Globalization and Exchange Rate Policy

Abstract:

Exchange rates powerfully affect cross-border economic transactions. Trade, investment, finance, tourism, migration, and more are all profoundly influenced by international monetary policies. Many developing-country governments have searched for alternatives to the uncertainty that can prevail on international currency markets. Policy entrepreneurs have rushed to peddle currency nostrums, urging a turn toward dollarization, managed floating, nominal anchors, target bands, or other options.

There are both theoretical and empirical reasons to expect globalization to heighten the importance of the exchange rate. Theoretically, open-economy macroeconomic principles imply that capital mobility profoundly affects exchange rate policy choices. As Robert Mundell showed more than forty years ago, the government of a financially integrated economy faces a choice between monetary policy autonomy and a fixed exchange rate (Mundell 1963). If the government opts for a fixed rate, capital mobility makes impossible a monetary stance different from that of the anchor currency; alternatively, if the government opts to sustain an independent monetary policy, it must allow the currency to move. These constraints mean that the economics and politics of monetary and exchange rate policy are likely to be very different in an economy that is financially open than in an economy that is not. By the same token, inasmuch as international economic integration involves increased exposure to international financial and commercial flows, it heightens the concerns of those involved in or exposed to international trade and finance. In a relatively closed economy, few economic actors care about currency movements. But as economies become “globalized” more firms, investors, and workers find their fortunes linked to the exchange rate, and to its impact on trade and financial flows. This concentrates attention on the exchange rate.

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