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CHAPTER 28
FIXED OR FLEXIBLE EXCHANGE RATES?
Learning Objectives:
■ Discuss the central points of debate between proponents of fixed exchange rates and
proponents of flexible exchange rates.
■ Explain the advantages and disadvantages of a currency board.
■ Describe the economic characteristics necessary for the formation of an optimal currency
area.
■ Compare and contrast the strengths and weaknesses of exchange rate systems that
combine elements of both fixed and flexible exchange rates.
I. Outline
Introduction
– Exchange Rate Experiences
Central Issues in the Fixed-Flexible Exchange Rate Debate
– Do Fixed or Flexible Exchange Rates Provide for Greater “Discipline” on the
– Will Destabilizing Speculation in Exchange Markets Be Greater under Fixed or
Flexible Exchange Rates?
– Will Countries Be Better Protected from External Shocks under a Fixed or a
Flexible Exchange Rate System?
Currency Boards
– Advantages of a Currency Board
– Disadvantages of a Currency Board
Optimum Currency Areas
Hybrid Systems Combining Fixed and Flexible Exchange Rates
Summary
II. Special Chapter Features
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In the Real World: Exchange Risk and International Trade
In the Real World: Reserve Holdings under Fixed and Flexible Exchange Rates
III. Purpose of Chapter
The purpose of this chapter is to bring together in one place various issues surrounding
the fixed-flexible exchange rate debate, and to survey some hybrid systems of fixed and flexible
IV. Teaching Tips
A. The choice of an appropriate exchange rate regime is critical for many developing
countries. Often faced with non-responsive economic systems and institutional rigidities, they
B. The “In the Real World” box on pages 705-706 deals with the influence of risk on trade
volume. We have leaned toward the conclusion that exchange risk reduces trade to some extent.
C. Note the framework of the Hutchison and Walsh discussion on page 715’s “In the Real
World” box. They are not concluding that there were fewer shocks in the flexible-rate period;
D. The vicious circle hypothesis early in the chapter can easily be related to hyperinflation
and PPP discussed in previous Chapters 20 and 22.
E. Regarding the “In the Real World” box on page 725, note that Colombia stopped having
a strict crawling peg in 1991. However, we still find the Colombian case interesting, and the
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
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G. We have generally tried to maintain a neutral position in this chapter on the fixed-flexible
debate. Obviously, however, you may want to dismiss some arguments, buttress others, and take
a position.
V. Answers to End-of-Chapter Questions and Problems
1. Other things equal, a country that is willing to pursue continually expansionary policy in
order to keep unemployment low (moving beyond its natural level of output and employment)
2. A case that flexible rates can reduce the flow of foreign direct investment (FDI) is built
around the fact that, if prices do not move exchange rates in purchasing-power-parity fashion, the
real value of the return flow of profits and dividends when converted into domestic currency is
3. Generally speaking, a country more susceptible to external rather than internal shocks
would tend to prefer a flexible rate. External real shocks conceptually would have no impact on
national income in the flexible-rate case but would be transmitted onto national income with a
4. If you believe that markets maximize welfare, the conclusion in the quote follows if the
exchange rate is a true scarcity price and reflects the true relative purchasing power of
currencies. Then consumers and producers would indeed be able to direct their purchases and
© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
305
as externalities and monopoly do not exist.) However, distortions in the exchange rate due to
rumors and speculation can mean that the exchange rate doesn’t truly reflect opportunity costs
and purchasing power, in which case maximum welfare is not assured. A fixed rate could
conceptually be the true scarcity rate, but this seems highly unlikely to be the case over any time
period other than the extremely short run.
5. Not necessarily. If underlying inflation rates and monetary conditions are compatible, for
example, there may be little reason for speculators to expect prolonged currency movements in
one direction, and any speculation may therefore be stabilizing. With stable monetary
6. Risk can be detrimental to trade and international specialization if forward markets (and
derivatives markets in general) are not well-developed; risk can also be detrimental to world
7. A currency board has potential as a useful, practical arrangement for a country if that
country has been facing severe inflationary problems due to rapid money creation by the central
bank (on its own or in its passive financing of government budget deficits). The currency board
8. The world as a whole might be an optimum currency area if factors of production could
move freely among all countries. Then any shifts in demand, for example, would produce supply
responses as factors moved, and there would not necessarily be a problem of “pockets” of
inflation in some countries and of unemployment in others. In addition, if national governments
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9. This is obviously an opinion question, and the student’s answer may depend on whether
he or she is a “glass half–full” or a “glass half–empty” person. The statement’s position could be
10. Chile’s increased intervention in the foreign exchange market was designed to keep the
Chilean peso from rising so much due to the foreign investment inflows. A more rapid rise in
11. A “true” (optimum) currency area preserves its fixed exchange rates by containing an
effective BOP adjustment mechanism. Because of this effective mechanism, which can certainly
be partly composed of coordinated macro policies, there is confidence in the fixed exchange
VI. Sample Exam Questions
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1. Explain why it is alleged that a system of flexible exchange rates could have “wasteful
resource movements.” Why are these movements thought to be wasteful? Don’t resources need
to move between sectors as demand, cost, and profitability conditions change in a dynamic
economy?
2. Suppose that a currency plummets downward because of speculation against it. Can it
necessarily be stated that this speculation is “destabilizing” in nature? Why or why not?
3. Present the argument that the adoption of flexible rates would lead to a removal of
restrictions on trade. Do you agree that these controls would be eliminated? Does the adoption
4. What case could be made for a wider “band” of permitted exchange rate changes of the
5. Using the IS/LM/BP framework, explain how two of the following shocks impact on the
domestic economy under flexible exchange rates and under fixed exchange rates.
6. How could exchange rate protection of, for example, 10 percent, be duplicated in its
effects across export and import-substitute industries by using tariffs and subsidies instead?
8. If an important oil exporter such as Saudi Arabia were successful in raising the price of