Under international monetary system governments are requiredto choose between currency stability and national economic autonomy. As aresult to choose between the two, a country in order to retain nation autonomywould rather allow its currency to fluctuate. In most major industrialized nations floating exchange ratesystem is prevailing since early 1970s, whereas developing ones continue tohave fixed exchange rate system.
To provide a stable system to importers, exporters,and investors and to limit speculation, developing economies tend to utilizefixed exchange rates. But neither the floating nor the fixed rate system is betterthan the other. Rather it’s a matter of recognizing that all exchange rate systemsencompass a significant trade-off between domestic economic economy andexchange rate stability. Consequently, when a country is forced to choosebetween a fixed exchange rates and domestic economic autonomy, governments gofor the latter.
Although fixed exchange rates provide exchange rate stabilityby stabilizing trade on one hand and help to achieve macroeconomic goals on theother hand, but they obstruct government’s ability to manage nation economicautonomy through monetary policy. Secondly, to maintain fixed exchange rates,it needs domestic adjustments which are costly. The country with trade deficit,wishes to maintain fixed exchange rates, have to face rising unemployment,falling output and recession, while the country with trade surplus for the samepurpose of maintain fixed exchange rates has to deal with acute inflation. Advancedindustrialized countries therefore favor floating exchange rates because theyare unwilling to forsake their national economic autonomy and also not willingto pay such costs in order to sustain fixed exchange rates.Hence it depends on how governments view the tradeoffbetween fixed exchange rates and domestic economic autonomy. Consequently, thecountries that desire domestic economic autonomy, have to consider independentcentral banks in order to maintain low inflation.
As inflation carriespotential large costs in terms of higher unemployment and less economic growth,society can be benefitted by monetary policies that maintain low inflationconsistently. In this respect, independent central banks come into play. Most governmentsare unable to achieve and maintain low inflation and thus establish crediblecommitment mechanisms for this purpose in the form of fixed exchange rates andindependent central banks. In theory, both mechanism provide crediblecommitment towards maintain low inflation but only independent central bankscan do actually in practice. Firstly, Independent central banks can decidefreely what economic goals to pursue, and how to use monetary policies topursue such goals without the interference of governments.
Secondly, fixedexchange rates cannot solve time- consistency problem. Independent central bankssolve this problem by preventing the governments to pursue short termobjectives. They take the use of monetary policy completely out of control ofpoliticians who now cannot set monetary policy for their short term politicalaims. In this way, an independent central bank ensures low inflation and strongeconomic growth. Therefore, a country which wants to retain domestic economic autonomy,consider only central bank independence because still the government does havethe power over exchange rates system.Exchange rates and monetary policy options can be explainedby three society based models of monetary and exchange rates politics:1. The electoral model: it argues that government’s exchangerate policy usually determine its decision concerning monetary policy. Accordingto this model, governments are more concerned with monetary policy autonomy.
Theywould maintain fixed exchange rates only when it allows monetary policy to accomplishdomestic economic objectives. The need to win elections/reelections shape theseeconomic objectives and governments pursue monetary policy accordingly. Usuallygovernments adopt floating exchange rates in order to maintain monetary policyautonomy. It is because macroeconomic conditions decide the government’selectoral fortune in two significant ways: pocketbook voters; this means thatpeople vote in favor or against the government on the basis of their personalgains.
The person would vote in favor whose income rose and one who lost hisjob tend to vote in against. Sociotropic model: people would support ton thebasis of overall performance of the government that is low inflation, less unemploymentand economic stability. So they become less willing to tighten their monetarypolicy for the sake of fixed exchange rates. 2. Partisan model: It assets the same assumptions aselectoral model with one distinction.
It argues that different politicalparties have different macroeconomic objectives. Those which want to limitinflation, use monetary policy in line with floating exchange rates, whileother use fixed exchange rates in order to reduce unemployment. 3. Sectoral model: this model assumes that interest groups’-import-competing producers, export-oriented producers, nontrade goodsproducers and the financial services industry- preferences shape exchange ratesand monetary policies. Some prefer strong currency and some weak currency,whilst some other groups fixed exchange rates and some prefer floating exchangerates.
These groups lobby the government on the basis of their preferences theypossess. Internationally, the countries have abandoned the use ofmonetary policy and have placed monetary policy into the hands of officials ofindependent central banks who are completely secured against any political pushand pull. Often the groups of central banks work together in a coordinated way inorder to maintain price stability and strong economic growth of the countries.