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Chapter 25
National and Global
Choices: Floating Rates
and the Alternatives

International
ECONOMICS
Eighteenth Edition
Thomas A. Pugel

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 Key Issues in the Choice of Exchange-Rate Policy

• The effects of macroeconomic shocks

• The effectiveness of government policies
• Differences in macroeconomic goals, priorities, and
policies
• Controlling inflation
• The real effects of exchange-rate variability

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 Effects of Macroeconomic Shocks

The performance of the country’s economy is better if shocks

are less disruptive because the economy is more stable.
The size of the effects of various macroeconomic shocks on
the country depend on the exchange-rate policy adopted by
the country.
• Internal shocks, especially monetary shocks, are less
disruptive with fixed exchange rates
• External shocks, especially international trade shocks, are
less disruptive with floating exchange rates.

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 The Effectiveness of Government Policies 1

• Government policies’ influence on aggregate demand and

domestic product is altered by the type of exchange-rate
policy chosen by the country.
• Monetary policy has less control over the money supply if
the country has a fixed exchange rate because monetary
policy is constrained by the need to defend the fixed
exchange rate.

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 The Effectiveness of Government Policies 2

• With perfect capital mobility, a country that is committed to

defending a fixed exchange rate cannot have an
independent monetary policy.
• The impossibility for a country to maintain a fixed
exchange rate, to permit free capital flows, and to have a
monetary policy directed toward domestic objectives is
often called the inconsistent trinity or trilemma.

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 The Effectiveness of Government Policies 3

• Monetary policy gains effectiveness with floating exchange

rates. The induced change in the exchange rate reinforces
the thrust of the policy change.
• If a country desires to use monetary policy to address
domestic objectives, then the country will favor a floating
exchange rate. A floating rate frees monetary policy from
the need to defend the exchange rate.

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 The Effectiveness of Government Policies 4

• The effectiveness of fiscal policy depends on how

responsive international capital flows are to interest rates.
• If capital is highly mobile, then fiscal policy gains
effectiveness under fixed rates.
• With floating exchange rates and highly mobile capital,
fiscal policy loses effectiveness. The resulting exchange-
rate change leads to international crowding out.
• If capital is not that mobile, or if capital flows decline
beyond a short-run period, the reverse is true. Fiscal policy
then loses effectiveness with a fixed exchange rate and
gains effectiveness with a floating rate.

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 Differences in Macroeconomic Goals, Priorities, and
Policies 1

• For fixed exchange rates between the currencies of two or

more countries to be successful, a kind of consistency or
coordination between the countries involved is necessary.
• Countries choosing fixed exchange rates must follow
policies that permit successful defense of the fixed rates. If
the policies diverge noticeably, large payments imbalances
are likely to develop, making the defense of the fixed rates
difficult or impossible.

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 Differences in Macroeconomic Goals, Priorities, and
Policies 2

• Floating exchange rates are tolerant of diversity in

countries’ goals, priorities, and policies.
• As long as the country is willing to let the exchange rate
change according to market pressures, external balance in
the country’s overall payments is maintained, whatever the
country’s policies.
• International policy coordination is still possible across
countries, but it is not necessary.

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 Controlling Inflation 1

For fixed exchange rates, relative PPP indicates that the

countries should have similar inflation rates. For the fixed
rate to be sustained, a country cannot have an inflation rate
that is much above (or below) the inflation rate(s) of its
partner(s).
• A discipline effect on a country that otherwise would have
high inflation.
• A country that otherwise would have a low inflation rate
may import inflation.

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 Controlling Inflation 2

A fixed-rate system in which most countries participate may

also impose price discipline to lower the average global
rate of price inflation.
• The fixed-rate system puts more pressure on governments
whose countries have international payments deficits than
on governments that have surpluses.

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 Controlling Inflation 3

• Floating exchange rates simply permit countries to have

different inflation rates.
• According to relative P P P, high-inflation countries tend to
have depreciating currencies, and low-inflation countries
tend to have appreciating currencies.
• The nominal exchange-rate changes maintain reasonable
price competitiveness for both types of countries in the
long run.

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 Real Effects of Exchange Rate Variability 1

• Floating exchange rates appear to be excessively variable.

• Exchange rate risk can reduce international transactions,
including exporting and importing.
• Wide swings in exchange rates (for example, overshooting
or speculative bandwagon) may send inappropriate price
and profit signals, leading to inappropriate resource shifts.

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 Real Effects of Exchange Rate Variability 2

Fixed exchange rates, while usually more stable, are a form

of price control.
• Resource misallocation occurs if the fixed price (exchange
rate) fails to signal the need for resource reallocation to
change international activities as part of a payments-
adjustment process.
• Possibility of large abrupt change in the fixed-rate value
(devaluation or revaluation), sometimes preceded by
crisis.

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 National Choices 1

• Strong arguments in favor of a country adopting a floating

exchange rate.
• Can use two important tools for adjusting toward internal
and external balances. National monetary policy and
exchange-rate changes.
• Can pursue goals, priorities, and policies that meet its own
domestic preferences and needs.
• No need to defend a fixed rate against speculative attacks.

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 National Choices 2

Strong arguments in favor of a country adopting a fixed

exchange rate.
Floating rates have been disturbingly variable since 1973.
• Increases exchange-rate risk, and this risk does seem to
have some effect in discouraging international activities
• Overshooting of floating exchange rates may have
promoted too much adjustment into or out of trade-
oriented production from time to time.
Fixed rates achieve substantial reductions in exchange-rate
variability and risk if the fixed rate can be defended and the
peg is not adjusted too often.

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 Extreme Fixes 1

• A currency board attempts to establish a fixed exchange

rate that is long-lived by mandating that the board, acting
as the country’s monetary authority, should focus almost
exclusively on maintaining the fixed rate.
• A currency board holds only foreign-currency assets
(official reserve assets). The board issues domestic
currency liabilities only in exchange for foreign-currency
assets that it acquires.
• The currency board holds no domestic assets, so it cannot
sterilize.

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 Extreme Fixes 2

• A country’s government can abolish its own currency and

use the currency of some other country. Because the other
currency is often the U.S. dollar, this arrangement is called
dollarization.
• Removes (almost all) exchange-rate risk that the
government would devalue its currency.
• This is a harder peg, but even this is not permanent—the
government could introduce its own currency in the future.

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 The International Fix—Monetary Union

• In a monetary union, exchange rates are permanently

fixed and a single monetary authority conducts a single,
unionwide monetary policy.
• In 1999, a subset of countries in the European Union
implemented a monetary union with a single currency, the
euro, and the European Central Bank as the monetary
authority.
• Before the euro, many EU countries had established fixed
exchange rates among their national currencies through
the Exchange Rate Mechanism (E R M).
• The Maastricht Treaty, adopted in 1993, set the process
for establishing the monetary union, including five criteria
for a country to join.
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 Maastricht Criteria

1. The country’s inflation rate must be no higher than 1.5

percentage points above the average inflation rate of the three
EU countries with the lowest inflation rates.
2. Its exchange rates must be maintained within the E R M bands
with no realignments during the preceding two years.
3. Its long-term interest rate on government bonds must be no
higher than 2 percentage points above the average of the
comparable interest rates in the three lowest inflation
countries.
4. The country’s government budget deficit must be no larger
than 3 percent of the value of its G D P.
5. The gross government debt must be no larger than 60 percent
of its G D P (or the country must show satisfactory progress to
achieving these two fiscal criteria in the near future).
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 European Monetary Union: Gains

• Eliminates foreign exchange transactions costs within the

euro area
• Eliminates exchange rate variability and risk within the
area
• Increases international trade within the area
• Increases integration of financial markets within the area

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 European Monetary Union: Risks and Possible Losses

Economic shocks affect different member countries in

different ways. Each country no longer can use national
monetary policy or exchange rate changes to pursue internal
balance.
Limits to mechanisms to reduce cross-national imbalances:
• Cross-national labor mobility within the euro area is low
• “Internal devaluation” to increase international price
competitiveness by lowering national wages and prices is
painful and slow
• Area-wide fiscal policy is very limited
• National fiscal policy can be problematic

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 European Monetary Union: National Fiscal Policy

• The main government policy available to pursue national

internal balance.
• A source of instability for the country and the euro area if
the government deficit and debt become too large: Greece
and the broader euro crisis.
• The euro area has attempted to state rules limiting
national government deficits and debt, but enforcement
has been weak.

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 Response to the economic effects of the COVID-19 (1)

In response to the economic effects of the COVID-19

pandemic crisis, the European Union adopted two major
changes:
• Innovation of large unionwide expansionary fiscal policy
• Suspension of the rules that imposed limits and
requirements on national fiscal policies

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 Response to the economic effects of the COVID-19 (2)

The expansionary EU-level fiscal policy comprises two

programs:
1. Totaling €100 billion, disbursed quickly to support national
efforts to keep people employed
2. Totaling €750 billion, disbursed over 6 years, to support
national efforts for recovery from the effects of the
pandemic.
The EU will repay the bonds it has issued partly with
revenues from new unionwide taxes.

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 Response to the economic effects of the COVID-19 (3)

The suspension of fiscal rules has allowed countries to adopt

expansionary national fiscal policies to cushion the adverse
national macroeconomic effects of the pandemic. As of early 2022,
11 of the 19 euro-area countries had made aggressive use of the
rules suspension.

Interesting questions arise from the EU policy response to the

COVID-19 pandemic crisis.
1. First, is the use of unionwide expansionary fiscal policy a one-time
event? Or, does it provide the opening for ongoing union-level active
fiscal policy?
2. Second, the current fiscal rules will be even more difficult to enforce
when the suspension is ended, especially because so many member
countries have government debt above 100 percent of G D P. Can
the fiscal rules be reformed to be more effective and enforceable?

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