17 Jan Fixed exchange rate? Flexible exchange rate? How do you eat this?
To the delight of my friend @mauracio, probably without olives. 🙂
Recently, an old debate has resurfaced about how a country manages its exchange rate; some favor the flexible approach, others support the fixed system, and nostalgic voices advocate for a managed approach, among others. In this post, I aim to clarify these concepts.
First, understand that the exchange rate is a number that usually reflects how many Bs can be exchanged for 1 dollar, 1 euro, 1 sol, or any foreign currency you choose. I like to call it a price, like any other, but one with a more significant impact on the economy.
Second, a fixed exchange rate is what Bolivia has experienced in recent years; one dollar equals Bs 6.96, regardless of what happens in the economy or the rest of the world. Bolivians knew Bs 6.96 was the ‘rate’ for exchanging dollars.
Third, a flexible exchange rate fluctuates based on national or international economic conditions. One day the dollar might be Bs 7.00, the next Bs 7.50, and the following week Bs 5.00. These changes are flexible, hence the name.
Fourth, a managed exchange rate changes regularly over a specified period. Bolivia experienced this in the 90s and early 2000s. People generally knew ‘the dollar would rise by a point each month.’ Economists often call this a ‘dirty float.’
I hope these concepts are clearer so far. Now come the details where the devil hides.
What is the magic behind a fixed exchange rate? Is it just about the Central Bank and exchange houses publishing the same number every day? Not really. To maintain Bs 6.96, the Central Bank must intervene daily. Imagine everyone suddenly wants the latest Samsung phone. Since Bolivia doesn’t produce these phones, they must be imported from China. The Chinese won’t accept Bs, so we need to pay in dollars. This increases the demand for dollars. To keep the rate at Bs 6.96, the Central Bank uses its piggy bank —what economists call ‘Central Bank reserves.’
Lesson 1: Maintaining a fixed exchange rate typically requires strong reserves, ensuring the Central Bank’s financial health.
What about a flexible exchange rate? When phone demand rises, the demand for dollars also rises, and the Central Bank observes without intervening. How does the market stabilize? Simply, when demand for dollars increases, the exchange rate rises from Bs 6.96 to Bs 8.00. The same occurs with football match tickets; when demand spikes, reseller prices rise. At Bs 8.00, a USD 200 phone would cost Bs 1,600, leading to price increases and potentially inflation.
Lesson 2: A flexible exchange rate could drive inflation higher, although not always, but the concern is valid.
Between these two extremes, countries have developed hybrid mechanisms: dirty floats, bands, and more. The truth is, there is no perfect formula, and arguments exist for and against each system.
Some countries sidestepped the issue altogether by adopting the dollar as their official currency, such as Ecuador. Is this like a fixed exchange rate? I argue it is not. I lived in Ecuador for two years, and people widely believed their lives improved under dollarization. In fact, the lady who helped us at home said dollarization improved her life.
Ecuador has often been tempted to abandon the dollar and return to its national currency, but the people resisted. This, in my view, shows it’s not equivalent to a fixed exchange rate. When a national currency like the Bs in Bolivia or the old Sucres in Ecuador is still circulating, the government always has the option to print more money.
I’ll leave for another post how exchange rates impact exports, imports, the financial system, and BoA leasing. Today, I just wanted to clarify the basics of fixed vs. flexible rates.
To end on a suspenseful note, like the old Batman TV episodes:
When the economy spirals out of control and multiple exchange rates appear—official and parallel (blue, black market, etc.)—corruption opportunities multiply. This, my friends, is infuriating and will be the topic of another post.
Best regards,
S. Mauricio Medinaceli Monrroy
Bogotá
January 17, 2025
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