Lecture 16 Fixed versus Floating Exchange Rates Econ 340Econ 340, Deardorff, Lecture 16: Fixed/Float 2 Outline: Fixed versus Floating Exchange Rates • Both Systems Are Used • What the “Experts” Recommend • Pros and Cons of Floating – Disruption When Rates Move – Automatic Adjustment • Pros and Cons of Pegging – Stability – Instability • Alternatives – Crawling Peg – Monetary Unification • The Problem of Undervalued CurrenciesEcon 340, Deardorff, Lecture 16: Fixed/Float 3 Who Uses Fixed and Float • Lessons from the list of exchange arrangements (below) – Floating rates are used by many countries • Rich & poor • Large & small • All over the world – Pegged rates are used today mostly by small countries – Many countries are between fixed and floating (Source of table below: IMF, “Annual Report on Exchange Arrangements and Exchange Restrictions 2013”)Econ 340, Deardorff, Lecture 16: Fixed/Float 4 Exchange Arrangements of Sample Countries, as of 2013 Floating Exchange Rates 48 countries + euro 17 Australia Mexico Canada Sweden India United Kingdom Japan United States Pegged Exchange Rates 45 countries Belize Latvia Denmark Nepal Jordan Saudi ArabiaEcon 340, Deardorff, Lecture 16: Fixed/Float 5 Exchange Arrangements of Sample Countries, as of 2013 Stabilized Arrangement 19 countries Costa Rica Ukraine Lebanon Vietnam Crawling Peg or Crawl-like Arrangement 17 countries Argentina China Other Managed Arrangement 19 countries Bangladesh Russia Malaysia Switzerland Between Floating and Pegged:Econ 340, Deardorff, Lecture 16: Fixed/Float 6 Exchange Arrangements of Sample Countries, as of 2013 Currency Board 12 countries Hong Kong Lithuania No Separate Legal Tender 13 countries Ecuador ($) Montenegro (€) More Fixed than Pegged: • Currency Board – Peg to another currency – Vary money supply automatically with changes in international reserves (= forced nonsterilization)Econ 340, Deardorff, Lecture 16: Fixed/Float 7 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Country Distribution of Currency Arrangements 2013 None Cur. Board Pegged Stabilized Crawl Managed Float Pegged Float More Fixed More FlexibleEcon 340, Deardorff, Lecture 16: Fixed/Float 8 Outline: Fixed versus Floating Exchange Rates • Both Systems Are Used • What the “Experts” Recommend • Pros and Cons of Floating – Disruption When Rates Move – Automatic Adjustment • Pros and Cons of Pegging – Stability – Instability • Alternatives – Crawling Peg – Monetary Unification • The Problem of Undervalued CurrenciesEcon 340, Deardorff, Lecture 16: Fixed/Float 9 What “Experts” Recommend • Some favor freely floating rates – Let exchange rate adjust to fix imbalances – “Let the market work” • Others favor perfectly fixed rates – Define currency rigidly in terms of something you can’t control • Gold • Foreign currency (“Currency Board”) – AND give up control of the money supply • Let flows of money fix imbalances i.e., do not sterilize!Econ 340, Deardorff, Lecture 16: Fixed/Float 10 What “Experts” Recommend • Advocates of floating rates – Milton Friedman (Nobel Prize 1976): “A country that enters into a hard-fixed rate bears an economic cost. The cost is discarding a means—a flexible exchange rate—of adjusting to external forces that impinge on it differently than on the other country or countries whose currency it shares.”Econ 340, Deardorff, Lecture 16: Fixed/Float 11 What “Experts” Recommend • Advocates of floating rates – Jeffrey Sachs: “Once reserves are gone, investors panic. The worst mistake is for countries to wait too long to float their currencies.”Econ 340, Deardorff, Lecture 16: Fixed/Float 12 What “Experts” Recommend • Advocates of fixed rates – Robert Mundell (Nobel Prize 1999): “A world currency of some sort has existed for most of the past 2,500 years. Two thousand years ago, in the age of Caesar Augustus, it was the Roman aureus... A hundred years ago it was the gold sovereign. Less than thirty years ago it was the 1944 gold dollar. The world has been without a universal currency for only a tiny fraction of its history.”Econ 340, Deardorff, Lecture 16: Fixed/Float 13 What “Experts” Recommend – Milton Friedman: “If [over the last 30 years] the Canadian dollar had been rigidly tied to the US dollar, those differences would have required Canada to deflate relative to the United States, with unfortunate consequences for Canada that would have strained, to put it mildly, the trade relations between the two countries, and have put strong pressure on Canada to devalue or float.”Econ 340, Deardorff, Lecture 16: Fixed/Float 14 What “Experts” Recommend – Robert Mundell: “Exchange rate uncertainty imposes a cost of trade much like a tariff ... If Canada and the United States shared a stable common currency or an irrevocably fixed exchange rate, Canada’s real income would soar, closing a large part of the gap between the two countries’ GDP per capita.”Econ 340, Deardorff, Lecture 16: Fixed/Float 15 What “Experts” Recommend • “Bradford DeLong, an economic historian at the University of California at Berkeley, explains the debate to his students this way: ” (WSJ) To Mr. Friedman, an exchange rate is a price; therefore, it is an infringement on human freedom to peg it. To Mr. Mundell, an exchange rate is a promise; to change it is to default on a commitment.Econ 340, Deardorff, Lecture 16: Fixed/Float 16 What “Experts” Recommend • Allan Meltzer (Carnegie-Mellon): “The best you can say of what economic research has produced is: – You can make a case for freely floating exchange rates if you’re willing to live with the consequences. – You can make a case for fixed exchange rates if you’re willing to live with the consequences. – You can’t make much of a case for anything in between.” (WSJ)Econ 340, Deardorff, Lecture 16: Fixed/Float 17 What “Experts” Recommend • Where they agree: An “adjustable peg” is worse than both fixed and floating rates – Friedman: “The reasons why a pegged exchange rate is a ticking bomb are well known.” – Mundell: “I have never nor ever would
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