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Exchange Rate Regimes: Is the Bipolar View Correct?

This paper is a summary of the Distinguished Lecture on Economics in Government: Exchange Rate Regimes: Is the Bipolar View Correct? article published in The Journal of Economic Perspectives in 2001. The article by Stanley Fischer describes the problems of reforming the global financial system. Precisely speaking, he notes that all of the recent crises have occurred in countries with fixed or semi-fixed exchange rates among which there are Russia, Thailand, Korea, and Brazil.

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However, for several countries especially rigidly pegged their currencies to the dollar, a fixed rate is proved to be more reliable. The author explains the fact that in the 1990s, changes in developed countries and emerging economies took place at a faster rate, mainly the introduction of the euro and financial crises. It is noted that the group of countries with floating rates comprises countries with managing float.

In this work, Fischer asserts that the regime based on the soft peg exchange rate is non-viable when the authorities undertake to maintain a certain level of the course or the narrow limits of its market fluctuations that are appeared in countries open with respect to international capital transactions. Currency crises have shown that the country cannot simultaneously perform the following operations:

  • to maintain fixed exchange rates;
  • to sustain the mobility of capital;
  • to conduct monetary policy oriented to domestic demand.

In the scientific literature, this statement is called the “impossible trinity”. In this paper, Fischer claims that in countries open to international capital flows a soft peg exchange rate cannot be maintained. Nevertheless, the existence of a wide variety of modes based on flexible exchange rates is possible. Moreover, it is expected that the policy would not be indifferent to the movement of exchange rates in the majority of countries.

The target of setting the bipolar mode in the exchange rate is reflected in the recommendations of the oversight of the IMF member states to some extent, although the formal introduction of a foreign exchange regime is voluntary to states themselves. In view of this installation, the so-called “exit strategy” was developed by experts for the countries of intermediate exchange rate regimes that are characterized by more or less rigidly fixed exchange rates and the transition to more flexible regimes with the courses.

As for developing countries, in particular, small and poor ones, the IMF encourages the establishment in one form or another of a currency board system that means in practice the conversion of the national monetary system in the sequel or branch of the financial system of one of the main countries of the West. Fischer also approves the phenomenon of “dollarization” that keeps a significant share of assets in the form of instruments denominated in foreign currency (in particular, US dollars). Thus, according to the Executive Board “dollarization” is a byproduct of the globalization of financial markets to a certain extent.

Fischer concludes that there is a reason to believe that there are only two stable systems of exchange rates: a free-floating exchange rate and the use of another country’s currency (perhaps, through the introduction of a currency board). Pending the success of the European Economic and Monetary Union new currency units might arise. The author admits that nowadays people live in an uncomfortable and transient world where floating rates sometimes too volatile, at the same time, fixed rates are often too vulnerable to speculative attacks.

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Thus, Fisher argues that at the present level, financial market integration pegs cannot be sustained, except cases where a country firmly committed to the binding mode and is ready to reinforce its necessary policy measures and institutions.

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