Milton Friedman and the case for flexible exchange rates and monetary rules

Harris Dellas and George S. Tavlas (both at Bank of Greece) review Friedman’s thinking on flexible exchange rates.

Milton Friedman was a strong proponent of flexible exchange rates accompanied by a domestic monetary rule. He believed that such a combination would deliver superior economic performance and would also be more consistent with democratic principles than a regime based on fixed exchange rates and discretionary monetary policy. John Taylor’s recent proposal of a rules-based international monetary system –- based on flexible exchange rates and a Taylor rule for each country – is very much in that spirit and represents a modern rendition of Friedman’s views. Under both the Friedman and Taylor proposals,
instead of policy coordination among countries there would be policy harmonization.

The paper reviews Friedman’s views on the three fixed exchange rate systems – Gold Standard, Inter-War Gold Exchange Standard and Bretton-Woods. The experiences of these three fixed systems convinced Friedman that flexible exchange rates were a much better system. This alone would discipline the central banker/government as exchange rates will move in line with the broad economic trends. If the domestic policymakers mess up with macros. this would reflect automatically in the exchange rate.

In order to further discipline the policymakers, the legislation should tie their hands with some monetary rule such as monetary targeting.

How ideas evolve over the years…

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