Chapter 10 - Fixed, Flexible and Managed Exchange Rates

Chapter Introduction
Prior to the move to generalized floating in 1973, the adoption of floating exchange rates had long been advocated by eminent economists such as Milton Friedman (1953), Egon Sohmen (1961) and Harry Johnson (1970). However, the experience with floating rates has not been the panacea that many advocates had presupposed, and this has led many economists to propose schemes designed to limit exchange rate flexibility.

In this chapter, we examine the traditional and more recent arguments for and against fixed and floating exchange rates. We start by looking at the traditional debate over the two regimes, based upon evaluating the arguments for and against each of the regimes. As we shall see, the traditional debate is inconclusive, with floating rates having some advantages and disadvantages as compared to fixed exchange rates. The failure of the traditional debate stimulated an alternative method of evaluating these regimes based upon comparing which regime best stabilizes the economy in the face of various shocks within the context of a formal macroeconomic model. To give a flavour of the insights gained by this more modern approach we use a simple macroeconomic model to evaluate the two regimes.

Although exchange rates have been allowed to float since 1973, authorities have frequently intervened in the foreign exchange market in a bid to influence the exchange rate at which their currency is traded, hence the term ‘managed’ floating. We look at the economic rationale behind discretionary intervention in the foreign exchange market. The chapter also includes Box 10.1 which takes a brief look at an important strand of international economic literature known as optimal currency area theory, which attempts to find a set of criteria for determining the optimal size of area for a single currency. This is a particularly important issue as the European countries have recently given up 12 national currencies for a single currency, the euro, and questions arise as to, how many countries should the euro encompass and what set of criteria does economics offer as to whether a country should be admitted to the euro?