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| Situation | Floating Exchange Rates | Soft Peg | Hard Peg | Merged Currency |
|---|---|---|---|---|
| Large short-run fluctuations in exchange rates? | Often a lot in the short term | Maybe less in the short run, but still large changes over time | None, unless a change in the fixed rate | None |
| Large long-term fluctuations in exchange rates? | Can often happen | Can often happen | Cannot happen unless hard peg changes, in which case substantial volatility can occur | Cannot happen |
| Power of central bank to conduct countercyclical monetary policy? | Flexible exchange rates make monetary policy stronger | Some power, although conflicts may arise between exchange rate policy and countercyclical policy | Very little; central bank must keep exchange rate fixed | None; nation does not have its own currency |
| Costs of holding foreign exchange reserves? | Do not need to hold reserves | Hold moderate reserves that rise and fall over time | Hold large reserves | No need to hold reserves |
| Risk of being stuck with an exchange rate that causes a large trade imbalance and very high inflows or outflows of financial capital? | Adjusts often | Adjusts over the medium term, if not the short term | May become stuck over time either far above or below the market level | Cannot adjust |
Global macroeconomics would be easier if the whole world had one currency and one central bank. The exchange rates between different currencies complicate the picture. If exchange rates are set solely by financial markets, they fluctuate substantially as short-term portfolio investors try to anticipate tomorrow’s news. If the government attempts to intervene in exchange rate markets through soft pegs or hard pegs, it gives up at least some of the power to use monetary policy to focus on domestic inflations and recessions, and it risks causing even greater fluctuations in foreign exchange markets.
There is no consensus among economists about which exchange rate policies are best: floating, soft peg, hard peg, or merged currencies. The choice depends both on how well a nation’s central bank can implement a specific exchange rate policy and on how well a nation’s firms and banks can adapt to different exchange rate policies. A national economy that does a fairly good job at achieving the four main economic goals of growth, low inflation, low unemployment, and a sustainable balance of trade will probably do just fine most of the time with any exchange rate policy; conversely, no exchange rate policy is likely to save an economy that consistently fails at achieving these goals. On the other hand, a merged currency applied across wide geographic and cultural areas carries with it its own set of problems, such as the ability for countries to conduct their own independent monetary policies.
The foreign exchange value of the dollar is a price and whether a higher price is good or bad depends on where you are standing: sellers benefit from higher prices and buyers are harmed. A stronger dollar is good for U.S. imports (and people working for U.S. importers) and U.S. investment abroad. It is also good for U.S. tourists going to other countries, since their dollar goes further. But a stronger dollar is bad for U.S. exports (and people working in U.S. export industries); it is bad for foreign investment in the United States (leading, for example, to higher U.S. interest rates); and it is bad for foreign tourists (as well as U.S hotels, restaurants, and others in the tourist industry). In short, whether the U.S. dollar is good or bad is a more complex question than you may have thought. The economic answer is “it depends.”
In a floating exchange rate policy, a country’s exchange rate is determined in the foreign exchange market. In a soft peg exchange rate policy, a country’s exchange rate is usually determined in the foreign exchange market, but the government sometimes intervenes to strengthen or weaken the exchange rate. In a hard peg exchange rate policy, the government chooses an exchange rate. A central bank can intervene in exchange markets in two ways. It can raise or lower interest rates to make the currency stronger or weaker. Or it can directly purchase or sell its currency in foreign exchange markets. All exchange rates policies face tradeoffs. A hard peg exchange rate policy will reduce exchange rate fluctuations, but means that a country must focus its monetary policy on the exchange rate, not on fighting recession or controlling inflation. When a nation merges its currency with another nation, it gives up on nationally oriented monetary policy altogether.
A soft peg exchange rate may create additional volatility as exchange rate markets try to anticipate when and how the government will intervene. A flexible exchange rate policy allows monetary policy to focus on inflation and unemployment, and allows the exchange rate to change with inflation and rates of return, but also raises a risk that exchange rates may sometimes make large and abrupt movements. The spectrum of exchange rate policies includes: (a) a floating exchange rate, (b) a pegged exchange rate, soft or hard, and (c) a merged currency. Monetary policy can focus on a variety of goals: (a) inflation; (b) inflation or unemployment, depending on which is the most dangerous obstacle; and (c) a long-term rule based policy designed to keep the money supply stable and predictable.
Friedman, Milton. Capitalism and Freedom . Chicago: University of Chicago Press, 1962.
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