Chapter 2 The International Monetary System 2. Defending a Fixed Exchange Rate. What did it mean under the gold standard to “defend a fixed exchange rate,” and what did this imply about a country’s money supply? Under the gold standard, a country’s central bank was responsible for preserving the exchange value of the country’s currency by being willing and able to exchange its currency for gold reserves upon the demand by a foreign central bank. This required the country to restrict the rate of growth in its money supply to a rate that would prevent inflationary forces from undermining the country’s own currency value. 4. Technical Float. What specifically does a floating rate of exchange mean? What is the role of government? A truly floating currency value means that the government does not set the currency’s value or intervene in the marketplace, allowing the supply and demand of the market for its currency to determine the exchange value. 5. Fixed Exchange Rate. Why do many emerging market economies prefer to adopt a fixed exchange rate? Many emerging economies resort to pegging their domestic currencies against major currencies. In emerging nations that are dependent on imports, a floating rate can cause inflation if import prices rise. Further, if their currencies depreciate, these nations may not benefit if there is low international demand for their exports. Under a floating system, speculation on the currencies of these nations can be damaging and destabilizing for the economy, causing uncertainty for investors. 7. Exchange Rates. Why do many developing countries fix their currencies, while emerging economies adopt a crawling peg? In most cases, when developing nations peg or fix their domestic currency, they keep it devalued to increase the price competitiveness of their exports and to curb imports. Not only does this help fix balance-of-payments deficits, but it also supports economic growth, creates jobs, and protects domestic industries. The high level of GDP growth of emerging market economies, however, makes them more interlinked with global markets. In order to build competitive advantage and to attract foreign investments, they tend to gradually float their currencies so that they approach their fair market value. They adopt a crawling peg system by which their central banks gradually revalue their currencies. The main advantage of a crawling peg system is to avoid sudden foreign exchange shocks. 9. The Impossible Trinity. With reference to the impossible trinity, what are the possible policy mixes that a nation could have? The impossible trinity states that a nation cannot have all of the following three policies: fixed exchange rate, no capital controls, and an independent monetary policy. The following are the possible policy combinations that nations can have: No capital controls + an independent monetary policy (the United States and Western Europe)A fixed exchange rate + an independent monetary policy (China and many emerging market economies)A fixed exchange rate + no capital control (Hong Kong) 11. Currency Boards. What is the difference between central banks and currency boards? A currency board is a monetary authority that is committed to adopt a pegged exchange rate while renouncing independent monetary policy. Similar to a central bank, a currency board issues notes and coins that it pegs to a foreign currency or a precious commodity. Unlike a central bank, a currency board is not the lender of last resort, and since it is not the government’s bank it cannot influence interest rates or money supply. Examples include most Caribbean nations, Argentina from 1991 till 2002, and some members of the Commonwealth of Independent States after the collapse of the USSR. Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability. 14. Currency Strength. Is a strong currency good or bad for the domestic economy? The answer to this question is not as straightforward as some might think. A currency appreciates when its value rises in comparison to other currencies, allowing it to buy more units of imports. The overall impact of a stronger domestic currency depends on the strength of the domestic currency as well as on the structure of the economy. At the macroeconomic level, a stronger currency reduces the price of imports; that is, it makes imports more affordable to domestic consumers as well as to firms that import foreign inputs or spare parts. However, industries that compete with the imported products will be hurt. Jobs would also be shed by firms that have suffered from the increase in competition. If the change in the value of the domestic currency is minimal, it will have negligible effects. If the economy is import-oriented, then the standard of living will rise as consumers are able to buy more imports and domestic firms are able to buy cheaper imported inputs. At the end of the day, a weak or strong currency is only one ingredient to understand the complex macroeconomic structure of an economy. If an emerging market economy needs to manage inflation, it cannot leave its exchange rate to float freely. This is even truer for nations that are over-dependent on imports for consumption as well as factors of production. In this case, their economic growth would be impaired as they would suffer from imported inflation. Hence, for such countries it is best to adopt a fixed or pegged exchange rate system. But the caveat is that this should not be prolonged but should only last till infant industries grow large enough to replaced some of the reliance on imports.
