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This chapter addresses what is perhaps the most important policy issue in international finance: to have fixed or floating exchange rates. The chapter focuses on three main features that affect the choice of system: volatility and risk, inflationary consequences, and monetary autonomy.
Volatility and risk refers to the tendency for exchange rates to change and the effect these changes have on the risk faced by traders and investors. Although in floating exchange systems volatility is a natural day-to-day occurrence, even in fixed exchange systems, devaluations or revaluations make volatility an issue. This chapter compares the two systems in light of this issue.
Inflationary consequences are shown to be a major potential problem for countries with floating exchange rates. For many countries facing this problem, fixed exchange rate systems can provide relief. The section shows that the relationship between inflation and the exchange rate system is an important element in the choice of system.
Finally, monetary autonomy, and the ability to control the economy, is lost with the choice of fixed exchange rates. We discuss why this loss of autonomy can be problematic in some circumstances but not in others.
The chapter concludes by providing some answers to the policy question, “fixed or floating?”
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”