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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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28.1 Five Advantages of Fixed Exchange Rates

We consider here five advantages of fixing. They are (i) providing a nominal anchor to monetary policy, (ii) facilitating trade, (iii) facilitating investment, (iv) precluding competitive depreciation, and (v) avoiding speculative bubbles.

Of the five advantages of fixed exchange rates, academic economists have tended to focus most on the nominal anchor for monetary policy. The argument is that there can be an inflationary bias when monetary policy is set with full discretion.3 A central bank that wants to fight inflation can commit more credibly by fixing the exchange rate, or even giving up its currency altogether. Workers, firm managers, and others who set wages and prices then perceive that inflation will be low in the future because the currency peg will prevent the central bank from expanding even if it wanted to. When workers and firm managers have low expectations of inflation, they set their wages and prices accordingly. The result is that the country is able to attain a lower level of inflation for any given level of output. The strength of the argument for basing monetary policy on an exchange rate target will depend on what alternative nominal anchors might be available; this topic will be explored in Section 28.6.

Another leading argument in favor of fixed exchange rates, especially popular among practitioners, is the second one on the list: the effect of currencies on international trade. Exchange rate variability creates ...

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