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It can draw upon reserves of foreign currency or borrow foreign currency to meet the excess demand for foreign currency. However, that recourse is limited by the amount of foreign exchange reserves and borrowing capacity. It is never easy to know whether a deficit is transitory and will soon be reversed or is a precursor to further deficits. The temptation is always to hope for the best, and avoid any actions that would depress the domestic economy.

Such a policy can smooth over minor and temporary problems, but lets minor problems that are not transitory accumulate. When that happens the minor adjustments in exchange rates that would have cleared up the initial problem will no longer suffice. It now takes a major change. Moreover, the direction of that change is clear, offering close to a one-way bet to currency speculators, who perform the useful function of forcing the central bank to accept the inevitable sooner rather than later. A hard fixed rate is a very different thing.

Such a policy requires not having a central bank. A further movement in this direction, creating perhaps a number of currency blocs consisting of a major country and a number of much smaller countries with close economic ties to the major country, may well occur and be a good thing. The one really new development is the euro, a transnational central bank issuing a common currency for its members. There is no historical precedent for such an arrangement. Such a system has economic advantages and disadvantages, but I believe that its real Achilles heel will prove to be political; that a system under which the political and currency boundaries do not match is bound to prove unstable.

In any event, I do not believe the euro will be imitated until it has a chance to demonstrate its viability. Although there are real differences between our positions on alternative routes to monetary stability, I am also convinced that an important part of the differences reduce to linguistic problems. There is a whole spectrum of possibilities underneath this term:.

Saluran unggulan

Other examples include San Marino, which uses the Italian lira, Monaco, which uses the French franc, and Andorra, which uses both the French franc and the Spanish peseta. Argentina has had a partial currency board since Estonia from , Lithuania from , Bulgaria from and Bosnia and Herzegovina from are other examples. An interesting variant on the currency board system is provided by the example of the 13 CFA franc countries in West and Equatorial Africa that were formally French colonies.

They had currency board arrangements, the exchange rates on which, with respect to the French franc, were underwritten or guaranteed by the French treasury. They altered the system somewhat with a large devaluation in , but they are now fixed to the euro through the French franc. Recent examples of this kind of fixed exchange rate system include Austria and the Benelux countries which, over most of the s and s, kept their currencies credibly fixed against the DM. Before , under the Bretton Woods arrangements, the major countries, with the single exception of Canada, practiced this system.

currency boards issues and experiences 94 Manual

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, but not enough to undermine confidence in the parities. Some countries that have pegged rates engage in sterilization operations. The Bank of England, for example, automatically buys government bonds whenever it sells foreign exchange to prevent the latter transaction from reducing the reserves of the banking system, and, conversely, it sells government bonds when it buys foreign exchange.

As a consequence, Britain faced periodic balance-of-payments crises over most of the post-war period. Pegged rate systems always break down. Monetary authorities may, as a temporary expedient, find pegged rates useful as a tactical weapon over some phase of the business cycle, but it cannot and should not be elevated into a general system. Where do Friedman and I differ in this category? I believe that larger countries can have a hard fix without establishing a currency board system or monetary union, and I would say that the Bretton Woods arrangements proved that, as did the gold standard in the past, and as did the experience of Austria and the Netherlands in the exchange rate mechanism of the European Monetary System.

There are something like currencies in the world. A vast number of these smaller currencies have been floating and unstable. Most of the smaller countries that have economic links to the dollar or euro areas would be better off fixing their currencies in hard-fix fashion to one or the other areas.

What Is a Currency Crisis?

But there are several countries that could also benefit from the stability that fixed rates can provide without going to the full extent of dollarization or euroization or adopting a currency board. There are other routes to credibility than currency boards. We have been friends for more than three decades, during which I have benefited greatly from his writings and many discussions, as I am benefiting from this one.

Bob and I have no disagreement on the theory of international trade and finance, as evident by my complete agreement with his taxonomy of alternative exchange arrangements. We share and strongly support the view that policies about trade and finance should have as their objective the maximum possible free trade in goods and services and free movement of capital. We also agree that maintenance of a relatively stable price level of final goods and services will generally promote that objective. However, this item is not as simple as it may appear. Robert Mundell: The choice between fixed and flexible exchange rates is an oxymoron.

The alternatives are incomparable. A fixed exchange rate system is a monetary rule. A flexible exchange rate is the absence of that particular monetary rule and is consistent with price stability or anything at all, including hyperinflation. The real choice is between a fixed exchange rate monetary rule and alternative monetary rules such as inflation targeting or monetary targeting.

What is a currency crisis?

The choice between the three monetary rules depends on several factors, including the actual and desired rate of inflation. Assuming a country wants monetary stability, but is in a state of high inflation, it should adopt a monetary rule because the high inflation rate is almost certainly due to excess growth of the reserve base of the money supply usually fiscal deficits that have to be financed by the central banks.

At lower rates of inflation, say below per cent per annum , it is better to shift to inflation targeting, which, at lower inflation rates is better for fine tuning because it is less susceptible to variations in the money multiplier and income velocity, even though its implementation depends on forecasts of inflation to take account of monetary lags. At rates of inflation below, say, five per cent, a fixed exchange rate can be the best monetary rule but not, of course, for all countries. When the balance is in surplus, the money supply expands and that increases expenditure on goods and securities and that corrects its surplus.

Unraveling the Central Banks' Misbehavior (w/ Jim Grant & Bill Fleckenstein)

When the balance of payments is in deficit, the money supply contracts and that decreases expenditure on goods and serves and corrects its deficit. This is how Austria and the Benelux countries maintained their equilibrium in the DM zone in the s and s, and it is how monetary policy works in the euro zone.

A fixed exchange rate monetary rule is not appropriate for all countries at the present time. Big countries cannot fix to little countries. But a fixed exchange rate with the dollar is a viable alternative for countries like Canada or Mexico and other Latin American countries, and a fixed exchange rate with the euro is a viable alternative for several countries in Central and Eastern Europe and Africa.


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A currency board system is a special case of a viable fixed exchange rate system. Under a pure currency board system a country fixes its currency to a foreign currency, and purchases and sales of the foreign currency are automatically reflected in changes of the monetary base.

IMF Policy Discussion Papers

The choice of system therefore depends on the current rate of inflation, the position of a country is it near a large and stable neighbour? To what would it fix? Smaller countries have an option. If California were a separate country, it would elbow Canada out of the G Countries with a unified currency system trade a great deal more with one another and are able to exploit the gains from trade and therefore have a higher standard of living.


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If Canada had the same currency as the United States and a genuine free trade area, Canadians would have as high or higher a standard of living as the average American. Two countries can have a common currency or maintain fixed exchange rates, however, only if they are willing to accept a common rate of inflation. If inflation preferences differ, they should have separate currencies and flexible exchange rates. Other things equal—including inflation rates—large currency areas are more stable and more resistant to shocks than small currency areas.

In a monetary union or fixed exchange rate arrangement between a large and a small country, most of the gain goes to the small country. Also, Canadians would have a stable purchasing power over a continental basket of goods and securities instead of the much smaller local Canadian basket. Another consideration for fixing is the quality of monetary policy. The United States has had some ups and downs in the quality of its monetary policy, but by and large it has been superior to that of its North American neighbors.

This greater stability is reflected in the exchange rates.

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After Mexico abandoned its fixed exchange rate system in , it lost its monetary stability, and suffered from debt and currency crises, from which it has not even to this day recovered. Canada had a dismal experience with floating exchange rates in the s and far from insulating itself from the US business cycle it duplicated it with recessions in and and stagnation after that. But the late s saw too much inflation and the late s too much deflation, and the end result was that the Canadian dollar is now hardly two-thirds of a US dollar. Over the long run the United States has had a more stable monetary policy than Canada.

I have no important objections to the factors Friedman includes on his list. The more closely countries are integrated, the more adjustment will be facilitated.

But the overriding criterion of a workable currency area is that member countries agree on the target rate of inflation and are willing to accept the arrangements for fixing exchange rates and deciding upon the monetary policy that will bring the common target rate of inflation about.

Milton Friedman: Where Bob and I sometimes disagree is about the best way to achieve the objective that we jointly seek. Such disagreement reflects divergent judgements about a the empirical importance of shocks affecting different entities differentially; b the efficiency of present mechanisms other than exchange rate changes for adjusting to those shocks; c perhaps the importance of such mechanisms; and d the political consequences of a monetary area that is not coterminous with a political entity.

But the late s saw too much inflation and the late s too much deflation, and the end result was that the Canadian dollar is now hardly twothirds of a US dollar. Over the 30 years from to , Canadian inflation has averaged about 0. That accounts for somewhat more than half of the decline in the Canadian dollar relative to the US dollar in the past 30 years. The important point for present purposes is the remaining nearly half of the decline in the Canadian dollar.

That reflected different forces affecting the Canadian than the US economy. If the Canadian dollar had been rigidly tied to the US dollar, those differences would have required Canada to deflate relative to the United States, with unfortunate consequences for Canada that would have strained, to put it mildly, the trade relations between the two countries, and have put strong pressure on Canada to devalue or float. In my opinion, Canada was better served by a flexible rate in those 30 years than it would have been by a fixed rate. But the situation is much worse for Canada, because, in the later s, when the United States was moving into an inflationary period of three years of back-to-back two-digit inflation , Canada was allowing its dollar to depreciate, and then, after the US had got, with Reaganomics, its inflation rate down to four per cent, the Bank of Canada announced, in early , a policy of zero inflation, and this policy was accepted, or at least condoned by the Canadian government.

But the Bank of Canada had no idea of what a zeroinflation equilibrium in Canada would mean at a time when the US had four per cent inflation, or if it did, its spokesmen never let the market or the government know their ideas. Assuming equal growth rates in Canada and the US, an inflation differential of four per cent would mean that Canadian wage rates would have to rise by four percentage points less than US wages. The Canadian dollar then soared from about US73 cents to over US91 cents in , only to begin its long descent in the s to a low point so far of US62 cents.