Academic journal article The Cato Journal

Friedman: Float or Fix?

Academic journal article The Cato Journal

Friedman: Float or Fix?

Article excerpt

With the passing of Milton Friedman on November 16, 2006, we lost one of the great champions of free markets. Friedman's obituaries and commentaries on his life's work and enormous influence have invariably mentioned his advocacy of floating exchange rates, leaving the impression that he always flavored floating rates. This was not the case.

Types of Exchange Rate Regimes

For Friedman, there were three distinct types of exchange rate regimes: floating, fixed, and pegged--each with different characteristics and different results (Table 1). Indeed, in his response to the opening question posed in an eight-part debate on exchange rates with Robert Mundell, Friedman insisted that the dichotomy (floating or fixed) be replaced by a trichotomy (floating, fixed, or pegged) (Friedman and Mundell 2000). What Friedman meant by these terms differs from the meanings they are often given, and to understand Friedman's thinking, one must understand the differences.

Free-Market Regimes

In Friedman's sense, strictly fixed and floating rates are regimes in which the monetary authority is aiming for only one target at a time. Although floating and fixed rates appear dissimilar, they are members of the same free-market family. Both operate without exchange controls and are free-market mechanisms for balance-of-payments adjustments. With a floating rate, a central bank sets a monetary policy but has no exchange rate policy--the exchange rate is on autopilot. In consequence, the monetary base is determined domestically by a central bank. With a fixed rate, or what Friedman often referred to as a unified currency, there are two possibilities: either a currency board sets the exchange rate, but has no monetary policy--the money supply is on autopilot--or a country is "dollarized" and uses a foreign currency as its own. In consequence, under a fixed-rate regime, a country's monetary base is determined by the balance of payments, moving in a one-to-one correspondence with changes in its foreign reserves. With both of these free-market exchange rate mechanisms, there cannot be conflicts between monetary and exchange rate policies, and balance-of-payments crises cannot rear their ugly heads. Floating- and fixed-rate regimes are inherently equilibrium systems in which market forces act to automatically rebalance financial flows and avert balance-of-payments crises.

Pegged Rates

Most economists use "fixed" and "pegged" as interchangeable or nearly interchangeable terms for exchange rates. Friedman, however, saw them as "superficially similar but basically very different exchange-rate arrangements" (Friedman 1990: 28). For him, pegged-rate systems are those where the monetary authority is aiming for more than one target at time. They often employ exchange controls and are not free-market mechanisms for international balance-of-payments adjustments. Pegged exchange rates are inherently disequilibrium systems, lacking an automatic mechanism to produce balance-of-payments adjustments. Pegged rates require a central bank to manage both the exchange rate and monetary policy. With a pegged rate, the monetary base contains both domestic and foreign components.

Unlike floating and fixed rates, pegged rates invariably result in conflicts between monetary and exchange rate policies. For example, when capital inflows become "excessive" under a pegged system, a central bank often attempts to sterilize the ensuing increase in the foreign component of the monetary base by selling bonds, reducing the domestic component of the base. And when outflows become "excessive," a central bank attempts to offset the decrease in the foreign component of the base by buying bonds, increasing the domestic component of the monetary base. Balance-of-payments crises erupt as a central bank begins to offset more and more of the reduction in the foreign component of the monetary base with domestically created base money. …

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