What Is The Effect Of Fixed Exchange Rates On Monetary Policy?

An ideal exchange rate system is one that allows high levels of predictability of relative prices while ensuring smooth adjustment to economic shocks. In a well functioning system, people can trade and invest in other countries without worrying that exchange rates will suddenly change and make their ventures unprofitable. This ideal seemed to be attained during most of the Breton Woods era, when exchange rate changes were infrequent yet output and trade grew rapidly. Outside of that period, the experience has been less satisfactory.

The flexible exchange rate regime since 1973 has been one of the great volatility as well as prolonged overvaluation and under valuation. Fixed exchange rate systems have sometimes been the subject of intense speculative attack as occurred in Europe in 1992 and Mexico in 1994.

The difficulty in all fixed exchange rate systems is that they may impede economic adjustment if prices and trade among countries get too far out of line. The most ambitious attempt to curb exchange rate market fluctuations came in Europe with the creation in 1978 of a currency bloc known as the European Monetary system.