Question

should we have a floating or fixed exchange rate

Answer 1

A floating exchange rate is one in which the market sets the price for the currency. A fixed exchange rate is one where the rate is fixed (obviously), usually by the government that controls the currency.

The benefit of a floating-rate currency is that it can act as a “shock absorber” to adjust imbalances. So for example if a country is importing a lot more than it is exporting, the currency is likely to depreciate (weaken). This will make imports more expensive and exports more competitive. The country should in theory import less and export more, and its trade should come back into balance.

Similarly, if a country has a high inflation rate, the currency is likely to depreciate, which will keep its exports competitive.

The problem is that sometimes the market sets a rate for a currency that the government doesn’t like. Many emerging market (EM) countries for example want to have a cheap currency so that they can promote exports over imports. This is one way to spur development in their country. They might therefore try to fix the rate of the currency at a cheaper level than what the market would set.

On the other hand, some countries (like Venezuela) try to fix their currency at an overvalued level, whether out of national pride or in order to enable the country to import essential goods. They then need to have a system of rationing the availability of foreign exchange, since obviously everyone will want to get their hands on it (imagine if you could buy a euro for $0.25.) This gives the government great power to reward & enrich its friends by enabling them to buy foreign exchange at the official (cheap) price. It’s why when I visited Ghana in 1982, they were importing sugar cubes from France even though they could grow their own sugar! The supermarket owners had access to foreign exchange, but the farmers didn’t. So the supermarket owners could get the money to import sugar cubes, but the farmers couldn’t get the foreign exchange to buy parts to repair their tractors.

Furthermore, with a floating currency sometimes foreign investors will pile into financial assets in a country (like Brazil). That will push up the value of the currency and make it difficult to carry on businesses, as imports become cheap relative to domestically produced goods. Then businesses will shut down. When foreigners then take their money out of the country, the value of the currency collapses. Now the country neither has its own manufacturing base nor can it afford imports. Trouble!

Hong Kong’s currency is pegged to the dollar. That means its interest rates are determined by the Fed, even though its economic conditions are more determined by the health of China’s economy. This can make for some seriously out-of-synch monetary policy, which can cause a big bubble in real estate.

So there are advantages and disadvantages to both systems. After the Asia Crisis in 1997, Malaysia pegged its currency. The IMF and other bodies roundly criticized it for this distortion, backing away from free-market principles, etc., but in fact Malaysia recovered faster than many other countries in the region.

You can look at the current problems of the Eurozone as problems of a fixed exchange rate system. In fact, the whole Greek debt crisis etc. was a currency crises masquerading as a bond market crisis. If Greece had its own currency, the crisis never would have occurred, or at least not in the form it did. The drachma would have fallen and that would have resolved much of the problems.

Many countries now operate what’s called a “dirty float.” That is, their currency floats within limits set by the government. That seems to be an effective half-way house between the two.