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Floating Fixed
Pros Allows monetary policy to be used Commitment to a fixed exchange
for other purposes rate is one way to discipline a
Policy makers free to pursue other nation’s monetary authority and
goals such as stabilising prevent excessive growth in
employment or prices 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
Cons Exchange rate uncertainty makes Monetary policy committed to
international trade more difficult maintaining the exchange rate at
After abandonment of Bretton announced level
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
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 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)