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Vivek Dehejia: Fixed or flexible exchange rate?

The current debate around the rupee is a perfect opportunity to revisit a classic debate between two titans: Friedman and Mundell

Vivek Dehejia 

Vivek Dehejia

Given all of the debate on the travails of the rupee, this seems an opportune time to revisit one of the great debates in macroeconomics. Should an economy operate under a flexible exchange rate or fix the value of its currency to a major international currency, such as the dollar?

First, a short history lesson: for much of the time since they came into being, paper currencies were tied to commodities, principally silver or gold, or sometimes both (called "bimetallism").

This was perfectly logical: after all, a currency note was originally nothing other than a receipt entitling the holder to an equivalent value of the underlying commodity. By the nineteenth century, most countries adopted the "gold standard", with the price of gold fixing the value of the currency.

Exchange rates, then, were nothing other than the ratio of the gold contents of currencies. The long-standing exchange rate between the pound sterling and the dollar of 4.86 reflected that the gold content of a pound was 4.86 times the gold content of a dollar. Two world wars and an intervening depression broke down the gold standard, which was re-established after the war as a modified gold-dollar standard. The dollar fixed the price of gold at $35 per ounce (!) and every other country fixed to the dollar.

That world vanished when Richard Nixon famously took the US off gold. Henceforth, the value of a "fiat currency" was determined by a central bank and had no backing from gold or any other commodity. By implication, the exchange rates between currencies would be determined by the market, not fixed by the ratio of their gold contents: the world of flexible, or "floating", exchange rates had been born.

The Nobel Prize-winning economist Milton Friedman was an early advocate of flexible exchange rates, and his theory remains the most widely held to this day. A flexible exchange rate, Friedman argued, provided "insulation" to an economy, like the shock absorber of a car.

If there were a sudden drop in economic activity, for instance, and domestic prices were unable to adjust downward - "sticky" in economic parlance - then exchange rates could do the work of adjustment by depreciating, therefore, allowing the real exchange rate (which is the exchange rate adjusted for the difference in price ratios between countries) to stay close to its equilibrium level. A recession might not be avoided, but it would be attenuated.

As against Friedman, the strongest argument for a fixed exchange rate was, and continues to be made, by another Nobel laureate, Robert Mundell, my own great guru. In Mundell's view, a flexible exchange rate system can't do the job that Friedman and his acolytes say it will, because, in a large country, such as the US or India, shocks might have opposite impacts on different regions of the country.

Suppose, for instance, there is a jump in demand for information technology services, so there is a boom in Bangalore and Hyderabad; whereas there is a simultaneous drop in the demand for automobiles, which causes a slump in Chennai. There is absolutely nothing that a flexible exchange rate can do to solve this problem. In practice, in a large federal country such as India, the best that a central bank can do is target an average across states, which means, in effect, that the exchange rate will be too high for some regions and too low for others.

The reductio ad absurdum of this argument is that every state, even every city, should have its own exchange rate. But this would create transactions costs so high as to nullify any benefit of the added flexibility that, say, Bangalore and Chennai might have different values of their currencies.

Contra Friedman, Mundell argued the benefit of a fixed exchange rate for a region which enjoyed mobility of "factors of production" (principally, labour and capital) and, crucially, coordinated fiscal policies and a system of fiscal federalism, so that booming regions could subsidise lagging regions depending on the state of the economic cycle. He called such a region an "optimum currency area". Mundell was an early advocate for a European common currency, and therefore is, rightly, credited as the "godfather" of the euro.

Unfortunately, as history has shown, the Eurozone failed to adhere to the underlying logic of Mundell's theory, with unsustainably high deficits in Greece and other southern countries. The result is the current unfolding crisis. Further, being part of a common currency, Greece cannot depreciate itself out of the mess in which it finds itself - which is exactly what we have been able to do in India.

Just imagine if the rupee had been fixed at 50 to the dollar when times were good. Rather than bemoaning a 25 per cent depreciation, we would be in the midst of an economic and social meltdown that would make our current situation look like a picnic.

The bottom line? A world currency, such as Mundell favours, might be best. But in our second best world of competing currency zones, the room to manoeuvre that a flexible currency buys us is invaluable. Just ask the folks in Greece.

The writer is an economics professor at Carleton University in Ottawa, Canada, and is co-author of Indianomix: Making Sense of Modern India (Random House India, 2012)
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First Published: Mon, September 02 2013. 21:48 IST