Floating Exchange Rates

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It Has A Bibliography. Very extensive research -

Floating Exchange Rates: The Only Viable Solution

Stentor Smith

For some, the collapse of Mexico's economy proves that floating exchange rates and markets

without capital controls are deadly. Others find the crash of the European exchange-rate mechanism

(ERM) in 1993 to be proof that targeted rates will always be overturned by the free market. Many

see the breakup of Bretton Woods as the failure of fixed rates. Yet others believe monetary

unification in Europe is the only way to achieve economic and political stability. Many others hold still

different beliefs. There are, however, four main proposals for the management of international

currency exchange rates: monetary unification, fixed rates, floating rates maintained within certain

'reasonable' limits of variability and freely floating rates. Both fixed exchange rates and rates based

on either explicit or unwritten targeting are impossible to maintain, especially in an era of free trade.

Complete monetary unification would be impossible to bring about without extensive integration and

unification of international governments and economies, a task so vast that it is unlikely ever to be

accomplished. Thus, the only option central banks have is to allow exchange rates to float freely.

The European Monetary System, which virtually collapsed in 1993, was an attempt to fix exchange

rates within certain tight bands, to coordinate monetary policy between member nations and to have

central banks intervene to keep exchange rates within the bands when necessary. The reasons for the

collapse were myriad, but, simply put, it happened because Germany, dealing with financial problems

in part arising from its reunification, refused to lower its high interest rates. This meant other European

countries either had to keep their rates equally high and allow themselves to fall into recession as a

result, or devalue their currency against the mark, a move viewed by many as a political

embarrassment. The possibility of a devaluation caused speculators to bolt from the lira, the pound,

the franc and other currencies, sending the markets into chaos and destroying all semblance of

stability. In the end, the ERM was adjusted to allow currencies to fluctuate within 15 percent on

either side of their assigned level, up from (in most cases) a limitation of 2.25 percent. The bands

became too wide to be meaningful or stabilizing, and the system remained alive 'in name only'

(Whitney 19).

Many saw this collapse as inevitable and say all attempts at government-imposed stability will fail:

Governments both will not and cannot stick to pegged or fixed rates. First, maintaining targeted or

fixed rates requires a consistent and fairly uniform monetary policy among nations. There are many

reasons that national governments will not consent to this, the foremost being that different countries

want different things, different economies have different needs and different governments have

different policies. For example, it is thought that Europe and Japan are more willing to tolerate

recession than inflation, while the United States prefers to keep interest rates low and the economy

growing, even if prices do increase (Whitt 11). In addition, many nations are in different stages of

their overall economic cycles ('Gold Standard' 79). Many countries thus cannot afford to subscribe

to uniform monetary policy. For a country that would otherwise have had low interest rates, for

example, raising them could be both economically counterproductive (what good is exchange rate

stability if recession is its cost?) and politically disastrous (more people notice high interest rates and

unemployment than care about currency stability). Even if the government were willing to bow to

international standards, nationalism is strong in the world today and most...
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