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