Mundell vs. Friedman

Mundell vs. Friedman - ONE WORLD, ONE MONEY? Robert Mundell...

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OPTIONS POLITIQUES MAI 2001 10 ONE WORLD, ONE MONEY? Creation of the euro, among other devel- opments, has increasingly focused atten- tion on the question of fixed exchange rates versus flexible exchange rates. Even in Canada, seminars and conferences have been held exploring the subject. Would a global move toward fixed exchange rates, including currency blocs, be a good idea or not? Milton Friedman: Discussion of this issue requires replacing the dichotomy fixed or flexible by a trichotomy: 1. hard fixed (e.g., members of Euro, Panama, Argentine currency board); 2. pegged by a national central bank (e.g., Bretton Woods, China currently); 3. flexible (e.g., US, Canada, Britain, Japan, Euro currency union). By now, there is widespread agree- ment that a global move to pegged rate regimes would be a bad idea. Every currency crisis has been connected with pegged rates. That was true most recently for the Mexican and East Asian crisis, before that for the 1992 and 1993 common market crises. By contrast, no country with a flexible rate has ever experienced a foreign exchange crisis, though there may well be an internal crisis as in Japan. The reasons why a pegged exchange rate is a ticking bomb are well known. A central bank control- ling a currency that comes under downward pressure does not have to alter domestic monetary policy. It can draw upon reserves of foreign currency or borrow foreign currency to meet the excess demand for foreign currency. However, that recourse is limited by the amount of foreign exchange reserves and borrowing capacity. It is never easy to know whether a deficit is transitory and will soon be reversed or is a precursor to further deficits. The temptation is always to hope for the best, and avoid any actions that would depress the domestic economy. Such a policy can smooth over minor and temporary problems, but lets minor problems that are not transitory accu- mulate. When that happens the minor adjustments in exchange rates that would have cleared up the initial prob- lem will no longer suffice. It now takes a major change. Moreover, the direc- tion of that change is clear, offering close to a one-way bet to currency speculators, who perform the useful function of forcing the central bank to accept the inevitable sooner rather than later. A hard fixed rate is a very differ- ent thing. My own view has long been that for a small country, to quote from a lecture that I gave in 1972, “the best policy would be to eschew the rev- enue from money creation, to unify its currency with the currency of a large, relatively stable developed country with which it has close eco- nomic relations, and to impose no barriers to the movement of money or prices, wages, and interest rates. Such a policy requires not having a central bank.” [Milton Friedman, Money and Economic Development , (Praeger,1973), p.59] Panama exemplifies this policy, which has since come to be called “dollarization.” A currency board is a slightly less rigid version of a hard
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Mundell vs. Friedman - ONE WORLD, ONE MONEY? Robert Mundell...

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