Page 201 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 17 : Process of Adjustments : Gold Standard, Fixed Exchange Rates and Flexible Exchange Rate

Such a system has two major advantages. The first is that fixed exchange rates imply reduced Notes
uncertainty, and this helps reduce the costs of international trade transactions. The second is that
fixed exchange rates act as to discipline monetary authorities, preventing them from pursuing
inflationary policies. This argument was emphasized when Brazil and Argentina adopted fixed-
exchange-rate-based arrangements in the 1990s. The logic is that excessive money supply expansion
generates inflation that, in turn, gives agents an incentive to shift into currencies with purchasing
power that is not being eroded. Such shifts force the central bank to intervene and buy the currency
to protect the exchange rate, thereby reducing the money supply. In this fashion, fixed exchange
rates establish an automatic mechanism that prevents central banks from excessive money supply
expansion, and central banks are forced to tighten the money supply whenever inflation starts to
increase to levels that will spur currency flight. This mechanism is referred to as a nominal anchor,
with the exchange rate serving to anchor the price level. In countries with histories of excessive
inflation and where central banks have lost credibility with financial markets, it is argued that
employing a fixed-exchange-rate nominal anchor is a good way to win back credibility. Moreover,
the costs of such commitment are small if monetary policy is viewed as being unable to systematically
impact equilibrium real interest rates and the equilibrium level of real economic activity.
Balanced against these advantages are several disadvantages. First, by committing to a fixed exchange
rate, a country gives up having the exchange rate as a shock absorber that helps insulate against
external economic shocks. Second, the fixed exchange rate limits the ability to use domestic monetary
policy to stabilize the economy, but, as noted above, this loss can be beneficial in cases where monetary
authorities have a credibility problem due to past high inflation.
Third, the nature of the adjustment process under fixed exchange rates may have a significant
deflationary bias. Abstracting from capital flows, countries with trade surpluses will experience an
excess demand for their currencies, while countries with trade deficits will experience an excess
supply of their currencies. If a deficit country is forced to keep buying its currency to defend the
exchange rate, this leads to domestic monetary contraction in the deficit country, while the money
supply of the surplus country increases due to the selling of foreign reserves by the deficit country.
The classical macroeconomic assumption is that reductions in the money supply cause prices to decline
but have no impact on output. This is the “neutrality of money proposition,” whereby output and
employment are determined by real economic factors (tastes, resources, and productive technology)
and not by the amount of circulating paper (i.e., money). Applied to the global economy with fixed
exchange rates, these money supply changes cause prices to fall in the deficit country and rise in the
surplus country, thereby altering relative competitiveness and eliminating the trade deficit. However,
such global monetarist reasoning is contested by Keynesian analysis that argues that monetary
contraction induces real output contraction that is worsened by price deflation due to debt effects.
The net result is that the adjustment process under fixed exchange rates causes domestic output
contraction that ricochets back into the international economy, as falling domestic income causes
reduced imports, in turn, reducing aggregate demand and income in other countries.
One possible way to avoid this contractionary outcome is to require the surplus country to defend its
currency and prevent it from appreciating, rather than require the deficit country to do the defending.
In this case, the system is prone to an expansionary bias, because the surplus country increases its
money supply to prevent appreciation. However, this arrangement removes the discipline of fixed
exchange rates on central banks. A second option for reducing contractionary bias is to have periodic
discrete adjustments of the fixed exchange rate to eliminate fundamental trade imbalances. This was
the Bretton Woods approach. However, it also removes (or at least significantly weakens) the discipline
of fixed exchange rates on central banks. Additionally, it does away with the certainty of fixed exchange
rates and invites market speculation aimed at anticipating or forcing a devaluation.
One claimed advantage of fixed exchange rates is that they reduce price uncertainty, which is good
for international trade. However, introducing international capital mobility into a system of fixed
exchange rates dramatically changes this conclusion. As noted earlier, capital mobility introduces
portfolio and wealth allocation concerns that impact currency markets. Most importantly, capital
mobility introduces financial market behaviors of speculation and herding into currency markets.
These behaviors can render a fixed exchange-rate system financially fragile. If a country has a persistent

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