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Chapter 25
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 25.1 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 (internal balance) 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 rates tend
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 exchange rate valueshave 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. Some countries have adopted 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 the problems of an exit strategy. With “dollarization,” used by El
Salvador, Ecuador, Panama, Zimbabwe, and several 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 20, 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. Then a series of speculative attacks weakened the ERM—Britain and Italy left it in
1992, realignments were necessary for the central rates of the currencies of some other countries,
and the bands for nearly all currencies were widened to plus or minus 15 percent in 1993. 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, 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.
Slovenia joined in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011,and Latvia
in 2014 (as well as Lithuania in 2015).
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 the loss of
national use of exchange rate changes and monetary policy to address shortcomings in national
economic performance. Thus, a major challenge for the member countries is finding effective
mechanisms for national adjustments when adverse economic shocks affect different countries in
different ways (for instance, Germany and Ireland during the early 2000s).Labor mobility
between member countries is low. “Internal devaluation” to improve international price
competitiveness is painfully slow. There is almost no unionwide fiscal policy.
Fiscal policy has become a flash point for the euro area. In the absence of national monetary
policy and national exchange rate policy, national fiscal policy should be valuable as the key tool
for national macroeconomic stabilization. But national governments may sometimes run
excessive fiscal deficits and build up excessive government debt. The Stability and Growth Pact
attempted to impose limits on the size of national government budget deficits, but the pact was
weakened in 2005. Then the global financial and economic crisis led to ballooning deficits in
some euro-area countries. Greece had to be rescued from a government debt crisis in 2010,
followed by Ireland and Portugal. In mid-2011 the government debts of Spain and Italy came
under market pressures. National fiscal policies and national government debt were centralto the
crisis that threatenedthe viability of the euro. The euro area countries have adopted a revised
fiscal compact, but it remains to be seen if it is effective and suitable.
Tips
One classroom exercise that can be both fun and challenging is to divide the class into several
groups and have a class debate about the desirability of different exchange rate systems for
NAFTA. For instance, one group could be the proponent of a rapid shift to monetary union, a
second the proponent of fixed but adjustable exchange rates among the Canadian dollar, the U.S.
dollar and the Mexican peso (a system like the European Exchange Rate Mechanism), and the
third the proponent of continuing the floating exchange rates among the NAFTA currencies. If
this is done without formal group preparation, then the instructor can call on a person from each
group to present one point, and then rotate around the groups until most points have been made.
Or, groups can meet and prepare formal statements of key arguments, with class presentations of
the groups' statements. After any follow-on discussion, the class could end with a vote—if you
were a Canadian (or a Mexican, or an American) politician or businessperson, what system
would you favor?
