to make a case that Leinster and Saxony should form a monetary union and ultimately replace their separate currencies with a new common currency called the scalira. 4. If a country prefers to use monetary policy rather than fiscal policy to achieve economic goals, would a fixed rate system or a flexible rate system provide the best environment for policymakers? 5. Compare the Federal Reserve Bank of the U.S. with the European Central Bank. Suggested answers to questions and problems (in the textbook) 2. Probably agree, but with a caution. It is usually argued that the average rate of global inflation would tend to be lower if most countries adhered to a system of fixed exchange rates. Countries that succeed in maintaining fixed exchange rates among their currencies must have similar inflation rates in the long run. This tends to discipline countries that otherwise would drift or surge toward higher inflation rates. Furthermore, there is more pressure on countries with payments deficits to adjust than there is on surplus countries. In defending the fixed exchange rates, countries with payments deficits must intervene to buy their own currency. This tends to contract their money supplies and reduce their inflation rates. Thus, overall, the world tends toward less money growth and a lower average rate of world inflation. There is one caution, however. If the system has a lead country, then the inflation rate that forms the standard for the system is this country's inflation rate. Some countries that otherwise would prefer to have an even lower inflation rate will find that their inflation rate is drifting up toward the rate in the lead country. 4. Agree or disagree. If you say agree, then you will emphasize points like the following. With a clean floating exchange rate, the rate is set by private competitive supply and demand in the market. This rate is a market price that represents all information about currency values that is available at that time. Governments have no special information, so that they cannot improve on the clean float. Intervention by the government in the exchange market often seems to have little effect on exchange rate values. When it does have an impact, it distorts the exchange rate, usually for political purposes, especially to respond to the desires of powerful special interests. If you disagree, then you will emphasize points like the following. Cleanly floating exchange rates are excessively variable, perhaps because private supply and demand are sometimes driven not by rational examination of information on the economic fundamentals, but rather by bandwagons and similar speculative behavior, or simply because exchange rates tend to overshoot their long-run values. Thus, a managed float permits a country to obtain many of the benefits of a floating exchange rate, including some policy independence and the ability to use exchange rate changes in the process of adjustment to external imbalances, while using intervention to limit wide swings and excessive variability in exchange rate values. 6. a. These economists believe that the variability exists for good reasons, and that many of the supposed bad effects of exchange rate variability are not that large. They believe that the variability results from rational and reasonable responses of market participants, especially international investors, to various kinds of shocks and news. As economic and political conditions change, exchange rates should change to reflect the new information about the relative values of currencies. They believe that variability does not lead to risk that unreasonably reduces international transactions. Those engaged in international transactions like trade in goods and services have a variety of ways to hedge their exposures to exchange rate risk, including forward foreign exchange contracts as well as currency futures, options, and swaps. b. These economists believe that the variability is excessive, and that the risks do have an undesirable impact on international transactions. They believe that the variability sometimes results from bandwagons and similar expectations that carry exchange rates away from their appropriate economic values. In addition, overshooting can cause exchange rates to deviate from their longer run values, even if the rates follow a path that is economically rational. They believe that some of the resulting exchange rate risk does have an impact on international transactions, because it is not possible to hedge perfectly and costlessly. Risk may especially affect real investments that support exports and similar international transactions, because the risk that must be hedged is further in the future, and because the payments at risk are themselves often of uncertain sizes. Furthermore, they believe that excessive rate movements that persist beyond the short run, such as the overshooting that can keep exchange rates away from their longer run values for a number of years, create signals for resource reallocations that are too large or too rapid. 8. The five convergence criteria are: (1) the country's inflation rate must be no more than 1.5 percentage points above the average inflation rate of the three lowest inflation EU countries, (2) the country's exchange rates must have been maintained within the ERM band with no realignments during the previous two years, (3) the country's long-term interest rate on government bonds must be no more than 2 percentage points above the average of the rates in the three lowest inflation countries, (4) the country's government budget deficit must be less than or equal to 3 percent of the value of its GDP, and (5) the country's gross government debt must be less than or equal to 60 percent of the value of its GDP. For the latter two criteria the country need not meet them exactly, as long as the country shows adequate progress toward achieving them in the near future. We can guess about the logic for each requirement. The inflation criterion shows that the country is ready to switch smoothly to fixed exchange rates with other low inflation countries. It is based on the logic of purchasing power parity-that countries must maintain similar inflation rates if fixed rates are to be sustained. The exchange rate criterion shows that the country already has been able to maintain a pegged exchange rate, so that it is ready to switch smoothly to completely fixed exchange rates. In addition, the criterion may be intended to limit a country's ability to use "one last" devaluation to gain a competitive edge in pricing just before it enters into "permanently" fixed exchange rates. The interest rate criterion may show that credit markets judge the country to be a good inflation rate risk and good credit risk. A country that is not expected to maintain a low inflation rate probably has to pay a higher interest rate on its long term debt. Its tendency toward higher inflation in the future would threaten the viability of the fixed exchange rates. Even worse, a country whose government might run into problems in repaying its debts also probably has to pay a higher interest rate on its long term government debt. If the government does then run into problems, the other countries may be forced to bail it out in order to defend the fixed exchange rates. The two criteria related to the government budget deficit and debt seem to be related to achieving fiscal policies that are not too different between the countries that enter into the fixed exchange rates. This may limit strains within the system. Especially, it keeps out countries who might favor more inflationary monetary policies to bail them out in the face of excessive government budget deficits and debt. Given the importance of having and maintaining similar inflation rates for the success of fixed exchange rates, the most important criterion is probably that related to the country's inflation rate. The criteria related to government budget deficits and debt seem to be the least important. A country that shifts to completely fixed exchange rates has given up the ability to use national monetary policy and exchange rate changes in seeking to address imbalances. This country may need to use fiscal policy more actively, including sometimes running large budget deficits. If the criteria also restrain the independence of fiscal policy, the country's government is left with little in the way of policy tools to address national imbalance. 10. Here are several arguments in favor of a Britain staying out of the European Monetary Union and instead maintaining its policy of an independently floating exchange rate for the pound. First, changes in the floating exchange-rate value of the pound can be used in adjusting to reduce external imbalances that Britain might face. Changes in the exchange-rate value of the pound can also reduce the Britain's vulnerability to external shocks, including shocks coming from other EU countries. Second, adoption of floating exchange rates allows Britain to pursue its own monetary policy. Monetary policy can be used to seek internal balance, and Britain's government has a greater ability to pursue its own goals and priorities. The ability to use monetary policy to fight a British recession and high British unemployment can be especially valuable if fiscal policy is not flexible enough to be useful in pursuing internal balance, and if movements of labor between countries of the union are not likely to be large enough (or perhaps even not desirable) as a way to smooth cyclical differences between these countries. Third, those affected by the variability of floating exchange rates have a variety of means of hedging their exposures to exchange rate risks, including forward foreign exchange contracts and currency futures, options, and swaps. These contracts are available with very low transactions costs. Finally, the British inflation rate is best controlled by a British central bank that is committed to this goal. Although the European Central Bank is structured like the German central bank, it is also subject to political pressures that could reduce its commitment to maintaining low inflation, so there is no guarantee that Britain will have lower inflation if it joins the monetary union.
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