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Fixed Vs Flexible Exchange Rates

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International Finance and Open-Economy Macroeconomics

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Abstract

It may seem that the old debate on fixed and flexible exchange rates has been made obsolete by international monetary events, as the international monetary system abandoned the Bretton Woods fixed exchange rate regime (of the adjustable peg type) in the early 1970s, and is now operating under a managed float regime mixed with others (see Sect. 3.3); nor does it seem liktractely that freely flexible exchange rates will be generally adopted or fixed ones will return. However, a general outline of the traditional arguments is not without its uses, because many of these keep cropping up. The reference to aspects already treated in previous chapters will allow us to streamline the exposition. In examining the main pros and cons of the two systems it should be borne in mind that the arguments for one system often consist of arguments against the other.

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Notes

  1. 1.

    Under normal conditions, all agents expect parities to remain fixed, so that there is no incentive for them to have recourse to the forward market. It is only in the case of fundamental disequilibrium that agents begin to fear parity changes. But, by the very nature of the adjustable peg, their expectations will be unidirectional, so that there will either be only a demand for forward exchange (if a devaluation is expected) by importers and other agents who have to make future payments abroad, or else only a supply of forward exchange (if a revaluation is expected) by exporters and other agents who are due to receive future payments from abroad. Thus in both cases the other side of the market will be absent, i.e. there will be no supply (if a devaluation expected) or no demand (if a revaluation is expected) to match the demand and supply respectively. This means that banking and other intermediaries will procure the forward cover at cost practically corresponding to the expected devaluation or revaluation.

  2. 2.

    It should be noticed that the official convertibility of the US dollar into gold put, at least in theory, restraints on the conduct of the US monetary policy (and, more generally, on US economic policy). See, for example, Argy (1981), Chaps. 3 and 6.

  3. 3.

    Some countries, amongst them Italy, adopted a two-tier (or dual) exchange rate, that is a regime where there are two distinct markets for foreign exchange: one for commercial (or, more generally, current account) transactions, where a “commercial” exchange rate (usually fixed) exists, and the other for the residual transactions, where a “financial” exchange rate (usually floating, more or less cleanly) is determined. The two markets must of course be completely separated, otherwise no spread could exist between the commercial and the financial exchange rate; the administrative measures required to bring about this segregation need not concern us here. The idea behind a two-tier market is to isolate the current account from disturbances deriving from possible destabilizing capital flows. This implies that the financial exchange rate is left completely free so as to equilibrate the capital account, whilst the commercial exchange rate is fixed or under a heavily managed float. The relative pros and cons of a perfect two-tier market are a matter of debate (for a theoretical analysis of dual exchange markets see, for example, Flood 1978, Adams and Greenwood 1985, and references therein); all agree, however, that for an actual two-tier market to approach the ideal theoretical form, the two markets must be effectively segregated. Otherwise, in fact, on the one hand the financial market comes to lose any practical importance and, on the other, clandestine capital movements (which, as we know, take place through current account transactions: see Sect. 5.1.4) are stimulated and a “parallel” market develops. This is what actually happened, for example, in Italy, so that in March, 1974, the dual market—which had lost any practical importance—was abolished. For a detailed description of actual two-tier markets see International Monetary Fund, Annual Report on Exchange Restrictions (years 1971 through 1974, and the current year for indication of those countries still maintaining dual exchange markets).

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  1. Classe di Scienze Morali, Accademia Nazionale dei Lincei, Rome, Italy

    Giancarlo Gandolfo

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Gandolfo, G. (2016). Fixed Vs Flexible Exchange Rates. In: International Finance and Open-Economy Macroeconomics. Springer Texts in Business and Economics. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-662-49862-0_17

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  • DOI: https://doi.org/10.1007/978-3-662-49862-0_17

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