Question

Several countries that have experienced political and economic stability adopt a fixed exchange rate regime to draw on the potential benefits, such as fiscal discipline, seigniorage, and expected future inflation. To what extent do you believe these potential benefits differ in cooperative versus noncooperative fixed exchange rate systems?

Answer 1

Cooperative exchange rate systems are generally more successful than noncooperative regimes. Countries can compromise on adjusting interest rates or exchange rates, preventing countries from being forced off of a fixed exchange rate regime. With cooperation, the costs of asymmetric shocks are shared by members of the fixed exchange rate regime, reducing stability costs. In practice, however, cooperative arrangements often break down because it is difficult for a country to let another country’s economic conditions dictate those at home, especially if the home country happens to be a center country. In terms of the benefits, to the extent that cooperative arrangements last longer, the efficiency gains from trade are higher because these take some time for the economy to realize. Also, cooperative arrangements may help impose fiscal discipline by providing a nominal anchor that is generally agreed upon.