FIXED VERSUS FLOATING EXCHANGE RATES
Peter B. Kenen
In the 1990s, a new consensus emerged regarding exchange rate
regimes. Governments must choose between flexible exchange rates
and firmly fixed exchange rates. Pegged rates of the adjustable sort,
like those of the Bretton Woods system and European Monetary
System (EMS) before 1993, are no longer viable because of their
vulnerability to speculative attacks. Note that I have substituted “flex-
ible” for “floating” rates, because many of those who subscribe to the
new consensus are not fully convinced that markets know more than
governments and do not rule out official intervention to influence
market-determined rates. Some, indeed, continue to believe that
wide-band target zones or crawling bands are still viable.
I subscribe to the new consensus insofar as it warns against adopt-
ing adjustable pegs, whether they be formal as in the case of the EMS
or informal as in the case of Asian countries that maintained de facto
dollar pegs for their currencies before the recent crisis. The consen-
sus seems also to suggest, however, that firmly fixed rates are both
viable and sensible, but I have reservations. For all but the smallest
countries, which are economic appendages of larger countries and
might as well adopt those large countries’ currencies, flexible rates are
more appropriate.
Several arguments have been adduced for fixing exchange rates
firmly. All of them have limited validity, but they are not compelling,
individually or collectively.
The Real Costs of Exchange Rate Changes
The first argument is often posed as an objection to flexible rates
but applies to adjustable rates as well. The uncertainty produced by
exchange rate changes acts as a tax on trade and, more importantly, a
Cato Journal, Vol. 20, No. 1 (Spring/Summer 2000). Copyright © Cato Institute. All rights
reserved.
Peter B. Kenen is the Walker Professor of Economics and International Finance at Princeton
University.
109
tax on investment in traded-goods industries. Although it is possible
to hedge