September 19, 2011
WASHINGTON—Monetary policymakers around the world have increased the instability of employment and inflation by responding too much to pressures on their exchange rates, according to Flexible Exchange Rates for a Stable World Economy, a new book by Senior Fellow Joseph E. Gagnon. The book combines the latest economic theory with a comprehensive examination of historical experience and shows that, when monetary policy focuses directly on stabilizing employment and inflation, even very large appreciations or depreciations of the currency do not cause economic harm.
This message is especially important at a time when the US economy continues to stagnate and the dollar is at a record low. Gagnon notes, for example, that the Federal Reserve’s action last fall to boost US growth sparked anger around the world as countries feared that it would weaken the dollar against their currencies. He suggests that these concerns are not warranted and that foreign policymakers have the tools to maintain healthy growth even if their currencies rise against the dollar. Moreover, any depreciation of the dollar would have been a side effect of the Fed’s action, which was limited to purchases in the US bond market. According to Gagnon, "US monetary policy should focus on getting Americans back to work."
The book documents that exchange rates are not closely linked to interest rates and inflation rates as is implied by standard economic models. Instead, movements in exchange rates are dominated by forces that economists do not understand well but that appear to be related to changing perceptions of, or tolerance for, risk. One way to reduce this risk and to stabilize exchange rates is to direct the central bank to use monetary policy to peg the exchange rate at a fixed value relative to the currency of a major trading partner. The book’s principal finding is that restricting monetary policy to defending a fixed exchange rate in this way leads to greater volatility of employment, output, and inflation so that this "cure" for exchange rate volatility is worse than the disease. In particular, the book shows that—contrary to a commonly held view—currency movements are not closely linked with movements in inflation and thus central banks have less to fear from them.
A policy that has become increasingly prevalent among developing economies in the past ten years is to stabilize exchange rates at an undervalued level in order to boost growth through increasing net exports. This policy is pursued through massive purchases of foreign exchange, which are sterilized so that central banks can still set interest rates to stabilize employment and inflation. China is the leading example. At a time when the major advanced economies are struggling to recover from the Great Recession, the reductions in net exports engendered by these currency interventions are a serious drag on their economic growth. The book notes that this strategy is creating a growing fiscal burden in the developing countries and recommends new international rules to limit its usage.
Flexible Exchange Rates for a Stable World Economy concludes that flexible exchange rates are best for most countries. For countries that desire close economic and political integration with their neighbors, a currency union may be appropriate, but—as is evident in Europe at present—implementing the policies needed to support currency union can also be difficult. For countries that lack the institutional ability to manage sound independent monetary policy, a fixed exchange rate may be the best feasible regime but even some very small and poor economies have had good outcomes with flexible exchange rates over the past ten years.
Flexible Exchange Rates for a Stable World Economy
Joseph E. Gagnon with Marc Hinterschweiger
ISBN paper 978-0-88132-627-7
September 2011 | 300 pp. | $26.95
About the Peterson Institute
The Peter G. Peterson Institute for International Economics is a private, nonprofit, nonpartisan research institution devoted to the study of international economic policy. Since 1981 the Institute has provided timely and objective analysis of, and concrete solutions to, a wide range of international economic problems. It is one of the very few economics think tanks that are widely regarded as "nonpartisan" by the press and "neutral" by the US Congress, its research staff is cited by the quality media more than that of any other such institution. Support is provided by a wide range of charitable foundations, private corporations and individual donors, and from earnings on the Institute’s publications and capital fund. It moved into its award-winning new building in 2001, and celebrated its 25th anniversary in 2006 and adopted its new name at that time, having previously been the Institute for International Economics.