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221 GLOBAL DEBATE DEBATE: Fixed FX Rates, Perhaps Hooked to Gold, or Floating Rates, Hooked to Faith? Most economists support the idea that floating exchange rates are beneficial for the world economy. A small minority of experts advocates a return to the gold standard and fixed exchange rates. Let’s further consider this choice. As we have seen, in the early 1970s, the U.S. government could not continue to guarantee that dollars floating around the world would be convertible to gold at the agreed rate. So it decoupled the dollar from gold, with the immediate effect that the world’s currency exchange rates were not fixed any more.* The economists Obstfeld and Rogoff argue that the main reason exchange rates could not stay fixed was the rapid evolution of world capital markets since the 1950s. Until the volume of trade grew, governments would buy or sell significant amounts of their currencies in the global markets in an effort to sustain their currency’s supply and demand equilibrium. When the volume of global transactions started exceeding most countries’ foreign exchange reserves, however, governments could no longer intervene effectively to sustain the value of their currency. At the same time, a speculative attack, that is, unexpected buying by previously inactive traders (a term first used in regard to FX trading by Krugman), on a specific currency by the market could cause a run on it that its government could not counter. With the advent of the Internet, in less than 15 years the amount of daily foreign exchange transactions increased from $1 trillion in 1994 to an estimated $1,378 trillion in 2013. This growth in scale made government control of its currency’s value difficult if not impossible. It also is difficult to imagine a day when the main currency regimes around the world would again be dominated by fixed-rate relationships. Even if a central bank could support its currency effectively, the impact on the rest of the economy could be considerable. In an environment where currency A is becoming relatively stronger than currency B, the interest rates in country A are likely to be higher than those in country B. This increases the cost of doing business in country A relative to country B. It is the case that interest rate movements, exchange rate values, and inflationary pressures, all forces that influence the monetary picture, tend to be interlinked. What are the key arguments for trying to fix exchange rates?** First, floating rates increase the cost of trade for industries that ship products from one country to another because rates can change in the time lag between ordering and receiving. Whether the manufacturer or the buyer bears the risk, or both, there are ways to minimize foreign exchange risk related to timing, but they introduce a new cost to the transaction. Second, exchange rate fluctuations of a floating rate system impede trade. They may lead to protectionist measures that can deprive a country’s people from trade benefits. (Yet, we must note that a fixed exchange rate means the government is depriving itself of the ability to manage its own monetary policy.) In a floating system, there are also psychological factors at work in the market. A currency from which buyers are fleeing will weaken and the one they are moving into will strengthen. A strengthening currency has a negative impact on the country’s ability to export because its goods become more expensive relative to others. Finally, fixed-rate proponents say fixed exchange rates impose monetary discipline on a government, that is, a readiness to limit the money supply if necessary. This explanation implies, however, that a government can act in isolation from other governments, an impossible option today. It appears that we have gone from the thing we valued, gold as a currency, to a currency that operated as a proxy for gold, to currencies that float against one another in a largely free float, hinged not to gold but to our faith in the monetary system. Questions 1. If the SDR were used, would a viable fixed-rate regime be possible or not? 2. Given the inclusion of the SDR, outline the pro and con arguments for a fixed-rate regime. * M. Obstfeld and K. Rogoff, “The Mirage of Fixed Exchange Rates,” Journal of Economic Perspectives 9, no. 4 (1995), pp. 73–96. ** P. B. Kenen, “Fixed versus Floating Exchange Rates,” Cato Journal 20, no. 1 (2000), pp. 109–13. at some of the most significant additional financial forces, one that governments can exert, beginning with currency exchange controls, and then move on to taxation, inflation and interest rates, and balance-of-payments effects. Study Smart and Improve Your Grades Go to http://bit.ly/SmartBookNOW


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