To Fix or Float? That Is the Question
At the end of World War II, countries wanting to promote international cooperation and reduce the economic incentives for war met in Bretton Woods, New Hampshire, and established a fixed exchange rate system pegged to the dollar. The benefit of such a system was that businesses could easily engage in foreign trade without fear of losing money from fluctuating exchange rates. In addition, by pegging currencies to the stable dollar, foreign governments were responsible for practicing sound economic policies such as not creating inflation by recklessly printing currency. The Bretton Woods system was at first very successful, but by 1971 it had completely collapsed. Today many approaches to exchange rates exist. Some countries let their currency float, others peg their currency to the dollar, and still others have unified under a single currency.
The United States and United Kingdom allow their respective currencies to float on the foreign exchange market, which means that they do not use official reserves to maintain exchange rates. The benefit of this system is that it gives policymakers the ability to practice interest rate policies to encourage domestic growth or slow inflation without having to consider exchange rates.
China's exchange rate policy is a political hot potato. On one hand, American consumers benefit from the low prices on imported goods. On the other hand, domestic producers find it hard to compete against China's prices.
China, Japan, and Hong Kong, however, peg their currencies to the U.S. dollar by actively trading their holdings of foreign reserves. This allows their respective countries to maintain a competitive advantage against others in the American market. China's exchange rate policy is what keeps Chinese exports relatively cheap. Under a floating exchange rate, American demand for Chinese goods would force up the exchange rate and eventually make Chinese goods less desirable. The downside for China is that all of the money spent on stabilizing the exchange rate could probably be put to more profitable use. Also, managing the exchange rate means acquiring more and more dollar-denominated financial assets, which makes China vulnerable to America's economic troubles.
The turn of this century saw another approach to exchange rate policy. Europe unified its economy under a single currency, the euro. France and Germany, for example, can now trade freely without regard to exchange rates. The advent of the euro created the world's second-largest currency after the dollar. For all of its benefits, the euro suffers a major drawback. Although Europe is united in name, the countries are quite distinct and have different economic conditions. The presence of a single currency managed beyond the national level means that the nations of Europe are unable to practice independent monetary policy to address economic problems unique to their specific countries. In 2010, Greece suffered a severe financial blow when its sovereign debt's credit rating was reduced. Unable to implement independent monetary policy, the Greeks have been forced to reduce their spending and raise taxes or risk default. The EU's reaction to this crisis will either weaken or bolster the euro's chances of becoming the dominant world currency.