David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 29 Exchange rate regimes
competitiveness can change because domestic prices can adjust relative to foreign prices. Second, by
curtailing the role of monetary policy, a monetary union raises the significance of fiscal policy for individual
member countries that wish to manage aggregate demand independently of the rest of the monetary union.
Third, monetary union is therefore easier when wage flexibility in member states is greater.
A_n_ a _di_us_ta _ bl_ e _p e _g
An adjustable peg is a fixed
exchange rate, the value of
which may occasionally be
changed.
In operation during 1945-73, the most famous example of an adjustable peg was
called the Bretton Woods system, after the small American town where US and
UK officials met in 1944 to agree its details. Because countries agreed to use dollars
as well as gold as foreign reserves, the system was also called the dollar standard.
Each country fixed its exchange rate against the dollar. The price of gold was fixed in dollars. Currencies
were convertible against dollars or gold, which together were foreign exchange reserves. At the fixed
exchange rate, central banks were committed to buy or sell domestic currency for foreign exchange
reserves. They intervened in the forex market to defend the exchange rate against the dollar.
Unlike the gold standard, the dollar standard did not require 100 per cent forex reserve backing for
domestic currency. Governments could print as much money as they wished. The designers of the Bretton
Woods system feared that the world gold supply could not increase quickly enough to keep up with the
rising demand for money that they hoped would accompany post-war prosperity.
Giving governments the discretion to print money solved that problem but created two others. First, it
inhibited the adjustment mechanism built into the gold standard, in which countries with a balance of
payments deficit lost gold and their domestic money supply fell, thereby bidding down their prices and
boosting their competitiveness. Under the dollar standard, countries with a payments deficit lost money,
but the government could print more money again. This prevented higher unemployment in the short run,
but also prevented long-run adjustment by stopping the fall in prices that raised competitiveness.
Such policies were not feasible for ever. If the balance of payments deficit persisted, the country ran out of
foreign exchange reserves. Then it had to devalue its exchange rate to raise competitiveness and remove the
underlying imbalance in international payments.
Speculators faced a one-way bet. When a country was in payment difficulties, either the exchange rate
would stay the same a bit longer or it would be devalued at once. Speculators might as well bet on
devaluation, since the exchange rate was unlikely to appreciate. Sometimes speculative pressure made
devaluation happen earlier because countries lost reserves not only from a current account deficit but also
because of a financial account outflow. Foreseeing this difficulty, the architects of the Bretton Woods system
decided to solve the problem of speculative capital flows by making private capital flows illegal.
Perfect capital mobility implies interest parity. Interest differentials must be offset by expected exchange
rate changes to equate expected returns in different currencies. Fixed exchange rates imply expected
exchange rate changes are zero. Hence, interest rates have to be equal. Countries cannot retain the
sovereignty to set interest rates.
Fixed exchange rates, perfect
capital mobility and monetary
sovereignty are the impossible
triad. All three cannot co-exist
at the same time.
In 1944 the architects of Bretton Woods decided that fixed exchange rates were
important, but that countries were not ready to surrender monetary sovereignty. Hence,
capital mobility had to be suspended. Capital flow controls were severe until 1960,
when controls on long-term capital flows were relaxed. After the adjustable peg
was abandoned in 1973, the need for capital controls diminished. Capital controls
were gradually dismantled and integration of global financial markets intensified.
The dollar standard had a second drawback. It led to a world of sustained inflation. Dollars had become
the world's medium of exchange. A US payments deficit could be financed by printing more dollars. In the
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