Quiz 14: Exchange Rates and the International Monetary System
The cost of maintaining a fixed exchange rate is giving up the use of monetary policy to control domestic inflation and/or output.The benefits include eliminating exchange rate instability,which should encourage and stabilize international trade as well as encourage capital flows and discourage speculation.
A flexible exchange rate system will eliminate the conflicts that arise in a fixed rate system between internal and external balance.In a flexible rate system,the exchange rate will adjust to clear the foreign exchange market.Monetary and fiscal policy can be employed to pursue domestic goals free from balance of payments constraints.
The international monetary agreement's primary goal was to set up a fixed exchange rate system where the value of the dollar was fixed in terms of gold and convertible into gold,and all other countries agreed to fix the price of their currency in terms of the dollar. To sustain these fixed exchange rates,however,all countries had to follow U.S.monetary and fiscal policy.When they did not during the 1960s,the U.S.began to run chronic deficits while other countries refused to revalue their currency.The situation finally became untenable and the U.S.chose to let the dollar float.