By L. Randall Wray
Floating vs fixed exchange rate regimes. Previous Modern Money primer blog posts were quite general and apply to all countries that use a domestic currency. It does not matter whether these currencies are pegged to a foreign currency or to a precious metal, or whether they are freely floating—the principles are the same. In this blog post we will examine the implications of exchange regimes for our analysis.
Let us deal with the case of governments that do not promise to convert their currencies on demand into precious metals or anything else. When a $5 note is presented to the US Treasury, it can be used to pay taxes or it can be exchanged for five $1 notes (or for some combination of notes and coins to total $5)—but the US government will not convert it to anything else.
Further, the US government does not promise to maintain the exchange rate of US Dollars at any particular level. We can designate the US Dollar as an example of a sovereign currency that is nonconvertible, and we can say that the US operates with a floating exchange rate. Examples of such currencies include the US Dollar, the Australian Dollar, the Canadian Dollar, the UK Pound, the Japanese Yen, the Turkish Lira, the Mexican Peso, the Argentinean Peso, and so on.
In the following sections we will distinguish between these sovereign nonconvertible floating currencies and currencies that are convertible at fixed exchange rates.
The gold standard and fixed exchange rates. A century ago, many nations operated with a gold standard in which the country not only promised to redeem its currency for gold, but also promised to make this redemption at a fixed exchange rate.
An example of a fixed exchange rate is a promise to convert thirty-five US Dollars to one ounce of gold. For many years, this was indeed the official US exchange rate. Other nations also adopted fixed exchange rates, pegging the value of their currency either to gold or, after WWII, to the US Dollar.
For example, the official exchange rate for the UK Pound was $2.80 US. In other words, the government of the UK would provide $2.80 (US currency) for each UK Pound presented for conversion. With an international fixed exchange rate system, each currency will be fixed in value relative to all other currencies in the system.
In order to make good on its promises to convert its currency at fixed exchange rates, the UK had to keep a reserve of foreign currencies (and/or gold). If a lot of UK Pounds were presented for conversion, the UK’s reserves of foreign currency could be depleted rapidly.
There were a number of actions that could be taken by the UK government to avoid running out of foreign currency reserves, but none of them was very pleasant. We will save most of the details for a later discussion. The choice mostly boiled down to three types of actions: a) depreciate the Pound; b) borrow foreign currency reserves; or c)deflate the economy.
In the first case, the government changes the conversion ratio to, say, $1.40 (US currency) per UK Pound. In this manner it effectively doubles its reserve because it only has to provide half as much foreign currency in exchange for the Pound. Unfortunately, such a move by the UK government could reduce confidence in the UK government and in its currency, which could actually increase the demands for redemption of Pounds.
In the second case, the government borrows foreign currencies to meet demanded conversions. This requires willing lenders, and puts the UK into debt on which interest has to be paid. For example, it could borrow US Dollars but then it would be committed to paying interest in Dollars—a currency it cannot issue.
Finally, the government can try to deflate, or slow, the economy. There are a number of policies that can be used to slow an economy—but the idea behind them is that slower economic growth in the UK will reduce imports of goods and services relative to exports. This will allow the UK to run a surplus budget on its foreign account, accumulating foreign currency reserves.
The advantage is that the UK obtains foreign currency without going into debt. The disadvantage, however, is that domestic economic growth is lower, which usually results in lower employment and higher unemployment.
Note that a deflation of the economy can work in conjunction with a currency depreciation to create a net export surplus. This is because a currency depreciation makes domestic output cheap for foreigners (they deliver less of their own currency per UK Pound) while foreign output is more expensive for British residents (it takes more Pounds to buy something denominated in a foreign currency).
Hence, the UK might use a combination of all three policies to meet the demand for conversions while increasing its holding of Dollars and other foreign currencies.
Floating exchange rates. However, since the early 1970s, the US, as well as most developed nations, has operated on a floating exchange rate system, in which the government does not promise to convert the dollar.
Of course, it is easy to convert the US dollar or any other major currency at private banks and at kiosks in international airports. Currency exchanges do these conversions at the current exchange rate set in international markets (less fees charged for the transactions). These exchange rates change day-by-day, or even minute-by-minute, fluctuating to match demand (from those trying to obtain dollars) and supply (from those offering dollars for other currencies).
The determination of exchange rates in a floating exchange rate system is exceedingly complex. The international value of the dollar might be influenced by such factors as the demand for US assets, the US trade balance, US interest rates relative to those in the rest of the world, US inflation, and US growth relative to that in the rest of the world. So many factors are involved that no model has yet been developed that can reliably predict movements of exchange rates.
What is important for our analysis, however, is that on a floating exchange rate, a government does not need to fear that it will run out of foreign currency reserves (or gold reserves) for the simple reason that it does not convert its domestic currency to foreign currency at a fixed exchange rate. Indeed, the government does not have to promise to make any conversions at all.
In practice, governments operating with floating exchange rates do hold foreign currency reserves, and they do offer currency exchange services for the convenience of their financial institutions. However, the conversions are done at current market exchange rates, rather than to keep the exchange rate from moving.
Governments can also intervene into currency exchange markets to try to nudge the exchange rate in the desired direction. They also will use macroeconomic policy (including monetary and fiscal policy) in an attempt to affect exchange rates. Sometimes this works, and sometimes it does not.
The point is that on a floating exchange rate, attempts to influence exchange rates are discretionary. By contrast, with a fixed exchange rate, government must use policy to try to keep the exchange rate from moving. The floating exchange rate ensures that the government has greater freedom to pursue other goals—such as maintenance of full employment, sufficient economic growth, and price stability.
As we continue this discussion in coming weeks, we will argue that a floating currency provides more policy space—the ability to use domestic fiscal and monetary policy to achieve policy goals. By contrast, a fixed exchange rate reduces policy space. That does not necessarily mean that a government with a fixed exchange rate cannot pursue domestic policy. It depends. One important factor will be whether it can accumulate sufficient foreign currency (or gold) to defend its currency.
Next week, however, we will take a brief diversion to examine so-called commodity money. The fixed exchange rate based on a gold standard has been a reality in relatively recent times. And during much of the past two millennia, governments issued coins with silver and gold content. Many equate these with “commodity money”—a monetary system supposedly based on precious metal, indeed, one in which money derives value from embodied gold or silver.
We will come to a surprising conclusion, however. Even coins made of gold and silver are really IOUs stamped on metal. They are not examples of commodity money. They are sovereign currencies.
I can already hear the teeth of our resident Austrian gold bugs rattling so hard their fillings threaten to shake loose.
This article first appeared on New Economic Perspectives.