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The crumple zone

June 14, 2015

Abstract: In floating rate systems, external shocks to an economy can and do trigger exchange rate volatility, which in turn activate both self-correcting forces and policy responses.  As a result, only limited disruptions occur to the economy and the situation is stabilized relatively quickly. In the floating rate systems, exchange rate movements thus act as a buffer against external shocks, much like the crumple zone of cars in the case of collisions.

Such buffers are missing in fixed exchange rates (FER) systems, as illustrated by the Greek debt crisis (2010-15). The crisis led to external shocks (to Greece), whose impact could not be softened, because the FER regime of the euro zone, of which Greece is a member, did not allow any movement of Greece’s exchange rate. Consequently, there were major disturbances to the Greek economy and protracted sufferings for its people.

Keywords: exchange rate; floating rate system; fixed exchange rate system; crumple zone; external shock; Greek debt crisis; eurozone

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