Canonical debates on exchange rates

The adoption of the appropriate exchange rate  has been largely considered by the canonical theoretical literature about fixed and floating exchange rate regimes. While  the fixed exchange rate is pegged  by the Central Bank in relation to the currency of another currency,  in the floating exchange rate regime  a country’s exchange rate  evolution depends on the  market forces without intervention of the Central Bank.

In the monetarist model, the adoption of a flexible regime lets an open economy achieve full employment with price stability. While each country has to take care of its monetary policy, the demand and supply forces of the free markets fix the relative prices between currencies. In the long-run, in each country, the stock of money supply and the domestic price level favour full employment, price stability and balance of payment equilibrium. Accordingly this approach, in a flexible exchange rate regime, the monetary rule is given by the Central Bank and it conditions the evolution of the exchange rate. In other words, the exchange rate fluctuations make possible the achievement of the monetary rule. The defence of exchange rate flexibility, in the orthodox view, also focuses on the argument that exchange rate fluctuations equilibrate the gap between prices and costs among countries. Consequently, Central Banks rescue the autonomy of monetary policy. Nowadays, Central Banks usually adopt floating exchange rate regines, follow the adoption of monetary rules (centred on interest rules) and compels fiscal surplus to finance government commitments.

The critique of this approach  has been developed by Post Keynesians. Under the Keynesian analysis to open economies, the financial challenges for exchange rate stability and the loss of Central Banks’ autonomy  in policy making have been highlighted. Taking into account the challenges for sustainable fixed exchange rate regimes, the Keynesian approach explains that the Central Banks’ actions in the exchange rate market are limited by the degree of capital mobility since exchange rate crises may happen as the result of the abrupt reversal of global financial cycles. This is explained in a context of speculation and uncertainty where decisions to balance risks and yields are not submitted to stochastic behaviours, that is to say, they are not predictable. In addition, in the context of random behaviour of investors and capital mobility,. floating exchange rate regimes bring out higher risks to manage domestic interest rates – and therefore to implement those Central Banks’ discretionary policies aimed to influence  the levels of product, employment  and prices.

What the Post Keynesian approach adds to the students’ understanding about the deep current challenges in the global economy is that the evolution of the exchange rates actually highlights some key-problems, such as the diversity of the process of economic global integration, the arbitrage/speculation within financial  global markets and the challenges for Central Banks.

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1 comment
  1. Jamie said:

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