Exchange Rate Systems

Choosing an exchange rate system is unquestionably among a country’s more important policy decisions. The choice of exchange rate system has direct effects on exchange rates, interest rates, and inflation. But the choice is also often difficult, as each currency option has distinct costs and benefits which can be difficult to weigh. An excellent conceptual framework for understanding competing options for an exchange rate system is provided by the Mundell-Fleming model, which states that the three generally desirable qualities of capital mobility, fixed exchange rates, and an independent monetary policy can never all be had simultaneously.

The general prevalence of the first of these conditions, capital mobility, has changed greatly over the past two centuries. Before the mid- to late nineteenth century, capital mobility was low, as large international financial markets had not yet developed. In the late nineteenth and early twentieth centuries, international finance and the global economy caused significant capital mobility for the first time.

First, it is helpful to consider in the abstract what makes each Mundell-Fleming condition desirable and the effect of incorporating it into an exchange rate system. Capital mobility is favored obviously by financiers and anyone involved in capital transfers, but also by governments who want to run large deficits. 

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    Raj

    Exchange Rate Systems 1 year ago