Pros and Cons of Different Exchange Rate Systems

Floating Fixed
Pros  Allows monetary policy to be used
for other purposes
 Policy makers free to pursue other
goals such as stabilising
employment or prices
Cons  Exchange rate uncertainty makes
international trade more difficult
 After abandonment of Bretton
Woods system of fixed e, real and
nominal exchange rates become v
volatile
 BUT even under exchange-rate
volatility, amount of world trade
has continued to rise under floating
exchange rates
 Commitment to a fixed exchange
rate is one way to discipline a
nation’s monetary authority and
prevent excessive growth in
monetary supply
 BUT other policy rules to which
central bank could be committed e.g.
inflation rate target
 Simpler to implement than other
policy rules because money supply
adjusts automatically
 BUT could lead to greater volatility
in income and employment
 Monetary policy committed to
maintaining the exchange rate at
announced level

Speculative Attacks, Currency Boards, ‘Dollarization’ and ‘Euroization’

 One issue with fixed exchange rate: you might not have enough of a currency to manipulate
the money supply!
 If people come to the central bank to sell large quantities of domestic currency, the c.b’s
foreign currency reserves may deplete
 Therefore central bank has to abandon the fixed exchange rate
 Raises possibility of a speculative attack (a change in investors’ perceptions that makes the
fixed exchange rate untenable)
 Rumous that exchange rate peg will be abandoned  people run to c.b to convert domestic
currency to foreign before domestic currency loses value  drain c.b reserves  peg
abandoned (rumour is self-fulfilling)
 To avoid this: fixed exchange rate should be supported by a currency board
o Currency board: an arrangement by which the central bank holds enough foreign
currency to back each unit of the domestic currency
o Once currency board adopted  country could just use the foreign currency
 However members of a monetary union typically share in the seigniorage revenue from
printing the common currency
 Country unilaterally decides to adopt another country’s currency: then issuing country gets
the revenue that is generated from printing money
 Advantage to adopting currency: effectively imports price and currency stability from the
issuing country
The Impossible Trinity

 Impossible for nation to have free capital flows, fixed exchange rate and independent
monetary policy
 Must choose one side of the triangle

1. Allow free flows of capital and conduct an independent monetary policy (UK)
 Exchange rate must float to equilibrate the FX exchange market

2. Allow free flows of capital and fix exchange rate (Hong Kong)
 Loses ability to run an independent monetary policy
 Money supply must adjust to keep the exchange rate at its predetermined level
 When nation fixes its currency to that of another nation  adopts other nation’s
monetary policy

3. Restrict the international flow of capital in and out of the country (China)
 Interest rate no longer fixed by world interest rates
 Instead determined by domestic forces ALMOST LIKE completely closed economy
 Therefore possibly to fix exchange rate and conduct an independent monetary policy
 Common Currency Areas and European Economic and Monetary Union

 Does a single currency offer sufficient flexibility for member countries to withstand/mitigate
the effects of financial crisis?
 Late 90s: European countries gave up national currencies and use a new common currency:
euro, forming European Economic and Monetary Union (EMU)
 Adopting a single currency  gave up control over own monetary policy

Common Currency Areas

 Common currency area: geographical area through which one currency circulates and is
accepted as the medium of exchange
o A.k.a currency union or monetary union
 EMU (European Economic and Monetary Union): common currency area formed by 17
European countries that have adopted the euro as their currency
o These countries make up the Euro Area
o Euro officially came into existence on 1 January 1999
o Since they have a single currency also have a single monetary policy
o Monetary policy formulated by the ECB (European Central bank) + ESCB (European
System of Central Banks)

The Benefits of a Single Currency

 Reduction in Transaction Costs in Trade

o When importing, no longer has to pay a charge to bank for converting domestic
currency to foreign currency
o Banking sector loses out on the commission it used to charge for converting
currencies BUT this does not affect the fact that the reduction in transaction costs is a
net gain
 Paying a cost to convert currencies is in fact a deadweight loss
 Companies pay the transaction cost but get nothing tangible in return
 Resources used in banking services formerly can be transferred elsewhere 
net increase in welfare
o Gains could be even larger from eliminated transaction costs if inter-bank payment
systems between countries were better integrated

 Reduction in Price Discrimination

o If goods are priced in a single currency, should be much harder to disguise price
differences across countries
 Assumes transparency in prices will lead to arbitrage in goods across the
common currency area (buy goods where cheaper, reducing demand where
they are more expensive)
o BUT EMU has not brought an end to price discrimination
 E.g. supermarkets
 Large transaction costs involved in arbitraging such as travelling, feasibility of
carrying goods across
 Even big ticket goods e.g. household appliances where transaction costs lower
percentage of the price of the good, likelihood of arbitrage is low due to
durable nature
  Reduction in Foreign-Exchange-Rate Variability
o Reduction in uncertainty that results from having a single currency
o Comes from removal of exchange-rate fluctuations
o May also affect investment in the economy
o Increase in investment  higher economic growth

The Costs of a Single Currency

 Loss of Monetary Policy Sovereignty

o Gives up national currency
o Therefore gives up freedom to set own monetary policy and possibility of
macroeconomic adjustment coming about through movements in the external value of
its currency

 Asymmetric Demand Shocks

 Asymmetric Supply Shocks

 Loss of Fiscal Policy Sovereignty