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Exchange rate regimes, author Ben Carliner argues, are determined by three main factors:
First, policy makers are faced with the structural constraints imposed by the so-called trilemma - the inability to maintain the combination of a fixed exchange rate, free capital mobility, and a monetary policy oriented toward domestic needs.
Second, the continuing growth of deep, liquid financial markets and institutions, along with rising international trade and investment, has made international capital flows increasingly hard to regulate. Given the constraints imposed by the trilemma, the difficulties in imposing and maintaining capital controls further limit the range of policy options available to governments.
Third, domestic political considerations - primarily interest group pressure to orient monetary policy towards specific domestic goals like full employment, inflation rate targeting, or exchange rate stability - cause policy makers to respond to the constraints imposed by the trilemma in predictable ways. That is, governments, especially democratic governments that can be held accountable through competitive elections, will tend to place a high value on maintaining domestic political support.
Large economies like the US, where international trade represents a relatively small proportion of GDP, will value domestic monetary policy autonomy over stable exchange rates. Small, open economies, on the other hand, that are highly dependent upon international trade, will value the price stability that a pegged exchange provides. All this implies that most governments will choose to "move to the corners," and adopt either floating exchange rates or hard pegs, like currency boards or even (as in Europe) monetary unions, depending upon the make-up of the national economy and domestic interest groups.
This paper begins with an analysis of the theoretical implications of the trilemma and free capital mobility, and then move on to examine the role of the trilemma and domestic politics with two case studies. First, we look at the decision of the Nixon administration to "close the gold window" and break the dollar peg to gold in 1971. This action triggered the collapse of the Bretton Woods international monetary regime and ushered in the modern era of floating exchange rates. Then we examine the efforts of the European Union to create a European Monetary Union and to expand the Euro to the new group of accession countries in eastern and central Europe.
We find that the US and Europe have chosen to respond the constraints imposed by the trilemma differently - their respective electorates have distinct economic interests, and their choice of exchange rate regimes reflects those interests.