Question

QUESTION 2. In the late 1960s advocates of a floating exchange rate system argued that one advantage of a world monetary system with market determined exchange rates is that it would impose symmetry on the system.

A. Discuss in what ways a system of fixed exchange rates, such as Bretton Woods, is asymmetric. What does asymmetric mean in this context? Why might it be advantageous for the world community to impose symmetry on the system?

B. Do floating exchange rates impose symmetry? Explain your answer.

Some Points to Address: By asymmetry, we mean that one country or countries is (are) different from the rest. Think about Bretton Woods and how it was set up. Is every country the same? To address the issue of symmetry and floating exchange rates, ask yourself the following questions. Is it the case that countries pursue their own economic policies independent of what happens to the exchange rate, or do they take the exchange rate into consideration when deciding on an overall economic policy? Then think about how one country’s economic policy may impact on another country under floating exchange rates. Will countries be forced to follow similar policies? Are there cases in which one country’s policies more or less dictate what another country will do?

Answer 1

To answer this question we need to think about two key economic indicators which are not only different between two or more countries but also change in different directions over a period of time. These two indicators are inflation and rate of interest.

If the fixed rates of exchange are set at say time t0, when these are i1, i2 and r1, r2 (inflation and rate of interest) for a set of two countries. The exchange rate (since it is fixed) will be sustainable only the change in these between t0 and t1 is in the same direction and proportion. If not, opportunities to profit from arbitrage arise which can create imbalances between the two countries. Since it is hard to accept that these indicators will move in the same direction and in the same proportion between t0 and t1 just for two countries, it can be imagined how difficult would it be when we consider a longer duration of time and multiple countries. Hence it makes sense to follow floating exchange rates to maintain symmetry (i.e., movement of exchange rates according to the differential manner in which inflation adn rate of interest move across different countries.