An Analysis: Flexibility of Exchange Rates
Flexible exchange rates--- its analysis of the argument by increasing trade risks would reduce foreign trade and investment is NOT very convincing.
Furthermore, its impact depends on the degree to which a country depends on foreign transactions for its economic welfare.
Certainly this argument is more forceful for Great Britain and the Netherlands than for the United States or France.
But where international transactions are a large part of total business, and businessmen think that fluctuating exchange rates involve substantial additional risk, it is likely that their introduction will disrupt business decisions and the domestic economy.
A second common argument is that short-term capital movements will be destabilizing and will cause violent movements in the exchange rate, thus distributing capital gains and losses at random and disrupting trade.
This argument is based on historical episodes. In the rush away from free convertibility which occurred during the monetary collapse of the early 1930s, flexible exchange rates fluctuated widely because of the massive capital flows.
The argument runs that since short-term capital movements were destabilizing with respect to exchange rates during the only occasions they have been attempted on a broad scale, such will be the case id they are tried again.
But this argument presupposes that flexible rates were the cause of the capital movements, when in fact a fairly solid case can be made that the international environment of depression, Hitler, uncertainty, and exchange rate manipulation, was actually the major cause of the 'hot' money flows of the 1930s.
In fact, all evidence suggests that they were the cause of the abandonment of fixed rates rather than vice versa.
The appeal to unusual historical experience is no basis for rejecting flexible rates, say its advocates. The Canadian experience in contrast actually suggests that private short-term capital movements were stabilizing, and cushioned exchange rate movements rather than accentuated them.
Whether destabilizing capital flows in the present international environment would prevail in a system of flexible rates can hardly be determined in advance.
The fact remains that the existing system also induces disruptive 'hot' money flows during currency crises, necessitating costly rescue operations, as with the pound sterling in 1964.
Is this any worse than one would expect if the pound had been free to seek an equilibrium level?
Another common argument is that flexible exchange rates will allow and validate inflationary domestic monetary policies. That is, the discipline of limited international reserves is removed and countries will be free to pursue rapid growth and high employment policies without consideration for the effects on domestic prices of imported raw materials.
As a result, the country's currency will depreciate, raising the prices of imported raw materials, which in turn will induce further price rises and wage demands to offset the new higher cost of living.