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15Fixed versus Floating: InternationalMonetary Experience

Notes to Instructor

Chapter SummaryChapter 15 examines the choice of fixed versus floating exchange rate regimesin more detail. We consider the potential benefits of a fixed exchange rateregime, such as efficiency gains from reduced transactions costs, fiscal disci-pline, and reducing valuation effects, and the costs, such as loss of stabilizationpolicy. We study exchange rate systems that involve cooperative and nonco-operative adjustments. The chapter concludes with an overview of two keyexchange rate systems: the gold standard and the Bretton Woods system.

CommentsThe majority of this chapter is dedicated to weighing the costs and benefitsof fixing the exchange rate. Fixed versus floating exchange rate regimes werebriefly examined in the previous chapter. Here we devote more attention tothe trade-offs facing a country when it chooses an exchange rate regime. Thisis a useful precursor to the theory of optimum currency area, which is pre-sented in more detail in Chapter 20. The chapter concludes with a historicaloverview of exchange rate systems from the gold standard to the present.

Lecture NotesThis chapter considers the costs and benefits associated with maintaining anexchange rate peg. As described by the historical overview of the interna-tional monetary experience at the end of this chapter, the choice to fix ver-sus float is not straightforward. In addition to using the IS-LM-FX modelfrom the previous chapter, this chapter introduces a new model to examinethese trade-offs: the symmetry-integration diagram. This allows us to betterunderstand the benefits and costs of fixing and to examine a variety of fixedexchange rate systems.

1 Exchange Rate Regime Choice: Key IssuesHistorically, fixed exchange rates were the preferred exchange rate regimeamong economists and policy makers. Most countries adopted the goldstandard, a system in which the value of a country’s currency was pegged toan ounce of gold. Because most countries adopted the gold standard, theircurrencies were fixed relative to each other. Figure 15-1 shows a timeline ofexchange rate regimes. The years 1914–1917 and 1940–1944 were WorldWars and, as such, are omitted from the textbook figure and this discussion.

■ 1870–1913: Metallic standards, especially the gold standard (peak: 70%of countries in 1913)

■ 1918–1939: Gold standard returned, then declined during the GreatDepression

■ 1945–1970s: Fixed exchange rate regimes common (Bretton Woods),with most currencies pegged to the U. S. dollar and British pound

■ 1970s–present: Floating exchange rate regimes more common, espe-cially among the world’s wealthiest countries

APPLICATION

Britain and Europe: The Big IssuesThis application examines Great Britain’s 1992 decision to move from a fixedto a floating exchange rate regime, highlighting key issues in the exchange rateregime debate.

As countries in the European Union (EU) moved toward a single currencyunit in the 1980s and 1990s, they adopted exchange rate pegs relative to eachother, called the Exchange Rate Mechanism (ERM). It was believed the adop-tion of a common currency in Europe would promote trade by lowering trans-actions costs. In addition, from Britain’s perspective, the ERM would help an-chor inflation to Germany’s low inflation rate. It joined the ERM in 1990.

In practice, ERM members were pegged to the German deutschmark(DM) because the Bundesbank had monetary autonomy and pursued anti-inflationary policies. The DM served as the base currency or center cur-rency. In the analysis, we treat Britain as the home country and Germany asthe foreign country.

A Shock in Germany As countries in Eastern Europe moved away fromcommunism, the Berlin Wall fell in 1989, reunifying East Germany and WestGermany. East Germany lagged behind West Germany and required signifi-cant public spending for social programs and to modernize infrastructure.

318 Chapter 15 ■ Fixed versus Floating: International Monetary Experience

This fiscal expansion led to an increase in output, creating inflationary pres-sure and an increase in Germany’s interest rate. The Bundesbank respondedby cutting the money supply to stabilize output, further raising Germany’s in-terest rate. This is illustrated in Figure 15-2, panel (a).

Choices for the Other ERM Countries An increase in Germany’s interestrate had two effects on ERM countries, illustrated in panels (b) and (c) of Fig-ure 15-2.

■ IS curve shifts to the right. Higher German interest rates leads to expenditure switching in favor of home-country goods, so the tradebalance rises, increasing external demand in the home country. Thishappens in both a floating and a fixed exchange rate regime.

■ LM curve shifts to the left. To prevent depreciation against the DM,interest rates must be increased elsewhere in the ERM. Central banksmust follow Germany’s lead, cutting the money supply and raising thenominal interest rate to keep the exchange rate fixed.

Choice 1: Float and Prosper Option 1: Britain chooses to keep its inter-est rate unchanged (Point 4)

■ IS curve shifts to the right.■ LM curve shifts to the right.■ To keep the interest rate unchanged, the Bank of England would need

to expand the money supply, shifting LM to the right.■ To keep the home interest rate unchanged, the new equilibrium is at

point 4, where output increases and the pound depreciates relative tothe DM.

Choice 2: Peg and Suffer Option 2: Britain remains part of the ERM(Point 2)

■ IS curve shifts to the right.■ LM curve shifts to the left.■ To remain part of the ERM, Britain would reach a new equilibrium at

point 2, suffering a decrease in output, while the exchange rate is un-changed.

Option 3: Britain stabilizes output (Point 3)■ IS curve shifts to the right.■ LM curve shifts to the left (by a smaller amount than is required to

maintain peg).■ Bank of England contracts the money supply only by the amount

needed to stabilize output.■ To stabilize output, Britain reaches a new equilibrium at point 3, at

which the pound depreciates relative to the DM.

What Happened Next? Britain opted out of the ERM, not wanting Ger-man-specific events to dictate domestic policy. Figure 15-3 compares Britainwith France, a country that opted to remain part of the ERM. The Britisheconomy boomed (Point 4), whereas France suffered a recession (Point 2). Thebenefits of integration into the Eurozone are longer term, so it is difficult todetermine whether the costs outweighed the benefits for Britain. ■

Chapter 15 ■ Fixed versus Floating: International Monetary Experience 319

Key Factors in Exchange Rate Regime Choice: Integration and SimilarityMeasuring the costs and benefits of a fixed exchange rate regime usuallymeans examining the degree of economic integration and economic similar-ity. Economic integration is measured by the volume of trade among thecountries as well as the amount of other cross-border transactions. Economicsimilarity means that the countries experience similar shocks at similar times.Each country will face a different set of costs and benefits. Like Britain andFrance, they will reach different conclusions about whether to fix or float.

Economic Integration and the Gains in EfficiencyEconomic integration refers to the growth of market linkages in goods, capi-tal, and labor markets between countries. Lowering transactions costs througha fixed exchange rate will help promote economic integration. Because ex-change rate fluctuations create uncertainty about prices, they create a barrierto cross-border exchange of goods, capital, and labor. The more countries en-gage in these transactions, the higher the costs of exchange rate fluctuations.

A greater degree of economic integration between the home and basecountries means a larger volume of transactions. This implies greater benefitsfrom fixed exchange rate regimes and increased efficiency benefits fromadopting a common currency.

Economic Similarity and the Costs of Asymmetric ShocksAn asymmetric shock is a shock that affects one country, leaving others un-affected. This was the case of the shock created by German reunification.Asymmetric shocks create conflicts in policy objectives of the countries withfixed exchange rates. In contrast, symmetric shocks are those that are com-mon to all countries that are part of the fixed exchange rate regime. If coun-tries experience the same shock, they will have the same policy response tostabilize output, leaving the exchange rate unchanged.

A greater degree of economic similarity between the home and base coun-tries means the countries face more symmetric shocks and fewer asymmetricshocks. That implies lower costs from the fixed exchange rate regime and de-creased stability costs of a common currency

Simple Criteria for a Fixed Exchange RateNow that we have identified the efficiency benefits and stability costs, we candefine a net benefit of fixed versus float.

Two conclusions emerge from the previous discussion:■ As integration rises, the efficiency benefits of a common currency increase.■ As symmetry rises, the stability costs of a common currency decrease.Figure 15-4 illustrates the symmetry-integration diagram, showing these

trade-offs in terms of symmetry of shocks (lower stability costs) and marketintegration (higher efficiency gains). The examples given on the graph arebased on a geographic sense of economic integration and market integration.Instructors may find it useful to discuss this from the perspective of a campuslocation in the city, state or province, country, or region among a group ofcountries nearby.


On the diagram, the FIX line indicates where the net benefit of a fixed ex-change rate regime is equal to zero.

■ Above the FIX line → high degree of economic integration, symmet-ric shocks → net benefit � 0 → fixed exchange rate regime

■ Below the FIX line → low degree of economic integration, asymmet-ric shocks → net benefit � 0 → floating exchange rate regime

The following two applications consider empirical evidence about whetherfixed exchange rate regimes in fact promote efficiency gains and hinder out-put stability.

APPLICATION

Do Fixed Exchange Rates Promote Trade?A fixed exchange rate regime eliminates exchange rate volatility, reducing thetransactions costs associated with cross-border exchange. Specifically, under apure fixed exchange rate, there is no exchange rate risk. Our hypothesis is thatremoving this risk will increase the volume of trade.

Benefits Measured by Trade Levels Economic historians found that pairsof countries that adopted the gold standard in the late 19th and early 20thcenturies enjoyed trade levels 30% to 100% higher than those with floatingexchange rates. Today, there are several versions of a fixed exchange rateregime, making this a challenging question to answer empirically. We canclassify countries in four ways:

■ Common currency (A and B use the same currency unit)■ Direct exchange rate peg (A’s currency is fixed to B’s)■ Indirect exchange rate peg (A and B have an exchange rate peg with a

third country, C)■ Floating exchange rate regime (A and B’s currencies are not linked di-

rectly or indirectly)Figure 15-5 tells the story. Countries with a common currency have a 38%higher trade volume than a floating rate. Countries that directly peg their ex-change rates to each other have a 21% higher trade volume. There is no sig-nificant benefit for countries with indirect pegs

Benefits Measured by Price Convergence If fixed exchange rates lowertransactions costs, differences in prices should be smaller among countrieswith fixed exchange rates. Earlier, we examined how nominal exchange ratesare linked through relative prices, using the law of one price (LOOP) and pur-chasing power parity (PPP). LOOP and PPP are more likely to hold in a fixedexchange rate regime if the argument posited previously is true.

Research on prices of baskets of goods shows that as exchange rate volatil-ity rises, price differences widen, and the speed of convergence in the prices(toward PPP) decreases. For individual goods, as exchange rate volatility rises,there are larger price differences across locations. In the case of Europe, theprice gaps have narrowed among ERM/euro countries and widened for thosecountries that left the ERM. ■


APPLICATION

Do Fixed Exchange Rates Diminish Monetary Autonomyand Stability?If capital markets are unrestricted, then uncovered interest parity (UIP) holds,and the home interest rate must be equal to the foreign interest rate. There-fore, policy in the base country dictates economic conditions in the countriespegged to the base currency. This application examines to what extent fixedexchange rate regimes imply interest rate parity (e. g. , no monetary policy au-tonomy) and affect output stability.

The Trilemma, Policy Constraints, and Interest Rate Correlations Solu-tions to the trilemma:

1. Open capital markets with fixed exchange rate (“open peg”)

2. Open capital markets with a floating exchange rate (“open nonpeg”)

3. Closed capital markets (“closed”)

Note that case 1 implies that monetary policy is not autonomous, so interestrates in the home country move one-for-one with the base country. Cases 2and 3 imply autonomous monetary policy, so that changes in interest ratesacross countries are independent.

Figure 15-6 shows interest rate movements in home countries relative to abase country. The estimated slope of the line should be equal to 1 in case 1.The data support this observation:

1. Panel (a): slope � 0. 88 (close to 1)

2. Panel (b): slope � 0. 58

3. Panel (c): slope � 0. 39

Costs Measured by Output Volatility Loss of monetary policy autonomymay not be a bad thing if central bankers are irresponsible or unable to achievemacroeconomic objectives. In some sense, the costs of a fixed exchange rateregime hinge more on output stability than monetary policy autonomy.

As shown in Figure 15-7, output volatility is higher for countries with a fixedexchange rate regime relative to float. The data show the instability is higher forpoorer countries. This suggests that loss of monetary policy autonomy is costlyin terms of output stability. From the figure, countries using intermediate ex-change rate regimes experience roughly the same volatility as float. ■

2 Other Benefits of FixingThis section extends the discussion of costs and benefits of fixed exchange rateregimes beyond economic integration and output stability.

Fiscal Discipline, Seigniorage, and InflationA fixed exchange rate regime prevents the government from financing a bud-get deficit by printing money. Since monetary policy must be dedicated tomaintaining the exchange rate, the central bank cannot simply create moneyfor the government to spend. In a floating exchange rate regime, the govern-ment may opt to monetize a deficit by printing money. This expansion of the


money supply inevitably leads to high inflation and imposes an inflation tax(seigniorage) on the public. In this way, the fixed exchange rate regime can, intheory, serve as a nominal anchor.

Table 15-1 shows that fixed exchange rate regimes do not prevent infla-tion. However, when we examine subgroups, we observe that the adoption ofa fixed exchange rate regime does eventually reduce inflation in emerging mar-kets and developing countries.

In general, fixed exchange rate regimes are neither necessary nor sufficientto ensure low inflation. Developing countries suffering from high inflationrates are an exception, as exchange rates may serve as the only viable nominalanchor for these countries.


Liability Dollarization, National Wealth, and Contractionary DepreciationsMany developing countries and emerging markets suffer from liability dollar-ization, in which a large portion of foreign investment from abroad is de-nominated in another currency. This creates the potential for large destabiliz-ing wealth effects when the exchange rate changes.

Assumptions:■ Two countries, home (pesos) and foreign ($).■ Nominal exchange rate, Epesos/$

■ Home external assets● AH denominated in home currency (pesos)● AF denominated in foreign currency ($) � EAF measured in home

currency (pesos)■ Home external liabilities

● LH denominated in home currency (pesos)● LF denominated in foreign currency ($) � ELF measured in home

currency (pesos)

S I D E B A R

The Inflation Tax

This section considers why monetizing the deficit imposes an in-flation tax (seigniorage) on the public.

Assume output is fixed, prices are flexible, and inflation and thenominal interest rate are constant. In this case, the growth rate ofthe money supply is equal to the inflation rate, �M / M � �. Fromthe Fisher effect, we know i � r* � �.

The inflation created from monetizing the deficit erodes thepurchasing power of money. When the public holds money bal-ances M / P, as prices rise, the value of real money balances out-standing falls. For example, if you hold $100 and P � 1, whenthe government expands M by 1%, P grows by 1%, so your realmoney balances fall to $99 � ($100 / 1.01). Therefore, this actsas an inflation tax, transferring resources from the public to thegovernment.

The extra money printed to purchase goods and services isworth �M / P � (�M / M) � (M / P) � � � (M / P). In the ex-ample above, the $1 tax borne by the public is “paid” to thegovernment. We can see how this relates to the interest rate byusing the money market equilibrium condition:

Seigniorage � � � (M / P) � � � L(r* � �)Y

Note that the revenue generated by monetizing the deficit isoffset partially by a decrease in real money demand. In the ex-treme case of a hyperinflation, money demand collapses to zero,eliminating potential seigniorage for the government.


Home country’s total external wealth is the sum of total assets less the liabili-ties expressed in home currency:

W � (AH � EAF) (LH � ELF)

Suppose the exchange rate changes by �E. The change in wealth is (valuationeffect):

�W � �E � (AF LF)

From the expression, there are two possible cases following a depreciation, �E � 0:

■ If AF � LF, then external wealth increases■ If AF � LF, then external wealth decreases (liability dollarization)

Destabilizing Wealth Shocks Note that wealth effects may offset or mag-nify the effects of a depreciation on aggregate demand. Although a deprecia-tion increases the trade balance, it also affects wealth because:

■ Consumption may be a function of wealth if households save or bor-row.

■ Investment may be a function of wealth if the ability of firms to obtaincredit depends on their net worth.

When a country’s foreign currency assets do not equal foreign currency lia-bilities, it has a currency mismatch on its external balance sheet. Now considerhow stabilization policy (a monetary expansion) affects the economy differ-ently in the presence of wealth effects.

■ If AF � LF, then external wealth increases → C and I increase → policy effect on output magnified

■ If AF � LF, then external wealth decreases → C and I decrease →policy effect on output dampened

In theory, a currency depreciation could actually be contractionary if the val-uation effects are large enough! And this is important for developing coun-tries, whose external liabilities are often nearly completely dollarized.

Evidence Based on Changes in Wealth Figure 15-8 reports data on thecumulative change in external wealth associated with valuation effects duringcurrency crises from 1993 to 2003. From the figure, these valuation effectscan be quite large, although they depend on the percent depreciation in thecurrency. Countries with a larger fraction of liabilities denominated in an-other currency (dollars or yen in these cases) or those experiencing larger de-preciations suffered larger losses in wealth.

Evidence Based on Output Contractions Do these wealth effects matterfor output? Figure 15-9 plots the relationship between the percentage changein output against the wealth losses associated with valuation effects. The fig-ure shows a clear relationship: countries suffering larger wealth losses experi-enced more severe contractions in output.

Original Sin Historically, most countries—especially those less-developedcountries operating on the fringes of the global capital market—were forcedto borrow in gold or in a “hard currency,” such as the British pound or theU. S. dollar. This created a currency mismatch. Table 15-2 reports data onthe percentage of external liabilities denominated in foreign currency acrossgroups of countries. Wealthier countries have a relatively small percentage of

their external liabilities denominated in foreign currency. But the rest of thecountries have between 72% and 100% of external debt denominated in for-eign currency.

“Original sin” refers to a country’s inability to borrow in its own cur-rency. This problem arises partly from a country’s historical macroeconomicpolicies. As the value of domestic currency debts was eroded by inflation,creditors required the debts be denominated in a foreign hard currency.

Options for Redemption?■ Another perspective argues that the real source of the problem is gol-

bal capital market failure. Because small countries have a small pool ofliabilities traded, investors benefit little from diversification into theseliabilities. These liabilities are more appealing when they are bundledwith others in the form of a security denominated in a single cur-rency.

■ Another prescription involves improving institutional quality and de-signing better macroeconomic policy to achieve low inflation.

■ Finally, countries can reduce currency mismatch through the centralbank’s acquisition of foreign currency and sovereign wealth funds (increasing AF).

Practical Limitations■ Government borrowing denominated in foreign currency is still a

problem.■ Also, currency mismatch in private sectors is a problem, compounded

by moral hazard (excessive risk-taking with the expectation of a gov-ernment bailout).

■ The private sector is unable to hedge against exchange rate risk be-cause their capital markets are underdeveloped.

What does this mean for the fixed versus floating debate? Among countriesthat cannot borrow in their own currency, floating exchange rates are less use-ful as a stabilization tool and may be destabilizing. This is particularly true ofdeveloping countries, so these countries will prefer fixed to floating exchangerates, all else equal.

SummaryIn addition to economic integration and economic similarity, there are severalfactors that influence a country’s decision to adopt a fixed exchange rateregime:

■ Fixed exchange rates impose fiscal discipline by preventing the imposi-tion of an inflation tax (seigniorage) on the public.

■ Fixed exchange rates avoid large changes in external wealth amongcountries with assets and liabilities denominated in a foreign currency.

These factors are more compelling for poorer countries, leading to a fear offloating. These additional considerations influence the symmetry-integrationdiagram as illustrated in Figure 15-10. The benefits of fiscal discipline andavoidance of wealth effects shift the FIX line down because they add to thenet benefit a country receives from adopting a fixed exchange rate regime.


3 Fixed Exchange Rate SystemsIn reality, there are several types of fixed exchange rate systems, often in-volving multiple countries, such as the Bretton Woods system and the EuropeanExchange Rate Mechanism (ERM). These are examples of reserve currencysystems in which N countries participate. The center (or base) country, usu-ally assigned the number N, is the currency to which all other countries peg.And the base country supplies the reserve currency for the rest of the world.

At the beginning of this chapter, we studied Britain’s decision to leave theERM and allow the pound to float (Application: Britain and Europe: The BigIssues). At that time, the German Deutschmark (DM) was the base currency.Germany, as the center country, had monetary policy autonomy. The Germancentral bank had the luxury of choosing i*. ERM countries had to set theirinterest rates equal to i* to maintain the peg. This fundamental asymmetry isknown as the Nth currency problem.

An alternative to the approach studied earlier is for countries to reach co-operative arrangements. There are two kinds of agreements studied in thischapter:

■ Mutual agreement and compromise between the center and noncentercountries through the adjustment of interest rates.

■ Mutual agreement to change the exchange rate peg.

Cooperative and Noncooperative Adjustments to Interest RatesIn the following examples, the home country is the noncenter country andthe foreign country is the center country. Suppose the noncenter country ex-periences an adverse demand shock but the center country does not. This isshown as a leftward shift in the home country’s IS curve in Figure 15-11.

Noncooperative (Point 1)■ To maintain the exchange rate peg, the home country must reduce

the money supply, shifting LM to the left to keep the interest rateunchanged.

■ With no response from the center country, each country’s equilibriumis at Point 1. The noncenter country’s Y is below the desired level,whereas the center country’s Y* is equal to the desired level.

Cooperative (Point 2)■ The center country agrees to allow its output to expand, lowering in-

terest rates by shifting the LM* curve to the right.■ The noncenter country follows, shifting the LM curve to the right, re-

ducing the loss in output.■ Because the home country’s interest rate falls, the IS* curve shifts to

the left (all else equal, the center country’s trade balance improveswhen the noncenter country’s interest rate falls). Similarly, IS shifts leftbecause i* falls.

■ Point 2 is the cooperative equilibrium, with the center country expe-riencing a small increase in Y* and the noncenter country experienc-ing a small decrease in Y.

Caveats Cooperative arrangements may arise if the countries seek to limitexchange rate volatility without a hard peg. In this way, the countries canachieve most of the benefits of fixing without high stability costs.


In practice, these cooperative arrangements are rarely credible. The shocksthat hit a group of countries are often asymmetric, and it may be difficult forone country to allow output to deviate from the desired level to help out an-other country. In the end, these asymmetric shocks should average out, butthis requires a long-term commitment. For example, in the ERM, countriespleaded with Germany to ease its monetary policy, which would to reduce thecontraction in output felt elsewhere in Europe.

As demonstrated in the case of the ERM and Germany, the center coun-try has a great deal of autonomy and may be unwilling to give it up, makingcooperative agreements difficult to achieve.

Cooperative and Noncooperative Adjustments to Exchange RatesInstead of adjusting interest rates, suppose that countries agree to reset theirexchange rate pegs following a shock. Countries that previously had an ex-change rate peg at E�1� announce that the new peg is E�2� � E�1�.

■ EE�2� � EE�1�: devaluation (in the home currency)■ EE�2� � E�1�: revaluation (in the home currency)

In the following examples, both the home and foreign countries are the non-center.

Devaluation and revaluation are analogous to depreciation and apprecia-tion, except these terms are used only to describe changes in exchange ratepegs. Figure 15-2 shows the effects of a home-country devaluation relative tothe other countries. The devaluation is achieved through a monetary expan-sion (LM shifts right), leading to a devaluation in the home currency thatboosts the trade balance and increases demand (IS shifts right) such that in-terest rates are unchanged.

Cooperative (Point 2)■ The devaluation in the home country leads to a decrease in demand in

the foreign noncenter country.■ The foreign noncenter country’s IS* curve shifts to the left. The for-

eign central bank shifts LM* to the left to maintain interest rate parity(this is a one-time change in the exchange rate).

■ The foreign country agrees to let output Y* fall to bring the homecountry closer to the desired output.

Noncooperative (Point 3)■ Here, the home country implements a larger devaluation, causing a

large increase in the demand for home goods and a large decrease inthe demand for foreign goods. LM shifts to the right.

■ IS shifts to the right and IS* shifts to the left by larger magnitudesthan under a cooperative agreement.

■ The foreign country must implement a large decrease in money sup-ply, shifting LM* to the left to maintain interest rate parity.

■ The foreign country suffers a larger decrease in Y*—the home countryessentially exports its recession to the foreign country.

We can use the same logic to analyze the effects of a home-country revalua-tion. Suppose the home country’s economy is “overheating” with Y higherthan the desired level. The analysis can be expanded to consider a centercountry’s choice to devalue or revalue.


Caveats A noncooperative adjustment in the exchange rate peg (especiallya devaluation) is known as a beggar-thy-neighbor policy. The homecountry improves its output at the expense of the foreign country’s output.This highlights a key problem with noncooperative agreements: they can leadto retaliation in which the peg is constantly adjusted, eliminating the poten-tial gains from a fixed exchange rate regime. Successful exchange rate systemsinvolve some degree of cooperation.

APPLICATION

The Gold StandardIs it possible to avoid the problem of asymmetric shocks in an exchange ratesystem? This would require that all countries are noncenter, avoiding the Nthcurrency problem, so that one country is unable to dominate the others withautonomous monetary policy. The gold standard is an example of such a sys-tem. Because all countries pegged to gold, no single country could act as acenter country with its own currency.

Mechanics of the gold standard: Britain (home) and France (foreign):■ Gold and money are seamlessly interchangeable. The money supply,

M, equals the combined value of gold and money in the hands of thepublic. (Under the pure gold standard, the only acceptable money wasgold coins. ).● Each country’s currency is pegged to a gold local currency price: P�g�,

P�*�g�. Thus one pound costs 1/P�g� ounces of gold and one ounce of goldcosts P�*�g� francs. In other words, an ounce of gold costs P�g� pounds inBritain and P�*�g� frances in France

● The par exchange rate (British pounds per French franc): Epar � P�g�/P�*�g�

● The gold standard depends heavily on maintaining free convertibil-ity: central banks must be willing and able to buy or sell gold in ex-change for their domestic currency. The prices are P�g�, P�*�g�.

■ Arbitrage keeps exchange rates fixed. Consider what happens whenthe French franc appreciates against the British pound:● If E � Epar, then Epar/E � P�*�g�/E�P�g < 1. This means that an ounce of

gold costs fewer pounds in Britain (P�g�) than it does in France (EP�*�g�).� Buy one ounce of gold in Britain for (P�g�) pounds� Sell gold in France for P�*�g� francs� Convert the francs to EP�g � P�*�g� 1 pounds

● Gold flows out of Britain and into France, expanding France’smoney supply and contracting Britain’s money supply. These flowslead to a decrease in E (the franc depreciates and the pound appre-ciates) until the par exchange rate is achieved.

Considerations and limitations:■ The arbitrage process is not without cost. If the exchange rate deviates

from the par value by a very small amount, it will not be worthwhileto exploit the difference. This means there is effectively an exchangerate band within which the currency can appreciate or depreciate,roughly 1%.

■ The arbitrage process works in reverse if the exchange rate is below itspar value. Gold flows out of France and into Britain, expanding


Britain’s money supply and contracting France’s. These flows lead toan increase in E until the par exchange rate is achieved.

■ Gold arbitrage implies interest rate parity across countries because theexpected depreciation is zero. The approach to fixed exchange rateregimes from earlier applies to the gold standard.

■ Under the gold standard, there is no center country. All countries co-operate without explicit policy intervention. ■

The gold standard has one major advantage: it is inherently symmetrical. Allcountries share in the adjustment process. And, since there is no reserve cur-rency, no country has the privilege of an independent monetary policy. In re-ality, though, the gold standard did not operate smoothly.

4 International Monetary ExperienceThis section provides a historical overview of exchange rate systems, begin-ning in 1870 and continuing through the present. The following text sum-marizes this information in a timeline and key points.

The Rise and Fall of the Gold Standard1870–1918: The first era of globalization and World War I

■ Origins● A combination of technological developments in transport and

communications plus policy changes increased economic integra-tion, increasing the benefits associated with a fixed exchange rateregime.

● A stabilization policy was politically irrelevant and price stabilitywas the primary goal.

■ Experience on the gold standard● A few countries adopted a gold peg, increasing the benefits to oth-

ers adopting a fixed exchange rate regime thereafter (network externality).

● Many countries joined the gold standard only to leave during a do-mestic economic crisis.� U.S. 1890 deflation and recession—William Jennings Bryan

“cross of gold. ”� Gold Standard Act of 1900—economic growth and gold discov-

ery meant higher output and prices.■ Collapse and World War I

● During World War I, the inflation tax became an important sourceof revenue, leading to several countries leaving the gold standard.

● Conflict reduced trade.� Close to 100% reduction among warring countries.� 50% reduction among these countries and neutral states.

1918–1945: The Great Depression and World War II■ 1920s

● Protectionism and beggar-thy-neighbor policies further reducedtrade.

● By the 1930s, world trade was half of the 1914 levels.


■ The Great Depression (1930s)● More severe output fluctuations caused stabilization policies to be

increasingly popular.● Remaining on gold standard meant continued deflation because of

slow growth in the world’s gold supply.● Developing countries experienced recession earlier; some devalued

as early as 1929 and increasingly relied on major currencies becausegold reserves were not available.

● Weakened confidence and credibility of gold pegs indicated by cur-rency traders.� In 1931, Austria and Germany imposed capital controls.� The major currencies abandon the gold standard: Britain in

1931, the United States in 1933.■ The trilemma revisited (Figure 15-13)

● Option 1: remain on the gold standard and forgo monetary policyautonomy (France).

● Option 2: remain on the gold standard and impose capital controls(Austria, Germany, several countries in South America).

● Option 3: abandon the gold standard (Britain and the UnitedStates).

In the end, the system collapsed because:■ the efficiency gains from trade were diminished as the results of war

and poor macroeconomic policy■ stability costs became more important■ lack of cooperation among countries in that they did not commit to

maintaining the gold peg■ slow growth in the world’s gold supply led to a worldwide deflation

Bretton Woods to the Present■ Background and design

● In 1944, economic policy makers gathered at Bretton Woods, NHto establish a cooperative international monetary system.

● Their objective was to maintain a system of fixed exchange rates torebuild trade among countries.� All countries that signed the Bretton Woods agreement pegged

their currencies to the U. S. dollar. The dollar, in turn, waspegged to gold.

� The Bretton Woods agreement included capital controls. Sincespeculators were blamed for destabilizing the gold standard, controlling the movements of capital was believed to reducespeculation.

■ Bretton Woods performance and collapse● Market pressures and the trilemma:

� To trade, some system of international credit was needed. Coun-tries wanted to liberalize financial transactions but limit speculation.

� By the 1960s, controls were leaky, with businesses using ac-counting tricks to move currency across countries or using un-regulated offshore accounts.


● From the trilemma, the deterioration of capital controls meant a lossof monetary policy autonomy to remain part of the Bretton Woodssystem.� Countries compromised on a “fixed but adjustable” system in

which countries devalued as a means of stabilizing output.� This made the system unstable, creating beggar-thy-neighbor

policies that encouraged speculation.● In the 1960s, the United States experienced inflation as the result of

fiscal expansion during the Vietnam War era.� Countries pegged to the dollar would be forced to follow by

expanding their money supplies, increasing inflation abroad.� Gradually, countries abandoned the dollar peg.

● In 1971, the U. S. dollar was no longer convertible to gold.■ Aftermath and options

● Countries faced several options after the collapse of the BrettonWoods system:� Most advanced countries have moved to a floating exchange

rate regime, preferring monetary policy autonomy over fixedexchange rates.

� A group of European countries attempted to preserve fixed ex-change rates through the ERM. Today a subset of those coun-tries is “irrevocably” committed to the euro. This group ofcountries is at the top corner of the trilemma diagram.

� Some developing countries have maintained capital controls, butmost have opened capital markets. There is a fear of floating(benefits greater than costs) for these countries.

� Some countries have adopted intermediate regimes, dirty floats,or pegs with limited flexibility (India).

� A small number of countries still rely on capital controls today(China), but this is changing.

● Today, there is no real international monetary system in the sense ofcooperative systems between countries. There are some notable ex-ceptions, such as the establishment of the ERM and the Eurozone.

5 ConclusionsThis chapter considered the choice of whether to adopt a fixed or a floatingexchange rate regime. The primary factors are economic integration and sta-bility costs, with other factors such as fiscal discipline and liability dollariza-tion playing an important role in emerging markets and developing countries.We considered the mechanics of a fixed exchange rate regime with coopera-tion and noncooperation in terms of interest rate parity and exchange rate ad-justments. The chapter concluded with a summary of exchange rate systemsin practice, focusing on the gold standard and the Bretton Woods systems.


Teaching Tips

1. Teaching Tip 1: Rep. Ron Paul (R-Texas) advocates returning theUnited States to the gold standard, eliminating the Federal Reserve, andallowing privately issued currency to compete with the dollar(http://www. ronpaul. com/2010-01-26/ron-paul-legalize-competing-currencies/ and http://www. ronpaul. com/2009-02-01/going-back-to-the-gold-standard/ for example). Ask your students whether a return tothe gold standard would be a good idea. Point out that most of the rest ofthe world would probably not follow our lead on this issue. Then askthem whether privately issued currencies are allowed in the United States.Give them a few days to do some research. You, luckily, have this resource.The E. F. Schumacher Society (Small Is Beautiful, Blond & Briggs, 1973)maintains a list of current and “retired” local currency experiments athttp://www.smallisbeautiful.org/local_currencies/retired_in-planning.htm.So there is competition for the dollar. Have the class discuss why the dol-lar has maintained its monopoly position as U. S. currency in the face ofthis competition.

2. Teaching Tip 2: German reunification was one of the biggest news sto-ries of 1990. Twenty years later, the shockwaves continue. As we saw inthis chapter, reunification imposed large fiscal costs on the West Germangovernment, ultimately resulting in the United Kingdom’s decision toleave the ERM. As of July, 2010, unemployment in eastern Germany was11. 5%, almost double the 6. 5% rate in the west. And government subsi-dies of € 80 billion flowed into the east, half of which paid for social ben-efits and welfare. The roots of this lay in the exchange rate between theWest German Deutschmark (DM) and the East German ostmark (OM).Before reunification, the official exchange rate was 1 to 1. But the blackmarket rate was between five and ten OM/DM. But, for political reasons,the West German government agreed to an exchange rate between 1 and3 OM/DM, with prices and wages converted at a 1:1 ratio. The problemwas that East German productivity was less than half that of West Germanworkers. In effect, East German labor was priced out of the market, re-sulting in the large flow of subsidies that continues today. West Germanyfinanced the increased government spending with debt, pushing up inter-est rates. The rest of the story is told in the textbook. So here’s the ques-tion for your students: what, if anything, should the West German govern-ment have done differently?

3. Sources: http://www.dw-world. de/dw/article/0,,6025610,00. html andhttp://www. sjsu. edu/faculty/watkins/germancurrency. htm



I N - C L A S S P R O B L E M S

1. Examine the empirical evidence on the benefitsand costs of currency pegs. First, identify the po-tential costs and benefits, then evaluate eachbased on the empirical analysis presented in thechapter.

Answer: The potential benefits of a fixed ex-change rate regime are: efficiency gains from thereduction of transactions costs and convergencein prices, fiscal discipline in the form of lowerinflation tax (seigniorage), and reduction inlosses from valuation effects arising from cur-rency mismatch in external wealth. The costs ofa fixed exchange rate rest mainly on lack of pol-icy autonomy, which could otherwise be used tostabilize output. The empirical evidence is sum-marized as follows:

■ Benefits● Countries with a common currency

and direct exchange rate peg have ahigher volume of trade relative tothose with floating exchange rates.There is no significant benefit forcountries with indirect pegs.

● Evidence testing in both baskets ofgoods (PPP) and individual goods indi-cate price convergence is faster amongcountries with lower exchange ratevolatility.

● Fixed exchange rate regimes do notprevent inflation in general. However,

the adoption of a fixed exchange rateregime does eventually reduce inflationin emerging markets and developingcountries.

● Losses in external wealth associatedwith valuation effects (from deprecia-tion) can be quite large, although theydepend on the percent depreciation inthe currency. Countries with a largerfraction of liabilities denominated inanother currency such as dollars or yenor those experiencing larger deprecia-tions suffered larger losses in wealth.The empirical evidence indicates theselosses have a significant effect on output.

■ Costs● Interest rate movements in home

countries relative to a base country.The estimated slope of the line shouldbe equal to 1 in case 1. The data sup-port this observation.

● Output volatility is higher for coun-tries with a fixed exchange rate regimerelative to float. The data show the in-stability is higher for poorer countries.This suggests that loss of monetarypolicy autonomy is costly in terms ofoutput stability.


2. The Bulgarian lev is currently pegged to theeuro. Using the IS/LM diagrams for home (Bul-garian lev) and foreign (Eurozone) illustrate howeach of the following scenarios affects the Bul-garian lev. Assume that this fixed exchange rateregime involves noncooperative adjustments tointerest rates and that the Eurozone is the center“country. ”

a. Bulgaria increases government spending tofinance social welfare programs.

Answer: The increase in governmentspending leads to a rightward shift in the IScurve. This leads to an increase in homecountry’s interest rate and an implied appre-ciation in the home currency, shifting IS*to the left. In a fixed exchange rate regime,the home country’s central bank shifts LMto the right to offset the increase in thehome interest rate and IS* does not shift.

Floating (B): Y ↑, i ↑, E ↓Fixed (C): Y ↑; i and E unchanged

i*

IS*1

LM*1

IS*2

BA C

i

IS1

LM1

LM2

IS2

i*1

i*2

i2

i1A

B

C

Y2 Y3Y1 Y*1 Y*Y*2Y

b. The Eurozone countries decrease themoney supply.

Answer: The decrease in foreign moneysupply leads to a leftward shift in the LM*curve. This leads to an increase in foreigncountry’s interest rate, i*, and an impliedappreciation in the foreign currency, shiftingIS to the right. In a fixed exchange rate

regime, the home country’s central bankshifts LM to the left to align home interestrate i with the foreign interest rate i*, shift-ing IS* to the right.

Floating (B): Y ↑, i ↑, E ↑Fixed (C): Y ↓, i ↑, E unchanged

i*

IS*1

LM*1

LM*2

IS*2

B

A

C

i

IS1

IS2

LM2

LM1

i*1

i*2

i*3

i2

i3

i1A

B

C

Y2Y3 Y1 Y*1 Y*Y*3Y*2Y


c. Investors expect a depreciation in the Bul-garian lev relative to the euro.

Answer: This increases the return on for-eign deposits, leading to a depreciation inthe home currency, shifting IS to the right.The result is an increase in home interestrates, which shifts IS* to the left. In a fixedexchange rate regime, the home country’s

central bank shifts LM to the left to preventthe depreciation and the home interest rate,i, rises, shifting IS* further to the right.Note that the interest rates may not beequal as long as investors expect a deprecia-tion, i � i*.

Floating (B): Y ↑, i ↑, E ↑Fixed (C): Y ↓, i ↑, E unchanged

i*

IS*1

LM*1

IS*2

IS*3

B

A

C

i

IS1

IS2

LM2

LM1

i*1

i*2

i*3

i2

i3

i1A

B

C

Y2Y3 Y1 Y*1 Y*Y*2 Y*3Y

3. The Chinese government manages the value ofthe Chinese yuan relative to the U. S. dollar.Between 1995 and 2005, the yuan was pegged tothe dollar at a rate of roughly 8. 28 yuan per dol-lar. China’s central bank, the People’s Bank ofChina (PBC), is responsible for using monetarypolicy to defend the fixed exchange rate. As a result of government policy geared towardspurring capital investment, China experienced asignificant increase in investment demand.

a. Using the IS/LM diagram for home(China) and foreign (the United States) il-lustrate the impact of this policy, assumingthe PBC responds to maintain a fixed ex-change rate.

Answer: See the following diagram.

i i*

i3

i1

i*3

i*1

Y1 Y3

IS1 IS*1

IS2

IS*3

LM2

LM1LM*1

Y2 Y Y*1 Y*3 Y*

A B

CC

A B


b. How would this policy and central bank re-sponse affect the government budget, cur-rent account, domestic interest rates, andoutput?

Answer: The government budget, trade bal-ance, and home interest rate are unaffectedby this policy. China’s output increases.

c. How would China’s experience be differentif the PBC allowed the yuan to float againstthe U. S. dollar? What would be the impli-cations for China’s exports to the UnitedStates? For China’s imports from the UnitedStates?

Answer: If the yuan floats against the dol-lar, the increase in investment demand willlead to an appreciation in the yuan by in-creasing the domestic return on China’s de-posits. China’s output increases by a smalleramount and its trade balance decreases be-cause of the increase in China’s interest rateand the appreciation in the yuan. Thiswould cause a decrease in China’s exportsand an increase in China’s imports from theUnited States, as shown by the rightwardshift in IS* in the previous figure.

d. In practice, China uses capital controls tofix its exchange rate. How does this affectthe previous answers? In the case of capitalcontrols, is the outcome more similar to thefixed case in (a) or the floating case in (c)?

Answer: In the case of capital controls,China can allow the interest rate in Chinato deviate from the U.S. interest ratethrough eliminating capital market arbi-trage. This will result in a situation similarto the floating case mentioned previously;because interest rates need not be equal,China’s central bank does not need to ex-pand the money supply to prevent the ap-preciation in the yuan.

4. During the mid-1990s, Mexico maintained anexchange rate peg against the U. S. dollar.When President Zedillo took office in Decem-ber 1994, he faced several challenges. A combi-nation of the assassination of a presidential can-didate (Luis Donald Colosio) and the rebellionin Chiapas had led to an increase in the expectedfuture exchange rate, Ee

peso/$.

a. Using the IS/LM diagram for home (Mex-ico) and foreign (the United States) illus-trate the impact of this change in investorexpectations, assuming the Banco de Mex-ico responds to maintain a fixed exchangerate.

Answer: See the following diagram. PointB shows the floating exchange rate out-come (for comparison); point C shows thefixed exchange rate output.

i i*

i3

i1

i2

i*3

i*1

i*2

Y3 Y1

IS1 IS*1

IS2

IS*2

IS*3

LM2

LM1 LM*1

Y2 Y Y*1Y*2 Y*3 Y*

A

B

C

A

B

C


b. How would the change in exchange rateexpectations and the subsequent centralbank response affect the government bud-get, trade balance, domestic interest rates,and output?

Answer: Mexico’s central bank is forced tocut the money supply to prevent an actualdepreciation in the peso because investorsshift deposits out of Mexico, expecting ahigher return on U.S. deposits. Also, theexpected depreciation leads to a rightwardshift in IS because the demand for Mexico’sgoods rises. The increase in Mexico’s inter-est rate leads to an increase in demand forU.S. goods, shifting IS* to the right andoffsetting gains in Mexico’s trade balance.

c. When president-elect Ernesto Zedillo tookoffice, he was forced to make a decision be-tween either establishing an exchange rateband (effectively floating the peso againstthe dollar) or continuing the monetary pol-icy mentioned previously. President Zedillodecided to establish an exchange rate band.The former President Salinas referred toZedillo’s policies as “el error de diciembre,”or “the December mistake. ” Do you be-lieve this decision was a mistake? Explain,considering the trade-offs between outputstabilization and exchange rate stability.

Answer: Based on the previous diagram, wecan see why President Zedillo may haveopted to float the peso against the dollar. Inthis case, Mexico does not suffer a contrac-tion in output and its trade balance im-proves. This highlights the trade-off be-

tween exchange rate stability and output sta-bility. In the case of a fixed exchange rate,Mexico suffers a contraction in output. Inthe floating case, it experiences an expan-sion.

d. Suppose that a large share of Mexico’s ex-ternal debt is denominated in U. S. dollars.How does this affect your answer to (c)?

Answer: If a large share of Mexico’s exter-nal debt is denominated in U. S. dollars,then a depreciation in the peso could haveadded costs in terms of valuation effects.The depreciation in the peso would reduceMexico’s external wealth, potentially con-tracting demand through reducing con-sumption and/or investment demand. Inthis case, it might be more beneficial tomaintain the exchange rate peg.

5. Consider a noncenter home country that is partof a fixed exchange rate regime. The homecountry currently has output higher than its de-sired level. Concerned about inflationary pres-sures, central bankers want to contract themoney supply. Using the IS/LM diagrams for ahome and a foreign country, show how each ofthe following would affect home and foreignoutput. In which cases are the monetary policyobjectives inconsistent with the home countryremaining in the fixed exchange rate regime?

a. The foreign country is a center country.Compare a cooperative versus a noncooper-ative adjustment in interest rates.

Answer: See the following diagram. In thenoncooperative case, there is little the homecountry can do. It remains at point A, un-


able to use monetary policy to achieve out-put stability. In the case of a cooperativeagreement, the foreign country and thehome country agree to raise interest rates,reducing output in both countries. Thispushes output below its desired level in theforeign country and brings home country

output closer to its desired level. This co-operative agreement is similar to how au-tonomous monetary policy would respond,except the home country must compromiseand not contract the money supply as muchas what is needed to achieve desired output(otherwise the foreign country might not

i

i1

i2

IS1

IS2

LM2

LM1

A

B

Y0 Y1Y2 Y

i*

i*1

i*2

IS*1

LM*2

Y*2 Y*0 Y*

A

B

IS*2

LM*1

agree to raise interest rate, i*).

b. The foreign country is a noncenter coun-try. Compare a cooperative versus a non-cooperative adjustment in exchange rates.

Answer: See the following diagram. In thiscase, the home country wants to implementa currency revaluation to reduce the tradebalance and contract output. In the coop-erative case, the foreign country agrees to

the revaluation, compromising to let its out-put rise above the desired level by a smallamount. In the noncooperative case, thehome country revalues by a larger amount,leading to a bigger boom in output in theforeign country. Essentially, the homecountry “exports” its economic boom tothe foreign country in part (in a coopera-tive agreement) or in full (noncooperative).

i

i1

IS1

IS2IS3

LM2LM3 LM1

ABC

Y0 Y1Y2 Y

A B C

i*

i*1

IS*3

IS*1

LM*2

LM*3

Y*2 Y*3Y*0 Y*

IS*2

LM*1i*2


6. During the 1980s, several Latin American coun-tries had currencies pegged to the U. S. dollar.Consider three such countries: Belize, Bolivia,and Mexico. A larger share of Mexico’s exportswas/is sold in the United States relative to Be-lizean and Bolivian exports to the United States.In addition, Mexico shares a large geographicborder with the United States, whereas Belize islocated further south in Central America, withcoastal access to the United States through theCaribbean Sea. Bolivia is located in SouthAmerica and is landlocked. Compare and con-trast these three countries in terms of their likelydegree of integration symmetry with the UnitedStates. Plot Belize, Bolivia, and Mexico on thesymmetry-integration diagram relative to theUnited States.

Answer: See the following diagram. Althoughit is not possible to determine the position of theFIX line without more information, we knowthat Mexico is in the upper right and Bolivia isin the lower left. Sharing a geographic borderwith the United States and trading heavily meansMexico’s efficiency gains are larger than those inBolivia and Belize. Because Belize has coastalaccess to the United States and is located closerthan Bolivia, it lies above and to the right of Bo-livia, but below and to the left of Mexico.

7. Several countries that have experienced politicaland economic stability adopt a fixed exchangerate regime to draw on the potential benefits,such as fiscal discipline, seigniorage, and expectedfuture inflation. To what extent do you believethese potential benefits differ in cooperative ver-sus noncooperative fixed exchange rate systems?

Answer: Cooperative exchange rate systems aregenerally more successful than noncooperativeregimes. Countries can compromise on adjust-ing interest rates or exchange rates, preventingcountries from being forced off of a fixed ex-change rate regime. With cooperation, the costsof asymmetric shocks are shared by members ofthe fixed exchange rate regime, reducing stabil-ity costs. In practice, however, cooperativearrangements often break down because it is dif-ficult for a country to let another country’s eco-nomic conditions dictate those at home, espe-cially if the home country happens to be a centercountry. In terms of the benefits, to the extentthat cooperative arrangements last longer, the ef-ficiency gains from trade are higher becausethese take some time for the economy to realize.Also, cooperative arrangements may help imposefiscal discipline by providing a nominal anchorthat is generally agreed upon.

8. In the context of the trilemma, compare andcontrast the dissolution of the gold standard dur-ing the 1920s and 1930s to the collapse of theBretton Woods system during the 1960s andearly 1970s. In what sense did the BrettonWoods system attempt to address the problemsassociated with the gold standard? To what ex-tent did the Bretton Woods system strengthen orweaken a country’s ability to maintain a fixedexchange rate?

Answer: The gold standard collapsed for a com-bination of reasons:

■ the efficiency gains from trade were di-minished as the results of war and poormacroeconomic policy

■ stability costs became more important topolicy makers politically

■ lack of cooperation between countries inthat they did not commit to maintainingthe gold peg

■ slow growth in the world gold supply ledto deflation

Symmetryof shocks

Market integration

Bolivia

Belize

Mexico

FIX


In comparison, the Bretton Wood’s collapsestemmed from:

■ market forces against capital controls (inaddition to being at odds with financialliberalization)

■ changes in U. S. domestic monetary pol-icy affecting world economic conditions

■ breakdown in cooperation and frequentdevaluations, leading to a loss of credibil-ity in the system

In the context of the trilemma, the gold standardeliminated monetary policy autonomy as an op-tion because it was premised on free convertibil-ity between gold and money, leaving speculatorsfree to arbitrage. The Bretton Woods system ad-dressed this through capital controls, leavingcountries free to pursue domestic monetary pol-icy. In addition, the Bretton Woods systempegged currencies to the U.S. dollar, rather thangold, so that the base currency could be adjustedas world economic conditions changed. In thissense, the Bretton Woods system could be suc-cessful as it offered some flexibility through co-operation. The breakdown of the systemstemmed from the U.S. expansion of its moneysupply in the 1960s (exporting its high inflationrates worldwide) and the de facto deteriorationof capital controls.

9. The International Monetary Fund (IMF) is oftenviewed as an international lender of last resort.When countries seek out loans from the IMF toalleviate banking and economic crises, the IMFoften requires countries to maintain a fixed ex-change rate. Why do you suspect the IMF pres-sures countries with large levels of foreign-denominated debt to maintain fixed exchangerates? Do you believe this is a good policy? Dis-cuss possible alternatives.

Answer: The IMF might require a fixed ex-change rate regime as a condition of lending todissuade countries from defaulting on their ex-ternal debt denominated in a foreign currency,such as the country’s loans from the IMF. As wehave seen in this chapter, there is considerabledebate about whether fixed exchange rates arebeneficial. However, it is clear that a fixed ex-change rate regime does reduce the probabilityof default. An alternative would be to lend in thecountry’s local currency. Even if this requireshigher interest rates, it would help to develop lo-cal capital markets through increased liquidity.