Floating Exchange Rates and Capital Mobility

Abstract

Since the breakdown of the Bretton Woods fixed exchange-rate system in the early 1970s, Finland, like Sweden and Norway and some other small countries, has pursued a policy of pegging the exchange rate by means of a currency index.¹ Lately, however, adherence to this policy has clearly diminished the scope for conducting monetary policies independently from the rest of the world because of the increased mobility and sensitivity of foreign-capital flows. As financial integration increases, a fixed exchange-rate regime in which the exchange rate is pegged to the currency index or to the EMS currencies is an obvious choice for exchange-rate policy as part of the integration process. However, the reduction of autonomy in domestic monetary policy could be especially severe if there were a loss of confidence in the fixed exchange-rate policy and consequent inflation target because of insufficient flexibility in the labour market and fiscal policy. In these circumstances, domestic monetary policy becomes tightly constrained by the need to safeguard external liquidity.