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The Great Dilemma: To Fix or to Float

1990-1991 Student Essay Contest Winner

June 1, 1991


Rebecca Ralston

The Great Dilemma: To Fix or to Float

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 bond respectively.

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

Rebecca Ralston
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 policy accordingly.

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.