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Fixed Versus Floating Exchange Rate Regimes

Graciela L. KaminskyDepartment of Economics

George Washington University

Lecture Notes

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Outline of Presentation

• Since 1870 countries have adopted in different periods fixed andfloating exchange rate regimes. What lessons can we draw from those experiences? We look at:

• The different exchange rate regimes adopted since 1870.

• The benefits and drawbacks of fixed and flexible exchange rate regimes.

• The lessons from some episodes with flexible or fixed exchange rate regimes

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The Gold Standard

• The gold standard dates from 1819 when the British Parliament resumed its practice of exchanging currency notes for gold on demand at a fixed rate.

• Later in the nineteenth century, Germany, Japan, the U.S., and other countries also adopted the gold standard.

• Each country fixes the price of its currency in terms of gold byintervening in the foreign exchange market.

• No single country occupies a privileged position within the system.

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Characteristics of the Gold Standard

• Official international reserves take the form of gold.• No country occupies a privileged position by being relieved of the commitment

to intervene.

• Benefits of the Gold Standard:– The gold standard places automatic limits on expansionary monetary

policies.

• Drawbacks of the Gold Standard:– It places undesirable constraints on the use of monetary policy to fight

unemployment.– The gold standard ensures a stable overall price level only if the relative

price of gold and other goods and services is stable.– P = $/goods = $/gold × gold/goods– As economies grow and so does money demand, money supply cannot

increase unless there are continual gold discoveries

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The Gold Exchange Standard, Interwar Period

• Similar to Gold Standard but now central banks’ reserves consist of gold and currencies.

• As the gold standard, the gold exchange standard restrains excessive monetary growth throughout the world.

• But it allows more flexibility in the growth of international reserves, which can consist of assets besides gold.

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The Bretton Woods System

• The U.S. dollar is the reserve currency.• Every central bank fixes the dollar exchange rate of its currency

through intervention, but not the U.S.• Drawbacks of the Reserve-Currency Standard:

– The U.S. occupies a special position because it never has to intervene in the foreign exchange market.

– The US can use its monetary policy for macroeconomic stabilization.

– The US has the power to affect its own economy, as well as foreign economies by using monetary policy.

– Other central banks have to import the monetary policy of the US.– This inherent asymmetry led eventually to policy disputes within

the system.

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GermanyForeign Exchange Reserves Growth Rate

(in percent)

-100-50

050

100150200250

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

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JapanForeign Exchange Reserves Growth Rate

(in Percent)

-100-50

050

100150200250300

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

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Floating Exchange Rates

• 1973 to the present.

• After the breakup of the Bretton Woods system, the currencies of the industrialized countries’ exchange rates were allowed to float in March 1973.

• The currencies of the U.S., Japan, Germany and Great Britain continues to float against each other to the present.

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Evidence from the Floating Exchange Rate Regime

• Floating rates gave central banks the ability to control their money supplies and to choose their preferred rates of inflation. For example, the accumulated inflation rate in Great Britain relative to the one in the U.S. from 1973 to 2003 was 75 percent.

• Still, the system did not become symmetric after the float. Central banks continue to hold dollar reserves and intervene.

• Variety of shocks since 1973 (oil shocks in 1973 and 1979). It is doubtful that any pattern of fixed exchange rates would have been viable without some significant parity changes.

• Without the need to defend a parity, countries do not need to restrict capital movements. Great gains from international capital mobility.

• Countries did not abuse the autonomy afforded by floating rates. In fact, inflation rates started to decline in 1979 after the two oil shocks.

• Contrary to expectations, exchange rate volatility has not harmed international trade. Trade has boomed during the floating exchange rate regime period

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The European Monetary System

• In March 1979, eight members of the European community-France, Germany, Italy, Belgium, Denmark, Ireland, Luxembourg, and the Netherlands-formed the European Monetary System.

• Spain joined the EMS in June 1989, Britain in October 1990, and Portugal in April 1992.

• Britain dropped out in September 1992. At the same time Italy floated the lira.

• Bilateral exchange rates within the EMS are allowed to fluctuatewithin specified limits called margins.

• When a currency’s market exchange rate against the ECU diverges sufficiently from its central rate, the central bank that issues the currency is expected to intervene.

• Intervention burdens may be shared symmetrically within the EMS,but they need not be. Only intervention at the bands is shared by central banks.

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Benefits of Flexible Exchange Rates

• Monetary Policy Autonomy:– Central banks are not obliged to intervene in currency market to

fix exchange rates.– No country is forced to import inflation (or deflation) from abroad.– Governments are able to use monetary policy to reach internal

balance, i.e., full employment level of output. • Symmetry:

– The U.S. Federal Reserve does not play anymore the leading role in determining the world money supply as during the Bretton Woods System.

• Exchange Rates as automatic stabilizers:– Floating rates promote swift and relatively painless adjustment to

certain shocks in the goods market, such as a fall in foreign demand for the country’s exports.

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Benefits of Fixed Exchange Rate Systems

• Discipline:– When central banks are freed from the obligation to fix their

exchange rates, they might embark on inflationary policies.• Injury to international trade and investment:

– Floating rates would make relative international prices more unpredictable and thus injure international trade and investment.

• The illusion of greater autonomy:– Floating exchange rates would not really give countries more policy

autonomy. Wide exchange rates would prompt central banks to intervene heavily to avoid real sector shocks.

• More vulnerability due to money market disturbances.– Disturbances to the home money market could be more disruptive

under floating than under fixed rate.

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Flexible Exchange Rates Fixed Exchange Rates

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Currency Areas: The EMU

• On January 1, 1999, 11 member countries of the European Union adopted a common currency, the euro.

• Two years later, they were joined by Greece.• EMU countries have sacrificed even more over their monetary policies than a

fixed exchange rate regimes normally requires. They agreed to give up national currencies entirely and to hand over control of their monetary policies to the ECB.

• Requirements to become a member;– Inflation rate in the year before admission must be no more that 1.5%

above the average rate of the three EU member states with lowestinflation.

– The country must have maintained a stable exchange rate within the ERM without devaluing on its own initiative.

– Public-sector deficit no higher than 3 percent of GDP– Public debt no higher than 60 percent of GDP.

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Is the Euro Area an Optimum Currency Area?

• Optimum currency areas are groups of regions with economies closely linked by trade in goods and services and by factor mobility.

• Free flow of goods and labor can guarantee full employment in the presence of asymmetric demand shocks across countries.

• Intra-EU trade has increased substantially since the start of the EMU,still lower than that across states in the U.S.

• Labor is not quite mobile yet. For example, the percent of people changing residence (as a percent of total population) in the U.S. is 3.1, whereas in Italy is 0.5.

• Monetary policy: One size fits all?– No, for example, monetary policy should be tighter in Ireland with

full employment compared to Germany with 11.4 % of unemployment.

• What to do next? More integration.