The Advantages and Disadvantages of Fixed Exchange Rates - dummies

The Advantages and Disadvantages of Fixed Exchange Rates

By Ayse Evrensel

Professional and laymen alike have an opinion about what kind of an international monetary system the world should have. A metallic standard system such as the gold standard or the reserve currency standard has the following advantages:

  • Price stability: This advantage has been viewed as one of the virtues of the metallic standard. Price stability implies that changes in prices are small, gradual, and expected. One of the most important factors that can affect price stability is monetary policy.

  • Economic stability and prosperity: A metallic standard can diminish the short-run fluctuations in a country’s output, which are also called business cycles. The reason for decreasing volatility in output may lie in price stability. Price stability, or the absence of large and unexpected changes in the average price level, may work as a signal to producers for how much to produce.

  • Fixed exchange rates: A metallic standard leads to fixed exchange rates. In a gold standard, each country determines the gold parity of its currency, which fixes the exchange rates between countries. In a reserve currency system, the reserve currency has a gold parity, and all other currencies are pegged to the reserve currency, which also leads to fixed exchange rates. Fixed exchange rates enable the following:

    • The reduction of uncertainty in international trade and portfolio flows: Exchange rate risk is a barrier to international business. Under the fixed exchange rate regime, nobody has to use scarce resources to guess the next period’s exchange rate.

    • An automatic balance of payment adjustment mechanism to maintain internal and external balance: This mechanism, also called the price–specie–flow mechanism, takes care of imbalances between countries’ current account and price levels. If a country runs a current account surplus and accumulates specie, prices increase, making this country’s goods more expensive to foreigners. This situation reduces the current account surplus in the home country and the current account deficit in the foreign country.

    • A symmetrical adjustment of monetary policies under a gold standard: If the home country’s central bank increases the money supply, it puts downward pressure on the home country’s interest rates. This situation makes other countries’ assets more attractive to investors.

However, fixed exchange rates have disadvantages as well. Before looking at these disadvantages, question some of the advantages of fixed exchange rates:

  • Questionable price stability: A metallic standard is considered to promote price stability. However, some studies indicate that the gold standard era experienced large fluctuations in the average price level. These fluctuations appear to have been caused by the changes in the relative price of gold with respect to the price of goods and services.

  • Questionable economic stability and prosperity: Because price stability leads to economic stability and, therefore, prosperity, the usual assumption is that the metallic standard years are associated with higher growth and lower volatility in growth. One of the disastrous economic slowdowns in recent history, the Great Depression, happened under the gold standard.

    Additionally, competitively contractionary monetary policies were implemented during the gold standard starting in the 18th century, which led to lower output growth and higher unemployment.

  • Questionable price–specie–flow mechanism: The price–specie–flow mechanism didn’t work as well in theory under a gold standard. But it really doesn’t work in a reserve currency standard. If the price–specie–flow mechanism had functioned, all countries’ current accounts would be balanced. However, during the Bretton Woods era, some countries had persistent current account surpluses, and others had current account deficits.

    Theoretically, surplus countries were to lend to deficit countries. This scheme doesn’t work when countries with persistently large current account deficits also have problems repaying their loans.

Additional disadvantages of the metallic standard follow:

  • Imports of other countries’ unemployment and inflation rates: Because countries can’t implement autonomous monetary policies under a metallic standard, they many import their trade partner’s inflation and unemployment rates. For example, if the inflation rate is increasing in a country, at the given exchange rate, its consumers may increase their demand for foreign goods, thus increasing the prices in other countries.

    Similarly, if a country experiences lower output growth and higher unemployment, at the given exchange rate, it buys less from other countries, which may have an adverse effect on other countries’ output and employment.

  • Increase in precious metal reserves: Under a metallic standard, such as the gold standard, central banks need to hold an adequate amount of gold reserves to maintain their currency’s gold parity and have some additional gold to intervene in their exchange rates. However, central banks cannot increase their gold reserves as their economies grow.

    One possibility for increasing gold reserves is discovering new gold mines. If gold production isn’t increasing, central banks compete for gold. They sell their domestic assets to buy gold, decreasing their money supply and possibly adversely affecting output and employment.

  • Potential influence of precious metal producers: Whatever precious metal is in the metallic standard, producers of this metal may have an influence on the macroeconomic conditions in countries with the metallic standard. In terms of gold production, South Africa, China, and the Russian Federation occupy first, third, and seventh places. In terms of gold reserves, South Africa, the Russian Federation, and Australia take the first three places.