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Forex: Limited Case for Flexible Exchange Rates

Experience to date does make a case for exchange-rate flexibility.

But, it is essential to avoid overstating that case. Flexible exchange rates do not cure cancer. They do not resolve the unemployment inflation dilemma. Even their likely ability to regulate the balance of payments and cushion national economies is subject to qualifications. A review of such issue reveals frequent cases in which the conclusion helping to strengthen faith in flexible exchange rates has admitted exceptions.

Letting a currency depreciate tends to improve its trade balance, but may worsen it in some cases. Some studies argued that flexible exchange rates tend to cushion an economy against some surprises, but not against others.

This entire dilemma saw a rough tendency for speculation to be stabilizing under flexible exchange rates, but exceptions were suggested by historical record. It must also be remembered that when fluctuations in the net demand for a currency are temporary and self-reversing, world welfare is raised if this recurring element is prevented from causing cycles in the exchange rate.

Perhaps the argument in favor of flexible exchange rates that has done to the most to persuade policymakers has been that monetary policy has greater control over the domestic economy with flexible rates than with fixed rates. Central banks have been unwilling to sacrifice this key monetary sovereignty to the vagaries of world demand and supply for money. As long as nations want control over their money supplies and national incomes to be nationwide, they are likely to find a strong case in favor of flexible exchange rates.

Theory and experience have combined to resolve partially some of the key issues in the debate over fixed and flexible exchange rates. The arguments that flexible exchange rates weaken official's price discipline and allow more inflation is almost correct. Whether one considers this an argument for or against fixed exchange rates depends on one's view of the unemployment-inflation dilemma. Also, the argument that flexible exchange rates expose traders and investors to greater risks is at least questionable and probably wrong.

The adjustments needed to defend fixed exchange rates against those distresses that face any system of exchange rates are likely to be costly and under fixed exchange rates individuals cannot hedge against what will happen in a definite and stable market the way they can hedge against exchange risk in the forward market.

However, the argument that flexible exchange rates breed destabilizing speculation is not persuasive on either theoretical or empricial grounds.