On the other hand, in opting for a rigidly fixed exchange rate over the long run and free convertibility, control over the domestic money supply must be subordinated to the foreign exchange mechanism and (implicitly) to the partner country. Otherwise the fixed exchange rate cannot long endure without inciting a speculative crisis. A balance of payments deficit signals that there is an excess of domestic money (guilders) in circulation: domestic firms and individuals are trying to rid themselves of forex money to buy foreign goods or securities net. To preserve the fixed exchange rate, the central bank, in the guise of the foreign exchange authority, naturally eliminates this excess supply by selling exchange reserves (dollars) and purchasing guilders, which thereby withdraws  them from circulation. And consistency requires that the guilders so removed stay out of domestic circulation.
 
Similarly, suppose the central bank does not create guilders fast enough, by domestic open market operations or discounting, to satisfy the existing demand for guilders at the given price level (exchange rate). Then a surplus wiIl appear in the balance payments where individuals and firms are net sellers of goods and securities to foreigners for money (dollars). The official exchange stabilization fund purchases the excess dollars from domestic nationals in return for guilders-thereby relieving the shortage of domestic currency while preventing its appreciation in the exchange market. A domestic money-supply operation is always the dual of a purchase or sale of foreign exchange, and the fixed exchange rate requires that the domestic dual not be undone.

In contrast, an inconsistent domestic monetary cum foreign exchange policy would be where excess guilders (at the existing price level) are pumped into the economy by domestic techniques-say, an uncontrolled deficit in the government budget covered by printing guilders. Then, under a fixed exchange rate and free convertibility, this excess would quickly appear as a deficit in the balance of payments, leading to a loss of exchange reserves that may well be unsustainable. A crisis, a discrete devaluation or perhap several devaluations, are then forced on the economy; or convertibility and free trade are undermined as the authority resorts to direct exchange controls to protect its reserve position. In either case, this inconsistent monetary policy detaches the domestic price level-and the relative prices of tradable goods-from those prevailing in world trade. Serious economic dislocation and losses in allocative efficiency result.

From 1954 to 1970, Mexico followed a consistent monetary cum exchangerate policy in pegging the peso  to the U.S. dollar and allowing incipient deficits in the balance of payments to contract the domestic monetary base in the short run, while permitting a secular increase in the supply of pesos from domestic sources to be more or less in line with the growing demand for them. Between 1954 and 1970, the Mexican price level in pesos was fairly stable and exchange controls and other restrictions were absent. From 1971 to 1976, however, the Mexican government embarked on a much higher rate of monetary expansion from domestic sources.

This could not be fully offset by drawing down dollar reserves-supplemented with heavy borrowing in the New York money marketto repurchase the excess pesos being created domestically. The result was a collapse in the value of the peso to 24 to the dollar in the fall of 1976, a spectacular internal price inflation, and the temporary imposition of exchange controls. The moral of our story is clear. The old argument on fixed versus floating exchange rates is misspecified when posed that way. Rather, ensuring consis¬tency in monetary cum exchange-rate policy-with either a fixed or a floating exchange rate-is probably the more important policy decision in preserving free convertibility.

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