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The Fixed vs. Floating Distinction

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  • Strongly Liberal Democrat
    Democrat
    Dallas, TX
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    In 1971, Pres. Nixon took us off the Bretton Woods fixed exchange system. Bretton Woods worked out likes this: exchange rates were "fixed" and the US maintained convertability of dollars held internationally into gold. This created a reserve constraint where foreign held dollars represented a claim against U.S. reserves of foreign currencies and gold. This created a condition where foreign demand leakages (dollar deposits held by foreigners) created the potential for a "convertability" crisis, even with U.S. trade balances in surplus.

    On fixed exchange, whether it be a full-on domestic and international gold-standard or fixed foreign currency exchange rates, the lowest interest rate in the economy is what it costs government to compete against convertibility demands. What the Austrians and Deficit Hawks have to say is, for the most part, applicable. Government deficit spending drives up interest rates. The government and the banks are reserve constrained. Government deficit spending 'crowds out' the funds for other spending. The loanable funds textbook model applies.

    However, we don't have fixed exchange, we have floating exchange. There is no competition wth convertibility. There's no reserve constraint. The lowest interest rate in the economy is what the FOMC decides it to be by vote and the FED defends as the monopoly supplier of bank reserves. If government didn't sell government securities, government deficit spending would drive rates below the FOMC's target. Loans in the banking system create deposits, and the FED supplies any needed bank reserves, after the fact. There has to be government intervention to keep the lowest interest rate in the economy above zero. Only when the economy is at full employment can additional government deficit spending 'crowd out' real resources.