ABSTRACT
So far in this book we have considered the determination of exchange rates when the exchange rate is freely floating. We now turn to the determination of exchange rates when exchange rates are fixed. It may seem odd to consider the determination of a price which is fixed, however, as Svensson and others have argued there is really no such thing as a truly fixed exchange rate (monetary unions aside). If we take the Classical Gold Standard period, in which participating currencies were fixed to each other because they first of all fixed their currency in terms of gold, there was nonetheless some exchange rate flexibility because of the costs of shipping gold between countries and certain opportunity costs (such as the funds tied in shipping gold). These costs set-up bands above and below the central parity which are referred to as a target zone. Admittedly, such bands were very narrow, but nonetheless some have argued (see, for example, Svensson 1994 and Bordo and MacDonald 2005) that they conferred on the government of the day some autonomy in the operation of its monetary policy (we consider this point in more detail later). The existence of target zones in other fixed rate regimes is perhaps clearer since such regimes have explicit bands above and below the central parity (in the Bretton Woods regime currencies were allowed to float by plus or minus 1% relative to the central rate, while in the ERM of the EMS the bands ranged from plus or minus 2.5% to plus or minus 15%). How then are exchange rates determined within such bands?
