Congress plays a role in promoting a stable and prosperous world economy. But this evidence does not prove that economic theory is wrong. If a government wishes to alter a floating exchange rate or maintain a fixed exchange rate, it may do so by altering monetary policy but only if it is willing to abandon other macroeconomic goals such as providing stable economic growth, preventing recessions, and maintaining a moderate, stable inflation rate. In a floating exchange rate regime, the exchange rate is a price freely determined in the market by supply and demand. How valuable the macroeconomic adjustment mechanism that floating exchange rates provide depends on the economic independence of the country. "Hard pegs," currency boards and currency unions, are considered first because they are the most stark example of a fixed exchange rate arrangement. This can be done through a currency board or a currency union. A currency board is a monetary arrangement where a country keeps its own currency, but the central bank cedes all of its power to alter interest rates, and monetary policy is tied to the policy of a foreign country. Argentina had a similar arrangement which it abandoned in 2002, during its economic crisis. Greater trade is widely seen to be an engine of growth, particularly among developing countries. For developing countries, these investment gains can be quite large. On the other hand, international capital flows can change rapidly in ways that can be destabilizing to developing countries, as will be discussed below. Whenever a country's inflation rate gets extremely high, it is a reflection of its fiscal policy. Fixed Exchange Rates

In a traditional fixed exchange rate regime, the government has agreed to buy or sell any amount of currency at a predetermined rate. As a result, countries with fixed exchange rates have limited freedom to use monetary and fiscal policy to pursue domestic goals without causing their exchange rate to become unsustainable. Economic Advantages of a Fixed Exchange Rate

As with a hard peg, a fixed exchange rate has the advantage of promoting international trade and investment by eliminating exchange rate risk. As with a hard peg, the drawback of a fixed exchange rate compared to floating exchange rates is that the government has less scope to use monetary and fiscal policy to promote domestic economic stability. The scope for the pursuit of domestic goals is greater for countries that fix their exchange rate to a basket of currencies—unlike a hard peg, the country is no longer placed at the mercy of the unique and idiosyncratic policies and shocks of any one foreign country. Political Advantages of a Fixed Exchange Rate

In previous decades, it was believed that developing countries with a profligate past could bolster a new commitment to macroeconomic credibility through the use of a fixed exchange rate for two reasons. In this view, while "soft pegs" may have been successful in the past, any attempt by a country open to international capital to maintain a soft peg today is likely to end in an exchange rate crisis, as happened to Mexico, the countries of Southeast Asia, Brazil, and Turkey. The previous discussion summarizes the textbook advantages and disadvantages of different exchange rate regimes. And that is the key reason why floating exchange rates are not prone to financial and economic crises. In making this argument, currency board proponents are only focusing on the political advantage to a currency board—it makes profligate fiscal and monetary policy impossible. How Interdependent Are International Economies? But a closer look at Canada suggests that a successful floating exchange rate may not be incompatible even with a country as closely interdependent with its neighbor as Canada is with the United States.
Congress is generally interested in promoting a stable and prosperous world economy. Stable currency exchange rate regimes are a key component to stable economic growth. This report explains the difference between fixed exchange rates, floating exchange rates, and currency boards/unions, and outlines the advantages and disadvantages of each. Floating exchange rate regimes are market determined; values fluctuate with market conditions. In fixed exchange rate regimes, the central bank is dedicated to using monetary policy to maintain the exchange rate at a predetermined price. In theory, under such an arrangement, a central bank would be unable to use monetary policy to promote any other goal; in practice, there is limited leeway to pursue other goals without disrupting the exchange rate. Currency boards and currency unions, or "hard pegs," are extreme examples of a fixed exchange rate regime where the central bank is truly stripped of all its capabilities other than converting any amount of domestic currency to a foreign currency at a predetermined price.
The main economic advantages of floating exchange rates are that they leave the monetary and fiscal authorities free to pursue internal goals—such as full employment, stable growth, and price stability—and exchange rate adjustment often works as an automatic stabilizer to promote those goals. The main economic advantage of fixed exchange rates is that they promote international trade and investment, which can be an important source of growth in the long run, particularly for developing countries. The merits of floating compared to fixed exchange rates for any given country depends on how interdependent that country is with its neighbors. If a country's economy is highly reliant on its neighbors for trade and investment and experiences economic shocks similar to its neighbors', there is little benefit to monetary and fiscal independence, and the country is better off with a fixed exchange rate. If a country experiences unique economic shocks and is economically independent of its neighbors, a floating exchange rate can be a valuable way to promote macroeconomic stability. A political advantage of a currency board or currency union in a country with a profligate past is that it "ties the hands" of the monetary and fiscal authorities, making it harder to finance budget deficits by printing money.
Recent experience with economic crisis in Mexico, East Asia, Russia, Brazil, and Turkey suggests that fixed exchange rates can be prone to currency crises that can spill over into wider economic crises. This is a factor not considered in the earlier exchange rate literature, in part because international capital mobility plays a greater role today than it did in the past. These experiences suggest that unless a country has substantial economic interdependence with a neighbor to which it can fix its exchange rate, floating exchange rates may be a better way to promote macroeconomic stability, provided the country is willing to use its monetary and fiscal policy in a disciplined fashion. The collapse of Argentina's currency board in 2002 suggests that such arrangements do not get around the problems with fixed exchange rates, as their proponents claimed. This report does not track legislation and will be updated as events warrant.