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Appendix II: Fixed vs Flexible Exchange Rates

There have been discussions about the optimal exchange rate regime for a very long time, 

reflecting the evolution of the world economy and the conduct of monetary policy. The gold 

standard, as well as systems tied to other commodities, provided a monetary anchor, as well as a 

standard for financing international transactions, for many different countries over the centuries. 

Histories of gold standards recount many periods of financial turmoil and very sharp variations 

in output and prices. 

The Bretton Woods system was established, with the U.S. dollar as the centerpiece, as a system 

of fixed, but variable, exchange rates.1 When this system came under stress in the 1960s, older 

debates of the relative merits of fixed versus flexible exchange rates developed new life and the 

original Bretton Woods system was replaced by a system of floating exchange rates among the 

major currencies. The question of the appropriate exchange rate regime for other currencies 

remained open to debate. In the early 1990s, influential economic arguments supported fixed 

exchange rate regimes as an anchor to break hyper- and high inflation in many emerging 

markets. The emerging market financial crises later in that decade, however, prompted a 

reassessment of these arguments and an emphasis on the virtues of flexible exchange rate 

regimes for large emerging markets, increasingly integrated into the global financial system. It 

became clear that economies operating in the framework of a flexible exchange rate system were 

better able to absorb shocks from open capital markets than economies with a pegged rate. 

A few points merit emphasis in any debate about exchange rate regime choices. 

• In a pure fixed exchange rate regime, economic activity adjusts to the exchange rate. In a 

purely floating regime, the exchange rate is a reflection of economic activity. In either case, 

the economy’s “fundamentals” are the chief determinant of whether economic stability and 

prosperity are achieved, not the exchange regime per se. 

• There is probably no universally “optimal” regime. Regime choices should reflect the 

individual properties and characteristics of an economy. 

Both “fixed” and “flexible” regimes have strengths and weaknesses. A fixed exchange rate is 

generally seen as being transparent and a simple anchor for monetary policy. Countries with 

weak institutions can “import” monetary credibility by anchoring to a currency with a credible 

central bank. A conventional view is that a fixed exchange rate has the advantage of reducing 

transaction costs and exchange rate risk. In countries with less developed financial sectors, 

economic agents may not have the financial tools to hedge long-term currency risks. 

But adjustments under fixed exchange rates can be very gradual and require significant 

flexibility in prices in the domestic economy, especially in the face of changing capital flows. 

The inflexibility of fixed exchange rates can place an enormous constraint on monetary policy 

and create pressures in a downturn for pro-cyclical fiscal policies. Fixed exchange rate regimes 

in economies where interest rates are higher than rates denominated in the anchor currency can 

also give debtors an incentive to borrow unhedged in the anchor currency, leaving national 

 

1

 The dollar was convertible into gold under the Bretton Woods system. Other currencies were defined in terms of 

the dollar. The U.S. gold window was closed in August 1971. 
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balance sheets vulnerable to exchange rate changes. To withstand currency pressures under 

fixed exchange rate regimes, authorities have an incentive to put in place harmful capital controls 

(to be sure, such pressures can exist under flexible regimes as well). 

A country cannot maintain a fixed exchange rate, open capital market, and monetary policy 

independence at the same time. In recent years more large emerging market countries, 

increasingly integrated into the global financial system, have begun to adopt policies that target 

low inflation and establish central bank independence. Flexible exchange rates have the 

advantage that they allow a country to pursue an independent monetary policy, rather than have 

its own monetary policy set by an anchor currency country. Experience shows that flexible 

exchange rates are more resilient in the face of shocks, and are better able to distribute the 

burden of adjustment between the external sector and the domestic economy. Also, fixed 

exchange rates have the effect of sharply reducing or eliminating exchange rate volatility. 

Protection from volatility dampens the incentives for financial markets to develop hedging 

products and financial instruments, so risk is more likely to be transferred to the public sector 

effectively. 

Against this background, exchange regime choices will vary. 

Major Currencies

It is broadly agreed that the major currencies – the dollar, the euro and the yen – should, and do, 

float against one another. The economies represented by these currencies account for 42% of 

global economic activity. Nearly all global trade and capital flow transactions are denominated 

in one of these three currencies, as are nearly 95% of official foreign exchange reserves. Other 

large economies with well developed financial sectors, such the U.K., Canada, or Australia 

should, and do, float as well. 

Emerging Market Economies

Larger emerging market economies should adopt more flexible exchange rate regimes. “Larger” 

is meant to apply to economies such as, though not exclusively, Mexico, Brazil, South Korea, 

and China. This is all the more true as these economies become integrated into the global 

financial system and have increasingly developed financial sectors. Where flexible exchange 

rates are in operation, economies have proven to be more robust and resilient. Brazil 

demonstrated this quite well in 2002 when the markets put substantial downward pressure on the 

Real ahead of the Presidential elections. In the case of downward currency pressure, greater 

flexibility limits the one-way betting that results in rapid depletion of reserves and allows the 

external sector to bear a portion of the needed adjustment, rather than imposing an undue burden 

on domestic demand. 

Flexible regimes for “larger” economies cannot solve all problems. In particular, there is no 

substitute for sound fiscal and monetary policies and resilient institutions. Economies with a 

flexible exchange rate need an alternative anchor for monetary policy, such as central bank 

independence and inflation targeting, and they should take steps to put in place a sound system 

of bank regulation.
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China is a clear case where increased trade and financial integration have shifted the balance 

strongly towards the need for a more flexible exchange rate: 

• Large capital inflows have fueled credit growth, leading to huge increases in investment in 

2003 and 2004 and an overheating economy. 

• Chinese authorities cannot effectively use monetary policy to control inflation, but instead, 

monetary policy is inexorably linked to that of the anchor currency, regardless of domestic 

developments in China itself. This creates pressure to use administrative controls. 

• Financial sector development and openness have reduced the effectiveness of administrative 

controls for adjusting monetary conditions and smoothing investment cycles. But the peg 

precludes the ability of monetary authorities to adjust interest rates. 

• The U.S. and China economic cycles are not synchronized so that monetary conditions in the 

U.S. may not be appropriate for the Chinese economy. 

• China’s transition to a more market-based economy where private agents adjust to price 

signals is hampered by constraints on the movements of interest rates and exchange rates. 

• In addition to being in China’s own interest, greater flexibility of the yuan would allow other 

Asian economies that are concerned about their relative competitiveness vis-à-vis China, to 

have more flexible exchange rates. This would help facilitate orderly adjustments of global 

imbalances and lessen protectionist pressures. 

Lower-Income Economies

Lower-income economies with less developed monetary and financial sectors, and less credible 

institutions, on the other hand, can face special problems. For some of these economies, a very 

hard peg to a major currency can improve monetary stability and improve the efficiency of 

commercial transactions. Typically, these economies, where credibility in existing institutions is 

not yet strong, still have underdeveloped financial sectors and supervisory systems, suffer from 

higher rates of inflation, and are in need of anchors for monetary policy. 

The IMF and Exchange Rates

The IMF’s Articles of Agreement allow members to adopt the exchange rate regime of their 

choice. However, the IMF – taken to mean both management and shareholders – has a 

responsibility rigorously and candidly to assess the consistency of that regime with both country 

circumstances and the international system. The Fund is not only a trusted advisor to each of its 

members but the protector of the system as a whole. 

The IMF Articles of Agreement recognize the danger of not permitting balance of payments 

adjustments to take place, and this danger motivated the IMF to establish procedures for 

surveillance of exchange rate policies. The implementation of these procedures needs to be 

significantly improved. In general terms, the international financial system would benefit from a 

multilateral approach to greater exchange rate flexibility. It is in the collective interest of all 
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economies for the IMF – the world’s central institution for global monetary cooperation – to 

assume this responsibility. 

More specifically, the U.S. Treasury has made four proposals to strengthen IMF surveillance.2

First, the membership of the IMF should clarify the principles of surveillance over exchange rate 

policies. Guidelines like “protracted large-scale intervention” and “excessive” reserve 

accumulation have been undefined for too long. Second, Article IV reports must include more 

substantial and pointed discussions of exchange rate issues – on a consistent basis, but especially 

in systemically important countries. The IMF – with its wealth of expertise and experience 

across the globe – is well positioned to discuss exchange rate policies with authorities and 

advocate change. Third, such engagement is more effective with credible consequences, and that 

is the “Special Consultation” mechanism. Consultations would be a more useful tool if designed 

to enable more regular use. Finally, the IMF should develop its techniques for assessing 

exchange rate behavior and extend this work more to emerging markets. Although the IMF 

should not be placed in the position of determining what the “right” exchange rate level is, 

quantitative efforts at exchange rate determination can be helpful in developing a qualitative 

assessment of a country’s exchange rate policies. 

The IMF Managing Director has since committed to strengthen IMF exchange rate surveillance, 

both bilaterally and multilaterally, in the context of his Medium-Term Strategy. Further, by 

bringing together the IMF, countries engaged in questionable currency policies, and countries 

most affected by those policies, the multilateral consultation process should help promote 

exchange rate policies that are consistent not only with domestic policies but also with the 

international monetary system. 

 

2

 Remarks by Treasury Under Secretary for International Affairs Timothy D. Adams at the American Enterprise 

Institute, February 2, 2006. “Working with the IMF to Strengthen Exchange Rate Surveillance.” 

http://www.treas.gov/press/releases/js4002.htm