IAJBS 23rd Annual World Forum University of Namur, Namur, Belgium

Experience level: 
R. Stafford Johnson (Contact Author), Department of Finance, Xavier University;

The Sustainability of the Current Exchange-Rate System—Insights from the Mundell-Fleming Flexible and Fixed Exchange-Rate Models

Under the Bretton Woods fixed exchange-rate system, a deficit country was required to intervene in the currency market to stop its exchange rate from increasing by using its international reserve holdings. The equilibrium adjustment to the external deficit worked through changes in the money supply and international reserves. This system, though, led to persistent external imbalances among countries that had inconsistent stabilization policies. For example, a deficit country fighting unemployment with expansionary monetary policy or fiscal policy found its policies offsetting the normal monetary contraction and balance of payments correction resulting from the deficit. These countries would eventually run out of international reserves needed to maintain the system. This was the case in the United States and Great Britain, and it led to both countries devaluing their currency in 1972 and 1973. In both devaluations, the countries allowed their exchange rates to be determined in the foreign currency market. In 1973, the United States and other countries announced that they would no longer support their currency. This marked the collapse of the fixed exchange-rate system and the de facto move to the flexible exchange-rate system. In retrospect, the Bretton-Woods system was unsustainable. Under the current flexible system, the equilibrium adjustment to an external imbalance occurs through changes in the exchange rate and money supply. However, under the flexible system, persistent imbalances can also occur because of inconsistent stabilization policies. For example, a surplus country with a central bank policy of sterilizing its reserves by not converting foreign currency in order to keep its currency devalued and its exports high. This is the case in China and other surplus countries, which have maintained large international reserve holdings, devalued currencies, and persistent surpluses. At times, this has led to a de facto fixed exchange-rate system among some trading countries, and in turn, questioned the sustainability of the current flexible system. For over thirty years, the Mundell-Fleming model has served as a template for research in international macroeconomics. Their model and related works represent an extension of the seminal work of James Meade. Meade’s treatise on the balance of payments combined Keynesian economic conditions with monetary factors to explain the balance of payments, the economic impacts of devaluations, and the factors governing the fixed and flexible exchange rate system. As Frenkel and Razin (1987) point out, Mundell’s model extended Meade’s work by providing an explanation of how international capital flows and monetary changes work to restore internal and external equilibriums, the monetary adjustment to external imbalances, and how inconsistent policies led to the collapse of the Bretton Wood system. This paper examines the sustainability of the current flexible exchange-rate system in which surplus countries like China maintain large international reserves. The paper revisits the fundamental differences between fixed and flexible system in terms of the Mundell-Fleming model. With this background, the paper then explains how current inconsistent policies are creating an unsustainable exchange-rate system.