Exchange Rate Policies

A Merged Currency

A final approach to exchange rate policy is for a nation to choose a common currency shared with one or more nations is also called a merged currency. A merged currency approach eliminates foreign exchange risk altogether. Just as no one worries about exchange rate movements when buying and selling between New York and California, Europeans know that the value of the euro will be the same in Germany and France and other European nations that have adopted the euro.

However, a merged currency also poses problems. Like a hard peg, a merged currency means that a nation has given up altogether on domestic monetary policy, and instead has put its interest rate policies in other hands. When Ecuador uses the U.S. dollar as its currency, it has no voice in whether the Federal Reserve raises or lowers interest rates. The European Central Bank that determines monetary policy for the euro has representatives from all the euro nations. However, from the standpoint of, say, Portugal, there will be times when the decisions of the European Central Bank about monetary policy do not match the decisions that a Portuguese central bank would have made.

The lines between these four different exchange rate policies can blend into each other. For example, a soft peg exchange rate policy in which the government almost never acts to intervene in the exchange rate market will look a great deal like a floating exchange rate. Conversely, a soft peg policy in which the government intervenes often to keep the exchange rate near a specific level will look a lot like a hard peg. A decision to merge currencies with another country is, in effect, a decision to have a permanently fixed exchange rate with those countries, which is like a very hard exchange rate peg. Table summarizes the range of exchange rates policy choices, with their advantages and disadvantages.

Situation Floating Exchange Rates Soft Peg Hard Peg Merged Currency
Large short-run fluctuations in exchange rates? Often considerable in the short term Maybe less in the short run, but still large changes over time None, unless a change in the fixed rate None
Large long-term fluctuations in exchange rates? Can often happen Can often happen Cannot happen unless hard peg changes, in which case substantial volatility can occur Cannot happen
Power of central bank to conduct countercyclical monetary policy? Flexible exchange rates make monetary policy stronger Some power, although conflicts may arise between exchange rate policy and countercyclical policy Very little; central bank must keep exchange rate fixed None; nation does not have its own currency
Costs of holding foreign exchange reserves? Do not need to hold reserves Hold moderate reserves that rise and fall over time Hold large reserves No need to hold reserves
Risk of ending up with an exchange rate that causes a large trade imbalance and very high inflows or outflows of financial capital? Adjusts often Adjusts over the medium term, if not the short term May end up over time either far above or below the market level Cannot adjust
Tradeoffs of Exchange Rate Policies

Global macroeconomics would be easier if the whole world had one currency and one central bank. The exchange rates between different currencies complicate the picture. If financial markets solely set exchange rates, they fluctuate substantially as short-term portfolio investors try to anticipate tomorrow’s news. If the government attempts to intervene in exchange rate markets through soft pegs or hard pegs, it gives up at least some of the power to use monetary policy to focus on domestic inflations and recessions, and it risks causing even greater fluctuations in foreign exchange markets.

There is no consensus among economists about which exchange rate policies are best: floating, soft peg, hard peg, or merged currencies. The choice depends both on how well a nation’s central bank can implement a specific exchange rate policy and on how well a nation’s firms and banks can adapt to different exchange rate policies. A national economy that does a fairly good job at achieving the four main economic goals of growth, low inflation, low unemployment, and a sustainable balance of trade will probably do just fine most of the time with any exchange rate policy. Conversely, no exchange rate policy is likely to save an economy that consistently fails at achieving these goals. Alternatively, a merged currency applied across wide geographic and cultural areas carries with it its own set of problems, such as the ability for countries to conduct their own independent monetary policies.

Is a Stronger Dollar Good for the U.S. Economy?

The foreign exchange value of the dollar is a price and whether a higher price is good or bad depends on where you are standing: sellers benefit from higher prices and buyers are harmed. A stronger dollar is good for U.S. imports (and people working for U.S. importers) and U.S. investment abroad. It is also good for U.S. tourists going to other countries, since their dollar goes further. However, a stronger dollar is bad for U.S. exports (and people working in U.S. export industries); it is bad for foreign investment in the United States (leading, for example, to higher U.S. interest rates); and it is bad for foreign tourists (as well as U.S hotels, restaurants, and others in the tourist industry). In short, whether the U.S. dollar is good or bad is a more complex question than you may have thought. The economic answer is “it depends.”