Monetary Policy 101: Exchange Rates

Over the next month I will examine monetary policy in my weekly pieces. To start, I am recycling this piece I wrote last July. Eternal thanks to economist Steve Hanke of Johns Hopkins University who’s taken the time to educate me on these matters.

Money Supply and monetary policy are set by the Federal Reserve. While the Fed has the dual mandate of keeping unemployment and inflation low, the effects of those decisions reach beyond our borders as dollars are created. Expansion of money supply threatens the dollar’s value. Let’s look at the three ways countries manage their currencies.

They do it with floating, fixed, or pegged exchange rate regimes.

These regimes are rules for how to determine money supply. It is important to understand that the type of money regime we have is our choice but once we have made that choice we are stuck with the benefits and risks of that regime.

First, let’s look at floating. That’s what we have here in the U.S. Under a floating regime, the central bank (the Federal Reserve in the U.S.) sets monetary policy (size of the money supply and short-term interest rates) but has zero say over exchange rates. The dollar floats freely. The Fed is free to increase or decrease the money supply to (presumably) satisfy its dual mandate of low inflation and low unemployment paying less attention to the dollar value.

Second, let’s look at fixed exchange rates. Under a fixed regime, a currency board which has no power over money supply sets the exchange rates and monetary supply movement is determined by the the balance of payments. This resembles the old gold standard where gold is replaced by foreign currencies. You increase your money supply when your foreign reserves increase and you decrease it when your foreign reserves decrease. There is also a type of fixed regime in which the currency is “dollarized” using a foreign currency as its own. This occurs in some Central American counties which use the U.S. dollar. Countries currently dollarized are Panama, Ecuador and Peru.

Both floating and fixed regimes have no conflict between monetary policy and exchange-rate policy. Market forces act so as to balance the flows of money and avert balance of payments crises.

Third, let’s look at pegged exchange rates. This regime is problematic because, unlike fixed and floating, it has no inherent equilibrium system. After all, this regime is called “pegged.” One problem is that economists are not precise in their use of the term “pegged” often using “pegged” and “fixed” as interchangeable. Hanke points out that the essential difference is that with a pegged rate system economic policy seeks to serve two goals – exchange rate and monetary policy and that such a system is doomed. Pegged rate systems create conflicts between money supply and exchange rates because the monetary base is composed of both foreign and domestic components.

The discussion about what is in the best interests of the U.S. to “convince” China to do with its exchange rate misses the point.

China should switch from its mega-awkward pegged system to a fixed system where it sets exchange rates and allows its monetary base to be determined solely by the foreign currencies deposited in its central bank. As longs as China maintains a pegged system the Chinese economy is at risk. Lacking the corrective equilibrium forces inherent in fixed and floating regimes a pegged regime will have its currency attacked by speculators who spot the inconsistencies between money policy and exchange rate.

When that happened in Thailand consequent to the Asian Currency Crisis of 1997, the Suharto government which had been more than a bit repressive since it started in 1966 collapsed.

In the words of that noted economist Cyndi Lauper – money changes everything.