Forex: The Debate over Fixed and Flexible Rates

The central policy debate in the international monetary arena continues to be that over the relative merits of fixed exchange rates, floating exchange rates, and compromises between them, as alternative ways to adjust nation's external payments positions.

The experiences of the 1970s have brought converts to both the fixed-rate and the floating-rate camps.

Some who had urged some variant on floating rates profess to be born again, and to have discovered new persuasive arguments for holding exchange rates fixed. At the same time, some previous defenders of fixed rates profess to have made their peace with the float.

Yet expert opinion is still far from unanimous.

A majority of monetary officials is still striving to restore greater fixity to exchange rates; though flexible rates have now attained greater popularity within the U.S. government. A bare majority of academic economists still seems to prefer flexible rates.

Though the debate continues, it is not completely unresolved.

Both theoretical analysis and our understanding of actual experience have now built up to a point where it is possible to sketch rough answers to many of the questions raised in the debate over exchange-rate policy.

It can be argued that we can narrow the choice to fixed rates, floating rates, and compromises between them, since exchange controls have high costs and few advantages except to bureaucrats. However, certain issues have addressed their importance of how easy it is to stabilize national economies under fixed and flexible exchange rates. In principle, one can design combinations of monetary and fiscal policy that could achieve both internal and external balance under fixed exchange rates. However, doing so may be difficult in practice. Whether it is easier to stabilize under fixed rates than under flexible rates depends on the shocks to which the economy is subject.

To repeat the broad pattern that emerged from more detailed analysis there, we found that flexible rates seem to cushion the economy better in the face of external shocks, whereas fixed rates offer better insurance against some of the damage of internal shocks.

It remains for all this to pull together what is known about the remaining key issues, in the exchange-rate debate: the issues of 'price discipline', risk, and the possibility of destabilizing speculation, and it does seem to be the case that the fixed-exchange-rate system constrains deficit countries more than surplus countries; they must face an obvious limit to their ability to sustain such deficits: they will soon run out of reserves and creditworthiness.