Page 207 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 18 : Merits and Demerits of Fixed and Flexible Exchange Rate

and idiosyncratic policies and shocks of any one foreign country. One method for creating a currency Notes
basket is to compose it of the currencies of the country’s primary trading partners, particularly if the
partner has a hard currency, with shares set in proportion to each country’s proportion of trade. If
the correlation of the business cycle with each trading partner is proportional to the share of trade
with that country, then the potential for idiosyncratic shocks to harm the economy should be
considerably reduced when pegged to a basket of currencies. On the down side, baskets do not
encourage as much bilateral trade and investment as a peg to a single currency because they reintroduce
bilateral exchange rate risk with each trading partner.
Political Advantages of a Fixed Exchange Rate : In previous decades, it was believed that developing
countries with a profligate past could bolster a new commitment to macroeconomic credibility through
the use of a fixed exchange rate for two reasons. First, for countries with inflation rates that were
previously very high, the maintenance of fixed exchange rates would act as a signal to market
participants that inflation was now under control. For example, inflation causes the number of dollars
that can be bought with a peso to decline just as it causes the number of apples that can be bought
with a peso to decline. Thus, a fixed exchange rate can only be maintained if large inflation differentials
are eliminated. Second, a fixed exchange rate was thought to anchor inflationary expectations by
providing stable import prices. For a given change in monetary policy, it is thought that inflation will
decline faster if people expect lower inflation.
After the many crises involving fixed exchange rate regimes in the 1980s and 1990s, this argument
has become less persuasive. Unlike a currency board, a fixed exchange rate regime does nothing
concrete to tie policymakers’ hands and prevent a return to bad macroeconomic policy. Resisting the
temptation to finance budget deficits through inflation ultimately depends on political will; if the
political will is lacking, then the exchange rate regime will be abandoned, as was the case in many
1980s exchange rate crises. Thus burnt in the past, investors may no longer see a fixed exchange rate
as a credible commitment by the government to macroeconomic stability, reducing the benefits of the
fixed exchange rate. Furthermore, some currency board proponents claim that this lack of credibility
means that investors will “test” the government’s commitment to maintaining a soft peg in ways that
are costly to the economy. By contrast, they claim that investors will not test a currency board because
they have no doubt of the government’s commitment.
For this reason, many economists who previously recommended fixed exchange rates on the basis of
their political merits have shifted in recent years towards support of a hard peg. This has been dubbed
the “bipolar view” of exchange rate regimes : growing international capital mobility has made the
world economy behave more similarly to what models have suggested. As capital flows become
more responsive to interest rate differentials, the ability of “soft peg” fixed exchange rate regimes to
simultaneously pursue domestic policy goals and maintain the exchange rate has become untenable.
As a result, countries are being pushed toward floating exchange rates (the pursuit of domestic goals)
or “hard pegs” (policy directed solely toward maintaining the exchange rate). In this view, while
“soft pegs” may have been successful in the past, any attempt by a country open to international
capital to maintain a soft peg today is likely to end in an exchange rate crisis, as happened to Mexico,
the countries of Southeast Asia, Brazil, and Turkey. Empirically, the trend does appear to be moving
in this direction. In 1991, 65% of the world’s 55 largest economies used “soft peg” exchange rate
arrangements; in 1999, the number had fallen to 27%.
Although the international trend has been towards greater capital mobility and openness, it should
be pointed out that there are still developing countries that are not open to capital flows. The “bipolar
view” argument may not hold for these countries : without capital flows reacting to changes in interest
rates, these countries may be capable of maintaining a soft peg and an independent monetary policy.
This has been the case for China.
Fixed exchange rates have the following merits :
1. The case for fixed exchange rate between different countries is based on the case for a common
currency within a country. A country having a common currency with a fixed value facilities
trade increases production and leads to faster growth of the economy. Similarly, a country
would benefit if it has a fixed value of its currency in relation to other countries. Thus fixed

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