Chapter 10 Outline

Fixed Versus Floating Exchange Rates

The breakdown of the Bretton Woods system has not stopped the debate about the relative merits of fixed versus floating exchange rate regimes. Disappointment with the system of floating rates in recent years has led to renewed debate about the merits of fixed exchange rates. In this section we review the arguments for fixed and floating exchange rate regimes.⁶ We will discuss the case for floating rates before discussing why many commentators are disappointed with the experience under floating exchange rates and yearn for a system of fixed rates.

The Case for Floating Exchange Rates

The case for floating exchange rates has two main elements: monetary policy autonomy and automatic trade balance adjustments.

Monetary Policy Autonomy

It is argued that under a fixed system, a country's ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity. Monetary expansion can lead to inflation, which puts downward pressure on a fixed exchange rate (as predicted by PPP theory; see Chapter 9). Similarly, monetary contraction requires high interest rates (to reduce the demand for money). Higher interest rates lead to an inflow of money from abroad, which puts upward pressure on a fixed exchange rate. Thus, to maintain exchange rate parity under a fixed system, countries were limited in their ability to use monetary policy to expand or contract their economies.

Advocates of a floating exchange rate regime argue that removal of the obligation to maintain exchange rate parity would restore monetary control to a government. If a government faced with unemployment wanted to increase its money supply to stimulate domestic demand and reduce unemployment, it could do so unencumbered by the need to maintain its exchange rate. While monetary expansion might lead to inflation, this would lead to a depreciation in the country's currency. If PPP theory is correct, the resulting currency depreciation on the foreign exchange markets should offset the effects of inflation. Although under a floating exchange rate regime domestic inflation would have an impact on the exchange rate, it should have no impact on businesses' international cost competitiveness due to exchange rate depreciation. The rise in domestic costs should be exactly offset by the fall in the value of the country's currency on the foreign exchange markets. Similarly, a government could use monetary policy to contract the economy without worrying about the need to maintain parity.

Trade Balance Adjustments

Under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade (importing more than it exported) that could not be corrected by domestic policy, this would require the IMF to agree to a currency devaluation. Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime. They argue that if a country is running a trade deficit, the imbalance between the supply and demand of that country's currency in the foreign exchange markets (supply exceeding demand) will lead to depreciation in its exchange rate. In turn, by making its exports cheaper and its imports more expensive, an exchange rate depreciation should correct the trade deficit.

The Case for Fixed Exchange Rates

The case for fixed exchange rates rests on arguments about monetary discipline, speculation, uncertainty, and the lack of connection between the trade balance and exchange rates.

Monetary Discipline

We have already discussed the nature of monetary discipline inherent in a fixed exchange rate system when we discussed the Bretton Woods system. The need to maintain a fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates. While advocates of floating rates argue that each country should be allowed to choose its own inflation rate (the monetary autonomy argument), advocates of fixed rates argue that governments all too often give in to political pressures and expand the monetary supply far too rapidly, causing unacceptably high price inflation. A fixed exchange rate regime will ensure that this does not occur.

Speculation

Critics of a floating exchange rate regime also argue that speculation can cause fluctuations in exchange rates. They point to the dollar's rapid rise and fall during the 1980s, which they claim had nothing to do with comparative inflation rates and the US trade deficit, but everything to do with speculation. They argue that when foreign exchange dealers see a currency depreciating, they tend to sell the currency in the expectation of future depreciation regardless of the currency's longer-term prospects. As more traders jump on the bandwagon, the expectations of depreciation are realized. Such destabilizing speculation tends to accentuate the fluctuations around the exchange rate's long-run value. It can damage a country's economy by distorting export and import prices. Thus, advocates of a fixed exchange rate regime argue that such a system will limit the destabilizing effects of speculation.

Uncertainty

Speculation also adds to the uncertainty surrounding future currency movements that characterizes floating exchange rate regimes. The unpredictability of exchange rate movements in the post-Bretton Woods era has made business planning difficult, and it makes exporting, importing, and foreign investment risky activities. Given a volatile exchange rate, international businesses do not know how to react to the changes--and often they do not react. Why change plans for exporting, importing, or foreign investment after a 6 percent fall in the dollar this month, when the dollar may rise 6 percent next month? This uncertainty, according to the critics, dampens the growth of international trade and investment. They argue that a fixed exchange rate, by eliminating such uncertainty, promotes the growth of international trade and investment. Advocates of a floating system reply that the forward exchange market insures against the risks associated with exchange rate fluctuations (see Chapter 9) so the adverse impact of uncertainty on the growth of international trade and investment has been overstated.

Trade Balance Adjustments

Those in favor of floating exchange rates argue that floating rates help adjust trade imbalances. Critics question the closeness of the link between the exchange rate and the trade balance. They claim trade deficits are determined by the balance between savings and investment in a country, not by the external value of its currency.⁷ They argue that depreciation in a currency will lead to inflation (due to the resulting increase in import prices). This inflation will wipe out any apparent gains in cost competitiveness that come from currency depreciation. In other words, a depreciating exchange rate will not boost exports and reduce imports, as advocates of floating rates claim; it will simply boost price inflation. In support of this argument, those who favor floating rates point out that the 40 percent drop in the value of the dollar between 1985 and 1988 did not correct the US trade deficit. In reply, advocates of a floating exchange rate regime argue that between 1985 and 1992, the US trade deficit fell from over $160 billion to about $70 billion, and they attribute this in part to the decline in the value of the dollar.

Who Is Right?

Which side is right in the vigorous debate between those who favor a fixed exchange rate regime and those who favor a floating exchange rate regime? Economists cannot agree on this issue. From a business perspective, this is unfortunate because business, as a major player on the international trade and investment scene, has a large stake in the resolution of the debate. Would international business be better off under a fixed regime, or are flexible rates better? The evidence is not clear.

We do, however, know that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work. Speculation ultimately broke the system, a phenomenon that advocates of fixed rate regimes claim is associated with floating exchange rates! Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment. In the next section, we look at potential models for such a system and the problems with such systems.