19 Fixed Versus Floating: International Monetary Experience
Notes to Instructor
Chapter Summary
This chapter examines the choice of fixed versus floating exchange rate regimes in more
detail. We consider the potential benefits of a fixed exchange rate regime, such as
efficiency gains from reduced transactions costs, fiscal discipline, and reducing valuation
effects, and the costs, such as loss of stabilization policy. We study exchange rate
systems that involve cooperative and noncooperative adjustments. The chapter concludes
with an overview of two key exchange rate systems: the gold standard and the Bretton
Woods system.
Comments
The majority of this chapter is dedicated to weighing the costs and benefits of fixing the
exchange rate. Fixed versus floating exchange rate regimes were briefly examined in the
previous chapter. Here, we devote more attention to the trade-offs facing a country when
it chooses an exchange rate regime. This is a useful precursor to the theory of optimum
currency area, which is presented in more detail in Chapter 20. The chapter concludes
with a historical overview of exchange rate systems from the gold standard to the present.
An outline of the chapter is given in the following.
1. Exchange Rate Regime Choice: Key Issues
a. Application: Britain and Europe: The Big Issues
b. Key Factors in Exchange Rate Regime Choice: Integration and Similarity
c. Economic Integration and the Gains in Efficiency
d. Economic Similarity and the Costs of Asymmetric Shocks
e. Simple Criteria for a Fixed Exchange Rate
f. Application: Do Fixed Exchange Rates Promote Trade?
i. Benefits Measured by Trade Levels
ii. Benefits Measured by Price Convergence
g. Application: Do Fixed Exchange Rates Diminish Monetary Autonomy and
Stability?
i. The Trilemma, Policy Constraints, and Interest Rate Correlations
ii. Costs of Fixing Measured by Output Volatility
2. Other Benefits of Fixing
a. Fiscal Discipline, Seigniorage, and Inflation
b. Side Bar: The Inflation Tax
iv. Original Sin
d. Summary
3. Fixed Exchange Rate Systems
a. Cooperative and Noncooperative Adjustments to Interest Rates
4. International Monetary Experience
a. The Rise and Fall of the Gold Standard
b. Bretton Woods to the Present
5. Conclusions
Lecture Notes
This chapter considers the costs and benefits associated with maintaining an exchange
rate peg. As described by the historical overview of the international monetary
experience at the end of this chapter, the choice to fix versus float is not straightforward.
In addition to using the IS‒LM‒FX model from the previous chapter, this chapter
introduces a new model to examine these trade-offs: the symmetryintegration diagram.
This allows us to better understand the benefits and costs of fixing and to examine a
variety of fixed exchange rate systems.
1 Exchange Rate Regime Choice: Key Issues
Historically, fixed exchange rates were the preferred exchange rate regime among
economists and policy makers. Most countries adopted the gold standard, a system in
which the value of a country’s currency was pegged to an ounce of gold. Because most
countries adopted the gold standard, their currencies were fixed relative to each other.
Figure 19-1 shows a timeline of exchange rate regimes. World War I and II occurred
during 1914–1917 and 1940–1944 and, as such, these years are omitted from the
textbook figure and this discussion.
■ 1870–1913: Metallic standards, especially the gold standard (peak: 70% of
APPLICATION
Britain and Europe: The Big Issues
This application examines Great Britain’s 1992 decision to move from a fixed to a
floating exchange rate regime, highlighting key issues in the exchange rate regime
debate.
in Europe would promote trade by lowering transactions costs. In addition, from Britain’s
perspective, the ERM would help anchor inflation to Germany’s low inflation rate. It
joined the ERM in 1990.
A Shock in Germany As countries in Eastern Europe moved away from communism,
the Berlin Wall fell in 1989, reunifying East Germany and West Germany. East Germany
lagged behind West Germany and required significant public spending for social
programs and to modernize infrastructure.
Choices for the Other ERM Countries An increase in Germany’s interest rate had two
effects on ERM countries, illustrated in panels (b) and (c) of Figure 19-2.
■ IS curve shifts to the right. Higher German interest rates lead to expenditure
■ LM curve shifts to the left. To prevent depreciation against the DM, interest rates
Choice 1: Float and Prosper Option 1: Britain chooses to keep its interest rate
unchanged (point 4).
■ IS curve shifts to the right since a rise in foreign interest rates always leads to
expenditure switching at home.
Choice 2: Peg and Suffer Option 2: Britain remains part of the ERM (point 2).
■ IS curve shifts to the right.
Option 3: Britain stabilizes output (point 3).
■ IS curve shifts to the right.
■ LM curve shifts to the left (by a smaller amount than is required to maintain peg
What Happened Next? Britain opted out of the ERM, not wanting German-specific
events to dictate domestic policy. Figure 19-3 compares Britain with France, a country
that opted to remain part of the ERM. The British economy boomed (point 4), whereas
Key Factors in Exchange Rate Regime Choice: Integration and Similarity
Measuring the costs and benefits of a fixed exchange rate regime usually means
Economic Integration and the Gains in Efficiency
Economic integration refers to the growth of market linkages in goods, capital, and labor
markets between countries. Lowering transactions costs through a fixed exchange rate
will help promote economic integration. Because exchange rate fluctuations create
Economic Similarity and the Costs of Asymmetric Shocks
An asymmetric shock is a shock that affects one country, leaving others unaffected. This
was the case of the shock created by German reunification. Asymmetric shocks create
conflicts in policy objectives of the countries with fixed exchange rates. In contrast,
Simple Criteria for a Fixed Exchange Rate
Now that we have identified the efficiency benefits and stability costs, we can define a
net benefit of fixed versus float.
Two conclusions emerge from the previous discussion:
■ As integration rises, the efficiency benefits of a common currency increase.
■ As symmetry rises, the stability costs of a common currency decrease. Figure
19-4 illustrates the symmetry–integration diagram, showing these trade–offs in terms of
In the diagram, the FIX line indicates where the net benefit of a fixed exchange rate
regime is equal to zero.
■ Above the FIX line → high degree of economic integration, symmetric shocks →
APPLICATION
Do Fixed Exchange Rates Promote Trade?
A fixed exchange rate regime eliminates exchange rate volatility, reducing the
transactions costs associated with cross-border exchange. Specifically, under a pure fixed
Benefits Measured by Trade Levels Economic historians found that pairs of countries
that adopted the gold standard in the late nineteenth and early twentieth centuries enjoyed
trade levels 30% to 100% higher than those with floating exchange rates. Today, there are
several versions of a fixed exchange rate regime, making this a challenging question to
answer empirically. We can classify countries in four ways:
Figure 19-5 suggests a strong relationship between currency regimes and trade.
Benefits Measured by Price Convergence If fixed exchange rates lower transactions
costs, differences in prices should be smaller among countries with fixed exchange rates.
are more likely to hold in a fixed exchange rate regime if the argument posited previously
is true.
APPLICATION
Do Fixed Exchange Rates Diminish Monetary Autonomy and Stability?
If capital markets are unrestricted, then uncovered interest parity (UIP) holds, and the
home interest rate must be equal to the foreign interest rate. Therefore, policy in the base
The Trilemma, Policy Constraints, and Interest Rate Correlations Solutions to the
trilemma:
1. Open capital markets with fixed exchange rate (“open peg”)
Note that case 1 implies that monetary policy is not autonomous, so interest rates in the
home country move one-for–one with the base country. Cases 2 and 3 imply autonomous
Costs Measured by Output Volatility Loss of monetary policy autonomy may not be a
bad thing if central bankers are irresponsible or unable to achieve macroeconomic
objectives. In some sense, the costs of a fixed exchange rate regime hinge more on output
stability than monetary policy autonomy.
2 Other Benefits of Fixing
This section extends the discussion of costs and benefits of fixed exchange rate regimes
beyond economic integration and output stability.
Fiscal Discipline, Seigniorage, and Inflation
A fixed exchange rate regime prevents the government from financing a budget deficit by
printing money. Since monetary policy must be dedicated to maintaining the exchange
rate, the central bank cannot simply create money for the government to spend. In a
Table 19-1 shows that fixed exchange rate regimes do not prevent inflation. However,
examining subgroups, we observe that the adoption of a fixed exchange rate regime does
eventually reduce inflation in emerging markets and developing countries.
S I D E B A R
The Inflation Tax
This section considers why monetizing the deficit imposes an inflation tax (seigniorage)
on the public.
money. When the public holds money balances M/P, as prices rise, the value of real
money balances outstanding falls. For example, if you hold $100 and P = 1, when the
The extra money printed to purchase goods and services is worth ∆M/P = (∆M/M) ×
(M/P) = π × (M/P). In the example above, the $1 tax borne by the public is “paid” to the
government. We can see how this relates to the interest rate by using the money market
equilibrium condition:
Liability Dollarization, National Wealth, and Contractionary Depreciations
Many developing countries and emerging markets suffer from liability dollarization, in
which a large portion of foreign investment from abroad is denominated in another
Assumptions:
■ Two countries, Home (pesos) and Foreign ($)
■ Nominal exchange rate, Epesos/$
■ Home external assets
■ Home external liabilities
● LH denominated in home currency (pesos)
Home country’s total external wealth is the sum of total assets less the liabilities
expressed in home currency:
Suppose the exchange rate changes by ∆E. The change in wealth is (valuation effect)
From the expression, there are two possible cases following a depreciation, ∆E > 0:
Destabilizing Wealth Shocks Note that wealth effects may offset or magnify the effects
of a depreciation on aggregate demand. Although a depreciation increases the trade
balance, it also affects wealth because:
When a country’s foreign currency assets do not equal foreign currency liabilities, it has a
currency mismatch on its external balance sheet. Now consider how stabilization policy
(a monetary expansion) affects the economy differently in the presence of wealth effects.
■ If AF > LF, then external wealth increases → C and I increase → policy effect on
In theory, a currency depreciation could actually be contractionary if the valuation effects
Evidence Based on Changes in Wealth Figure 19-8 reports data on the cumulative
change in external wealth associated with valuation effects during currency crises from
1993 to 2003. From the figure, we see these valuation effects can be quite large, although
Evidence Based on Output Contractions Do these wealth effects matter for output?
Figure 19-9 plots the relationship between the percentage change in output against the
Original Sin Historically, most countries—especially those less-developed countries
operating on the fringes of the global capital market—were forced to borrow in gold or in
a “hard currency,” such as the British pound or the U.S. dollar. This created a currency
Options for Redemption?
■ Another perspective argues that the real source of the problem is global capital
market failure. Because small countries have a small pool of liabilities traded, investors
benefit little from diversification into these liabilities. These liabilities are more appealing
when they are bundled with others in the form of a security denominated in a single
currency.
■ Another prescription involves improving institutional quality and designing better
Practical Limitations
■ Government borrowing denominated in foreign currency is still a problem.
■ Also, currency mismatch in private sectors is a problem, compounded by moral
Summary
In addition to economic integration and economic similarity, there are several factors that
influence a country’s decision to adopt a fixed exchange rate regime:
■ Fixed exchange rates impose fiscal discipline by preventing the imposition of an
inflation tax (seigniorage) on the public.
3 Fixed Exchange Rate Systems
In reality, there are several types of fixed exchange rate systems, often involving
multiple countries, such as the Bretton Woods system and the European Exchange Rate
Mechanism (ERM). These are examples of reserve currency systems in which N
countries participate. The center (or base) country, usually assigned the number N, is the
currency to which all other countries peg. And the base country supplies the reserve
currency for the rest of the world.
At the beginning of this chapter, we studied Britain’s decision to leave the ERM and
allow the pound to float (see Application: Britain and Europe: The Big Issues). At that
time, the German Deutsch Mark (DM) was the base currency. Germany, as the center
country, had monetary policy autonomy. The German central bank had the luxury of
choosing i*. ERM countries had to set their interest rates equal to i* to maintain the peg.
This fundamental asymmetry is known as the Nth currency problem.
An alternative to the approach studied earlier is for countries to reach cooperative
Cooperative and Noncooperative Adjustments to Interest Rates
In the following examples, the home country is the noncenter country and the foreign
country is the center country. Suppose the noncenter country experiences an adverse
demand shock but the center country does not. This is shown as a leftward shift in the
home country’s IS curve in Figure 19-11.
Noncooperative (point 1):
■ To maintain the exchange rate peg, the home country must reduce the money
Cooperative (point 2):
■ The center country agrees to allow its output to expand, lowering interest rates by
shifting the LM* curve to the right.
■ The noncenter country follows, shifting the LM curve to the right, reducing the
loss in output.
Caveats Cooperative arrangements may arise if the countries seek to limit exchange rate
volatility without a hard peg. In this way, the countries can achieve most of the benefits
of fixing without high stability costs.