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Fixed Exchange Rates
CHAPTER 15
Reinert/Windows on the World Economy, 2005
Introduction

Chapter defines a number of alternative exchange
rate regimes
 Places them on a continuum between “fixed” and
“flexible”



Focuses on the case of fixed exchange rates
Examines various ways that balance of payments
adjustment can occur under this regime
Considers the policy trilemma in international
finance
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Alternative Exchange Rate
Regimes

Menu of exchange rate arrangements from which a country can choose—in
2001
 41 countries pursued a floating or flexible exchange rate regime
• Monetary authority did not intervene to influence market value of nominal exchange rate
 42 countries maintained a managed floating regime
• Monetary authority may have intervened to influence the nominal exchange rate in some way
 6 countries used crawling bands
• Monetary authorities intervened to maintain nominal exchange rate in a band around a central
rate, and these bands were periodically adjusted
 4 countries employed crawling pegs
• Nominal exchange rate was fixed in value to another currency or to a “basket” of other
currencies, but adjusted periodically by small amounts
 45 countries pursued fixed exchange rates or fixed pegs
• Monetary authorities adopted a policy goal of keeping the nominal exchange rate at a fixed
value in terms of another currency or in terms of a “basket” of other currencies
 8 countries pursued an extreme form of fixed exchange rate known as a currency
board
• Monetary authority is required to fully back up the domestic currency with reserves of foreign
currency to which domestic currency is pegged
 Relatively large number of (usually very small) countries maintained no independent
currency whatsoever
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Table 15.1 Exchange Rate
Arrangements, 2001
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A Model of Fixed Exchange
Rates

In contrast to flexible or floating exchange rate regime, we
will consider the polar opposite case of a fixed exchange
rate regime
 Mexico will be our home country
 United States will be our foreign country
• Although peso began floating in 1995, in previous years, it was fixed
against US dollar

Under a fixed exchange rate regime, when Mexican
government raises (lowers) e and thereby decreases
(increases) value of peso
 Called a devaluation (revaluation) of peso
• Contrasts with a market-driven, upward movement in e under a flexible
exchange rate regime known as a(n) depreciation (appreciation)

In practice, devaluations are more common than
revaluations
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Table 15.2. Mexican Balance of Payments,
1993 (billions of US dollars)
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Table 15.3. Exchange Rate
Terminology Revisited
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A Model of Fixed Exchange
Rates

Suppose an overvaluation of peso exists (1/e1 >
1/e0)
 Implies an excess supply of pesos or an excess demand
for dollars

How can this be sustained?
 Must be some additional demand for pesos or supply of
dollars which can come from
• Positive net factor receipts
• Positive net transfers (e.g. inflows of foreign aid)
• Positive net official reserve transactions

Mexico’s central bank can sell its holdings of dollars (buying pesos)
which draws down foreign reserves
 Helps eliminate excess supply of pesos or demand for dollars
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Figure 15.1 The Peso Market
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A Model of Fixed Exchange
Rates

Suppose an undervaluation of the peso exists (1/e2 < 1/e0)
 Implies an excess demand for pesos or an excess supply of dollars
 Situation can be sustained via additional supply of pesos or demand
for dollars which can come from
• Negative net factor receipts
• Negative net transfers
• Negative net official reserve transactions


Mexico’s central bank can buy dollars (sell pesos) which builds up foreign
reserves
Conclusion: Central banks in countries with overvalued
currencies tend to draw down foreign exchange reserves
 While central banks in countries with overvalued currencies tend to
build up foreign reserves
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Interest Rates and Exchange
Rates
Suppose Mexican government successfully
ensures that a fixed rate e3 is an equilibrium
rate
 What must be the relationship between e3
and ee?
 If e3 is both a fixed and an equilibrium rate, then

e3 must equal ee
• Causes a change in interest rate parity condition

ee – e = 0 therefore: rM = rUS
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Interest Rates and Exchange
Rates

For the Mexican government to maintain a fixed,
equilibrium exchange rate, it must ensure that its
interest rate equals that in United States
 By increasing or decreasing rM into equality with rUS, the
Mexican government can move SF graph to left or right
until equilibrium e and e3 are identical

Complexities of real world cause fixed exchange
rates to be maintained with combinations of net
factor receipts, net transfers, official reserve
transactions, and interest rates
 However, one principle is always operable
• The farther a fixed exchange rate is from the equilibrium
exchange rate, the more difficult it is to maintain for an extended
period of time
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Figure 15.2 An Equilibrium Fixed
Exchange Rate
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The Policy Trilemma



“Dilemma” refers to a necessary choice between two
undesirable alternatives
“Trilemma” refers to a necessary choice among three
undesirable alternatives
Policy trilemma recognizes countries would ideally like to
pursue three desired objectives
 Monetary independence
• Ability to conduct an independent monetary policy with an eye to
stabilizing the domestic macroeconomic policy
 Exchange rate stability
• Ability to avoid destabilizing volatility in nominal exchange rate
 Capital mobility
• Ability to take advantage of flows on direct and portfolio capital accounts
from foreign savings

However, countries must sacrifice one of above desired
objectives in order to achieve other two
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Figure 15.3. The Policy Trilemma
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The Policy Trilemma

Suppose a country wants to maintain both
capital mobility and exchange rate stability
 Must pursue a fixed exchange rate regime
• Must give up monetary independence
• If a country wants to maintain its fixed exchange rate
•
as an equilibrium rate, it must adjust its interest rate to
that in country to which its currency is pegged
Since interest rates are set via monetary policy, in
maintaining capital mobility and exchange rate
stability, country must sacrifice its independent
monetary policy
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The Policy Trilemma

Suppose a country wants to maintain both
capital mobility and monetary independence
 Must allow currency to float
• Must give up exchange rate stability
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The Policy Trilemma

Suppose a country wants to maintain both
monetary independence and exchange rate
stability
 Must restrict transactions on capital account of
the balance of payments in order to suppress
portfolio considerations
• Must give up capital mobility
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