Friedman: "Discussion of this issue requires replacing the dichotomy fixed or flexible by a trichotomy:1. hard fixed (e.g., members of Euro, Panama, Argentine currency board);2. pegged by a national central bank (e.g., Bretton Woods, China currently);3. flexible (e.g., US, Canada, Britain, Japan, Euro currency union)."By now, there is widespread agreement that a global move to pegged rate regimes [Friedman's type 2] would be a bad idea. Every currency crisis has been connected with pegged rates. That was true most recently for the Mexican  and East Asian [1997-98] crisis, before that for the 1992 and 1993 [European] common market crises. By contrast, no country with a flexible rate has ever experienced a foreign exchange crisis, though there may well be an internal crisis as in Japan."The reasons why a pegged exchange rate is a ticking bomb are well known. A central bank controlling a currency that comes under downward pressure does not have to alter domestic monetary policy...A hard fixed rate [Friedman's type 1] is a very different thing."Mundell: "...I am also convinced that an important part of the differences reduce to linguistic problems. I can illustrate this by the use of the term 'fixed' exchange rates. I use the term 'fixed exchange rates' to mean a process in which the central bank fixes the price of foreign exchange (or gold, but that is not relevant in the current context) and lets the money supply move in a direction that keeps the balance of payments in equilibrium [adjusts supply to match demand at the fixed-value parity]..." A currency board system. Under this arrangement, a country has its own currency, but it is completely backed by a foreign currency to which it is rigidly fixed. The money supply moves in exactly the same way as if the country used the foreign currency to which it is fixed. This fits Friedman's category of 'hard fixed'." Fixed rates. A looser form of fixed exchange rate system in which the monetary authority exercises some discretion with respect to the use of domestic monetary operations but nevertheless allows the adjustment mechanism to work [the outcome is similar to that of a currency board, although a wider range of operational tools are used]. A deficit in the balance of payments [excess base money supply compared to demand, and tendency for the currency to fall below its parity value] requires sales of foreign exchange reserves to keep the currency from depreciating, and this sale automatically reduces the money base of the financial system...An analogous process occurs in the opposite direction to eliminate a surplus."Recent examples of this kind of fixed exchange rate system include Austria and the Benelux countries which, over most of the 1980s and 1990s, kept their currencies credibly fixed against the [Deutschemark]. Before 1971, under the Bretton Woods arrangements, the major countries, with the single exception of Canada, practiced this system. Germany, Japan, Italy and Mexico, for example, were able to keep fixed exchange rates in equilibrium for most of the period between 1950 and 1970. The gold standard system that prevailed before the First World War was precisely such a system with a considerable amount of discretion on the part of central banks [in terms of operating mechanisms] ..." Pegged exchange rates. The distinction between fixed and pegged rates that I find useful refers to the adjustment mechanism. Under a fixed rate system, the adjustment mechanism is allowed to work [supply is adjusted to match demand] and is perceived by the market to be allowed to work. Whereas under "pegged" rates or "adjustable peg" arrangements, the central bank pegs the exchange rate but does not give any priority to maintaining equilibrium in the balance of payments [does not adjust the base money supply automatically as a currency board would, but has a discretionary 'domestic monetary policy']. There is no real commitment of policy to maintaining the parity and it makes the currency a sitting duck for speculators."
Save your cookie preferences
Please select an option below and 'Save' your preferences.
You can update your cookie preferences at any time from the 'Cookies' link in the footer.
Gold Price News
Gold Investing In Depth
Gold Investment Analysis
Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.
See the full archive of Nathan Lewis articles.
Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News, RSS links are shown there.