Is there an Optimal Exchange Rate Regime?

Starting from the gold standard regime of fixed rates, passing through the adjustable peg system after the Second World War, it has finally ended up with a system of managed floats after 1973. Since 1985, the pendulum has started swinging, though very slowly and erratically, in the direction of introducing some amount of fixity and rule based management of exchange rates.

Despite these empirical facts, there is a school of thought within the professional which argues that in the years to come there will be only two types of exchange rate regimes: truly fixed rate arrangements like currency unions or currency boards, or truly market determined, independently floating exchange rates. The “middle ground” – regimes such as adjustable pegs, crawling pegs, crawling bands and managed floating – will pass into history. Some analysts even predict that three currency blocks – the US dollar block, the Euro block and the Yen block – will emerge with currency union within each and free floating between them. The argument for the impossibility of the middle ground refers to the “impossibility trinity” i.e., it asserts that a country can achieve any two of the following three policy goals but not all three:

1. A stable exchange rate

2. A financial system integrated with the global financial system i.e., an open capital account; and

3. Freedom to conduct an independent monetary policy

Of these, (1) and (2) can be achieved with a currency union board, (2) and (3) with an independently floating exchange rate and (1) and (3) with capital control.

As of now, there is no consensus either among academic economists or among policy makers or among businessmen and bankers as to the ideal exchange rate regime. The debate is extremely complicated and made more so by the fact that it is very difficult if not impossible to sort out the effects of exchange rate fluctuations on the world economy from those of other shocks, real and monetary (oil price gyrations, Mid East wars, political developments in East Europe, disagreements over trade liberalisation, developing country debt crisis etc.).

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