Robert Cauneau – MMT France
Ivan Invernizzi – Rete MMT Italia / MMT France
30 may 2020
When one makes an economic argument with a monetary dimension, it is essential to specify whether one is reasoning within a framework of a floating exchange rate or a fixed exchange rate. Unfortunately, the other economic traditions that MMT often does not take this precaution, so that the validity and rigor of economic thinking is altered. The result is a profoundly biased appreciation of the potentialities of our economies, based on non-existent, and therefore self-imposed, technical and financial limits, especially in terms of budget deficit and public debt.
On the other hand, MMT clearly expresses the fact that the implications are different between these two types of regime. It therefore develops its reasoning always by specifying in which type of regime it is reasoning, fixed or floating, it being specified that a large part of MMT’s literature is linked to the floating exchange rate regime, insofar as this is currently the majority regime and is the one that guarantees the maximum space for action for economic policies.
When one first approaches MMT, one quickly realizes how much more room for action is given to governments to define public policies by operating under a floating exchange rate regime. Indeed, this regime has put an end to the financial restrictions imposed by the practice of fixed exchange rates.
For MMT, the question of the exchange rate regime is therefore fundamental.
MMT makes a clear and comprehensive distinction between these two main types of regime, and understands their implications. It explains the policy space for governments with both fixed and floating exchange rate currencies, but recognizes that under a floating exchange rate regime governments have the maximum policy space.
The purpose of this article is to define and compare the fixed exchange rate regime and the floating exchange rate regime.1 The definition of these two regimes can be summarized as follows :
The floating exchange rate regime is the situation in which the government does not link its exchange rate to a standard. Consequently, its action is not conditional on the maintenance of a stock-tampon/standard. Public expenditure is independent of public revenue. They are constrained only by the availability of real resources.2 Unlike the fixed exchange rate regime, this is a regime that does not impose fiscal restraint.3 Under this regime, the government has no nominal constraints on the level of its spending. It can therefore permanently guarantee full employment in its currency.
The fixed exchange rate regime is a situation in which the currency is pegged to a standard that requires a buffer stock to maintain it, either a commodity (usually a precious metal) or a foreign currency. The exchange rate must then be manipulated, in a continuous manner (above all by selling and acquiring the standard (gold, silver or foreign currencies) and domestic currencies) by a monetary policy, in order to keep it fixed. Indeed, insofar as the currency is fixed to a standard, the government must be permanently prepared to sell this standard whenever a buyer is willing to purchase it at that price and cannot find it on the private market, which therefore entails the need for government intervention. This point about the need to maintain the fixed exchange rate through government manipulation is central to differentiating it from the floating exchange rate. There is thus a close relationship between the buffer stock constituted by the standard and the government’s ability to maintain the fixed rate, which makes this exchange rate regime fragile. The result is that the pressure that the government must permanently exert limits its ability to spend. Under this regime, when it spends, the government must compensate with revenues in the form of taxes or borrowing. This regime is therefore a regime that entails financial restrictions.
In summary, it is important to understand that the government can either fix interest rates (both on bank reserves and on government securities) and let the exchange rate float, or it can try to fix the exchange rate but lose control of interest rates. It cannot intervene simultaneously on the exchange rate and on interest rates. Under a floating exchange rate regime, the interest rate on government securities is a political choice between letting it be fixed by demand or fixing it itself. In contrast, under a fixed exchange rate regime, the interest rate becomes endogenous, a function of market forces. Indeed, under this regime, there is a competition between (i) exchanging one’s own currency for a foreign currency at a fixed price and (ii) buying government securities at an interest rate that is sufficiently attractive (see an illustration on the ruble here).
Finally, it should be noted that in some countries, the qualification of the exchange rate regime in place may be difficult to define, especially if one limits oneself to verifying the existence of government intervention. Indeed, the government can intervene in both systems to influence the exchange rate. On the other hand, the demarcation between these two regimes is clear: on the one hand, the regimes in which fiscal policy is a priori conditioned by a fixed rate that requires almost constant government intervention to maintain this rate at its level, and, on the other hand, those in which it is not, with a floating rate in which the government can certainly intervene on the rate, but in a discretionary manner.4 The exchange rate is a key element in the development of the economy.
1 The reader may usefully refer to the Wikipedia page devoted to Modern Monetary Theory, which presents many of the points developed in this article: https://fr.wikipedia.org/
2 By real resources we mean technological resources, natural resources and labor power.
3 The floating exchange rate commonly refers to a « fiat » national currency, in other words, a government-issued national currency convertible only into itself (Keynes 1930), as opposed to a fixed rate policy such as a gold standard or any other commodity or national currency fixed by the issuing government (such as currency boards, pegged national currencies or currency unions). The United States, Japan and most of the world’s industrial economies are examples of such monetary systems, including the Eurozone, although individual countries are no longer issuers of their national currencies.
4 For the history of exchange rate regimes, readers may find it useful to refer to this article by Bill Mitchell : https://mmt-france.org/2020/03/07/etalon-or-et-taux-de-change-fixes-des-mythes-encore-dactualite/