The Role of Preference Reversals in the Collapse of Fixed Exchange Rate Systems

Abstract

This paper draws on the structural instability of fixed exchange rate systems, also referring to Bretton Woods and the European Monetary System. In particular, the collapse of such systems is seen as a consequence of, amongst other things, formational and cognitive factors with an emphasis on the processes of preference reversal. Taking a dynamic view of such processes, the intertemporal nature of decisions made on the issue of exchange rate systems can induce electors and governments to reconsider, in time, the importance of certain major objectives they set themselves. A core issue of the analysis is the still unsolved problem of the relationship between inflation and unemployment. Recent financial crises have demonstrated that even governments “ideologically” oriented to a monetarist approach can adopt, in particular situations, Keynesian policies. This occurs for reasons of a social and political order, outside of economic logic. Therefore, in the analysis developed in this paper, attention is focused on informational and cognitive factors.

The paper is essentially arranged in three parts. In the first part, we examine the role of the forms of exchange rates, seen as social institutions in act by countries that have a two-objective utility function. Subsequently we examine the question of instability of the system of fixed exchange rates with an approach that is focused on incomplete information. Finally, beyond the role of incomplete information, in the third part we examine the role of distortive factors of a cognitive order that are capable of overthrowing exchange rate preferences..

JEL Classification.: D7, E11, E5, E6.

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