1990-1991 Student Essay Contest
Last September Ninth District high school juniors and seniors were
invited to participate in the Minneapolis Fed's third annual essay contest. When the March deadline arrived, 248 entries had been
received from five of the six Ninth District states.
The question posed to the district's budding economists was: How
successful has the floating exchange rate system been compared to
the fixed exchange rate system? And, what modifications would you
recommend, if any?
Students were required to address the pros and cons of each system
in just five double-spaced typed pages and, according to the contest
judges, acquitted themselves well in wrestling with a complex topic.
The contest culminated in a one-day workshop and awards program in
Minneapolis for 30 finalists who received a $75 U.S. savings bond.
First and second place winners received an additional $200 and $100
Rebecca Ralston, Grand Rapids Senior High School, Grand
Rapids, Minn., wrote the winning essay. Second
place went to Theresa Flowers, Forest Lake Senior High School,
Forest Lake, Minn.
The Great Dilemma: To Fix or to Float
Grand Rapids Senior High School
Grand Rapids, Minnesota
As the nations of the world have progressed in their interdependence,
there has evolved a heated controversy regarding the most efficient
exchange rate system. Two basic policies—fixed rates and floating
rates—have been employed. Unfortunately, neither has produced the
precise results intended by even their strongest supporters. In our
ever-growing quest for the perfect system, we have been disappointed
time and time again. Thus, in choosing the best method of exchange rate
management, we are forced to choose between the lesser of two evils.
Ultimately, we must develop a compromise between the two in order to
maximize the effectiveness of international exchange rates.
The main focus on the business of exchange rates began with the
meeting at Bretton Woods, N.H., in 1944. This gathering of representatives
from most major countries was an attempt to create an agreement
that would ensure stability by using a gold standard of exchange.
Despite the good intentions of the Bretton Woods system, it failed
in nearly all of its primary objectives.
Bretton Woods was not able to succeed in its three main areas
of intended reform. Initially, the so-called adjustable peg system
was unable to accommodate short-term fluctuations in currency. Because
of the dependence on the supply of gold, immediate changes in currency
value were virtually impossible. In addition, this system could
not make significant adjustments to the secular demand for foreign
exchange, creating a long-term disequilibrium.
Finally, speculation over the direction and extent of currency
adjustments was rampant. Speculators could often make fairly certain
guesses as to the upcoming changes in exchange rates. This proved
to be the most detrimental aspect to the Bretton Woods system, as
speculation increased the instability of rates and skewed the effectiveness
of the adjustment function. Rates needed to be continually appreciated
or devalued, and the fixed exchange rate system was finally abandoned
at the end of 1973.
The subsequent decision to allow exchange rates to float resulted
in no great success story either. Advocates maintained economic
stability through the correction of trade balances as a primary
target of the new policy. Economic stability was thought to be attainable
by correcting trade imbalances. Once currency values were allowed
to settle into their "natural" levels, it was believed, the flow
of imports and exports would also assume an equilibrium.
According to the net exports of major countries since 1974, however,
this assumption has proven to be false. Both the United States and
Great Britain have experienced absolute levels of trade imbalance
that are even larger than when Bretton Woods was in effect. Germany
underwent severe fluctuations in trade balances between 1961 and
1981, and from that point ran a persistent trade surplus. Rates
of volatility have also increased significantly compared to real
currency values under Bretton Woods. Thus, floating rates have been
unable to correct trade imbalances and economic instability.
Pure floating exchange rates can no longer be depended upon to
provide an effective solution to the problems of international trade.
Exchange rates have fluctuated much more drastically than anyone
had originally expected. Currencies have appreciated in nations
with large trade deficits and high inflation. According to the Economist of Dec. 1, 1990, from 1980 to 1985 the dollar rose by 30 percent
against the yen and by 76 percent against the Deutsche mark. This
occurred in spite of the extremely high inflation rates of the dollar
compared to those in Japan or Germany. Such action has seriously
hampered America's competitiveness and resulted in fueling a huge
deficit in our current account.
The nations of the world need to adopt a more suitable system
if they are to experience both domestic and foreign stability. The
cost burdens of exchange rate uncertainty have reached significant
proportions. It has been estimated that the cost of hedging was
anywhere from $6.5 billion to $39 billion in 1989 for the United
States and its trading partners. This does not even take into consideration
the businesses that chose not to trade internationally because of
the high risks. There simply exist too many harmful effects which
prevent a smooth international trade policy.
Floating and fixed rate systems both have advantages which are
critical and disadvantages which are equally as crippling. History
has shown us the damage that each has produced. We must now take
stock of the comparative advantages of this system, and select a
Fixed rates offer the equivalent merit of a single world currency.
This serves to facilitate competition between producers in different
countries, encouraging a more integrated world economy. A system
which provides confidence in exchange rates would be enormously
beneficial in decreasing protectionism. Former Federal Reserve Chairman
Paul Volcker feels that fluctuations in exchange rates have been
responsible for such sentiments. He states, "It seems to me beyond
doubt that protectionist pressures in the United States, and probably
elsewhere, have been fed by the well founded impression that exchange
rates have deviated widely from their equilibrium levels."
Yet a system of pure floating exchange rates allows domestic control
over monetary policy. A case in point is the United States, which
has experienced, in the past few years, the lowest levels of inflation
in the past two decades. Economist Milton Friedman advocates floating
because it provides the opportunity for governments to devote monetary
policy to the regulation of inflation, something he feels is its
proper purpose. To be without this power particularly in the current
economic status of the United States, is indeed a frightening thought.
A viable alternative to both fixed and floating rates is the adoption
of a plan accommodating the prime advantages of each, suggested
by John Williamson of the Institute for International Economics.
Governments would set targets for real exchange rates. These rates
would be used on the market and would be subject to the influence
of changes in inflation rates. A band of perhaps 5 percent would
surround the target rates, allowing them to shift slightly, without
permitting drastic fluctuations.
This type of system would supply greater control of domestic policy
than pure fixed rates. Severe impacts from speculation could be
avoided by permitting the band to be breached under particular conditions.
Nations would have more freedom to utilize monetary control, as
there is elasticity in the range of target rates. The problems of
exchange rate uncertainty would be eliminated, and international
trade could be conducted on a much more stable basis. This proposal
would require full cooperation from all governments, however, as
the determination of target rates requires the input of all affected.
As the world continues to advance in its interdependence, it will demand
the most efficient policy of exchanging currency possible. By setting
target rates and allowing them to float within a set band, the global
nations will have the capability to trade and govern domestically in a
productive and stable manner. When this occurs, the international confusion
we are now involved in will finally be able to slowly untangle itself.