Question

Develop this idea: (why did Milton Friedman think this?)

"Either extreme: a fixed exchange rate through a currency board, but no central bank, or a central bank plus truly floating exchange rates; either of those is a tenable arrangement. But a pegged exchange rate with a central bank is a recipe for trouble."

(Hint: a peg is a contingent commitment, and needs reserves. With no central bank, local banks can print money of they have a "USD" per home peso. In other words, 100% reserves. This is the case in HK. )

Answer 1

The pegged exchange rate system is a system in which the the currency value of a nation is fixes either in terms of other currency system or as a measure of gold or a basket of other currencies. The process of pegging is done to stabilise a currency by fixing its value on the basis of a more stable currency structure. Thus as in a floating exchange rate regime, the value of currency exchange doesnit change with the market forces in a pegged exchange rate system. Thus, trade and investment opportunities of such countries would be encouraged, especially those smaller economies who trade with pegged currency system.

According to Friedman's theory,, he favoured a combination of flexible exchange rate and domestic monetary rule. He suggested that such a combination would help in reducing the earlier effects on economic systems that originated from discretionary monetary policies. He also believed that such exchange rate combinations are more suited to democratic principles. He also believed that the gold exchange rate would also help in eliminating the disriminatory tendencies of monetary systems. Friedman believed that in the modern era economixs, government should have some control over the exchange rate system. But increased control woukd also prove to be discriminatory. This is where he advocated floating exchange rate over the fixed rate or pegged rate that it has the power to decentralise the policymaking to the national level when compared to the pegges exchange rate where the currency always has to follow the principles of the currency to which it is pegged to and thus limits the monetary values of the currency concerned. Thus floating rates could help in saving the domestic economy from external shocks and also makes the government accountable to its citizens. Thus according to Friedman, flexible exchange rates represents the more stable rates when compared to pegged rates as the latter has more limitations when compared to the former.