Exchange rate systems Essay Example | Topics and Well Written Essays - 1250 words

Exchange rate systems - Essay Example The traditional debate on exchange rate systems focused on insulating properties of flexible exchange rates as in Friedman (1953) and Meade (1955). The subsequent literature showed that insulating properties depend on some structural characteristics1 (e.g., openness, capital mobility), as well as the types and the sources of shocks impinging on the domestic economy. The monetary theory of the balance of payments emphasized the differences in macroeconomic adjustment under fixed versus flexible exchange rates. One consequence of fixed exchange rates is that nations may not be able to pursue independent monetary policies. Specifically, an external imbalance has to be offset by a change in the net reserve position which can affect the domestic money supply. Commitment to a fixed rate also entails buying or selling domestic currency in exchange for foreign currencies at declared parities to satisfy autonomous changes in currency demands, which unless successfully sterilized, makes the mo ney supply endogenous.Another aspect of the exchange rate system is the different operating procedures of macroeconomic policies under alternative exchange rate systems. The Mundell-Fleming framework compares the effectiveness of monetary and fiscal policy under fixed and flexible exchange rate systems. The textbook version of the model (e.g., Mankiw, 1997, pp. 308-323; Blanchard, 1997, pp. 250-267) predicts that under high capital mobility, fixed exchange rates render fiscal policy powerful in altering aggregate demand while monetary policy is impotent.