Flexible Exchange Rates - Arguments For and Against - International Economics

1/26/2021 Flexible Exchange Rates: Arguments for and against | International Economics
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Flexible Exchange
Rates: Arguments for
and against |
International
Economics
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The debate concerning the fixed versus flexible

exchange rates is not complete unless the
arguments that the economists have advanced in
support of and against the system of flexible or
fluctuating rates of exchange are considered.
Arguments for Flexible Exchange Rates:

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The main arguments in favour of the| Sponsored
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(i) Simple Mechanism:
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The system of flexible exchange rates operates in

an easy, quick and efficient manner in clearing
the foreign exchange market. It ensures an
automatic adjustment between the forces of
demand and supply. The mechanism is simple
because it can work efficiently without involving
any intervention of the monetary or fiscal
authorities in the foreign exchange market.
(ii) Continuous Adjustments:
Under a fixed exchange system, there are periodic

crisis and aggravation of balance of payments
pressures. It is essential that the corrective
actions are taken. The success of these corrective
measures is never definite. In contrast, under a
system of flexible exchange rates,Top
there are
24 Richest and Poorest Countries of Africa -
smooth and continuous adjustments in the
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foreign exchange market through appropriate
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changes in the rates of exchange.
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(iii) No Need of Accommodating Gold or

Capital Movements:
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Unlike the fixed, exchange system where the

achievement of BOP equilibrium requires the
accommodating gold or capital movements, there
is no such necessity under flexible exchange rates.
The automatic exchange rate adjustments ensure
the maintenance of BOP equilibrium even
without the accommodating transactions.
(iv) No Necessity of Adjustments through

Price and Income Changes:
In the fixed exchange system the BOP

equilibrium may necessitate deliberate resort to
deflationary or inflationary policies. The objective
may be achieved sometimes also through the
income and expenditure policies. The effects of
such policies may be quite widespread in the
economy. In contrast, the flexible exchange
system can ensure the automatic BOP adjustment
through the simple mechanism of freely flexible
exchange rates rather than price and income
variations.
(v) Removal of the Problem of

International Liquidity:
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In a system of flexible exchange rates, a deficit

country is simply to allow its currency to
depreciate and adjust the BOP equilibrium. On
the other hand, the pegging of exchange rate and
the removal of payments deficit under the fixed
exchange rates requires large inflows of foreign
currencies.
Therefore, the countries under the latter system

remain faced with the problem of shortage of
international liquidity. There is no such problem
under flexible exchange rates. The activities of
speculators will ensure the additional supply of
liquid resources or withdrawal of surplus liquidity
from the exchange market.
(vi) Economical:
The flexible exchange system is very economical.

There is no idle holding of international currency
reserves that is so essential underEveryday
the systemChimpof
fixed exchange rates. The countries having
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flexible exchange system can make an optimum

use of their entire available exchange reserves.
(vii) Beneficial for International Trade:
There is a wrong impression that the instability of

exchange rates will have an adverse effect on the
expansion of international trade. On that logic,
the fixed exchange rates were supported. In this
connection, it is argued that the flexibility of
exchange rates maintains the rates of exchange at
their natural level. Sometimes the problems in
international trade under the fixed exchange
system arise because there are objections that the
currency of a particular country is over-valued or
under-valued compared with what should have
been its natural rate of exchange.
In such situations the trade is seriously

hampered. No such problems, however, can arise
in the case of a flexible exchange system because
exchange rates are likely to remain at the natural
level due to continuous market adjustments.
Therefore, the latter can ensure sustained
expansion of trade and steady growth of the
economy.
(viii) No Need of International

Institutional Arrangements:
In a system of stable exchange rates, there
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necessity of international monetary institutions
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for borrowing and lending of short- term funds Privacy - Terms
for maintaining exchange rate parities and for

settling BOP problems. The job done by the
institutions like IMF can be handled quite
efficiently by the freely fluctuating system of
exchange rates. Thus the flexible exchange system
can dispense with complex international
institutional arrangements.
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(ix) Autonomy in Domestic Policies:
Under a stable exchange system, conflict may

arise between the objectives of internal price
stability and full employment on the one hand
and exchange stability on the other. A country,
faced with BOP deficit and possible depreciation
in exchange rate, will have to resort to
contractionary monetary and fiscal policies. Thus
domestic economic policies become subordinated
to the state of external trade and Top
payments.
24 RichestThe
and Poorest Countries of Africa -
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internal stability is likely to be sacrificed for the
achievement of external stability. Continue Reading
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In case of flexible exchange system, the

continuous automatic adjustments in external
disequilibria can be possible without resort to
deliberate deflationary or inflationary policies. In
this regard, Johnson comments, “The
fundamental argument for flexible exchange rates
is that they allow countries autonomy with
respect to their use of monetary, fiscal and other
policy instruments, by automatically ensuring the
preservation of external equilibrium.”
(x) No Necessity of Controls:
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The BOP adjustments under a system of fixed

exchange rate can be effected only if there is an
elaborate regime of controls on imports, exports
and capital movements. These controls cause
distortion in the efficient production and
distribution of goods. The efficiency of Richest
Top 24 the systemand Poorest Countries of Africa -
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of controls is highly doubtful on account of
bureaucratic red-tapism, corruption and a Continue Reading
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tendency to screw up the whole system more and

more tightly.
In contrast, the flexible exchange system can

maintain the exchange values of the currencies at
their natural level through market adjustments.
The regime, of controls can be dismantled, if
reliance is placed upon the flexible exchange
rates.
(xi) No Retaliation:
In the past, under the system of fixed exchange

rates, the world was witness to competitive and
retaliatory devaluation. Such developments and
tariff warfare are not likely to exist, atleast to
some extent, under a system of freely flexible
exchange rates.
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(xii) Reinforces Monetary Policy:
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If a country is faced with inflationary conditions Continue Reading
along with a BOP deficit, a restrictive monetary Privacy - Terms
policy of higher discount and interest rates may

be adopted. Such a policy is likely to restrict
spending which will have a disinflationary effect.
It may also bring about some reduction in
imports. As a consequence, the BOP deficit is
likely to be reduced. Sohmen pointed out that the
flexible exchange rates will reinforce the anti-
inflationary monetary policy and contribute also
in removing the BOP deficit.
The higher interest rate policy will induce inflow

of capital from abroad. It will bridge up whatever
external deficit is left. The rise in the exchange
rate of the home currency will stimulate imports
and lower exports. These developments have a
further disinflationary effect. Similarly
expansionary monetary policy, involving lower
interest rates to tackle internal recession and
unemployment, will be strengthened by
depreciation of the home currency caused by the
outflow of capital.
The exchange depreciation will encourage

domestic exports and restrict imports. These
factors will have the off-setting effect on
recessionary tendencies. Thus the free
movements of exchange rates can reinforce the
domestic monetary policy to make it more
effective both during the periods of inflation and
recession. Everyday Chimp
Arguments against Flexible Exchange Continue Reading
Rates: Privacy - Terms
The main objections which are raised

against the system of flexible exchange
rates are as follows:
(i) Possibility of Disequilibrium:
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In case of flexible exchange system, it is believed

that the free working of the market forces results
in the establishment of rate of exchange that
corresponds with the BOP equilibrium. There is a
possibility that the demand and supply forces in
the foreign exchange market operate in such a
way that the exchange rate diverges farther and
farther from the natural level of rate of exchange
and the variations in the rate of exchange fail to
bring about the BOP equilibrium.
(ii) Indirect Government Intervention:

The flexible exchange system presumes
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government does not interfere inEverydaychimp
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exchange market. The government may not
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https://www.economicsdiscussion.net/exchange-rate/flexible-exchange-rates-system/flexible-exchange-rates-arguments-for-and-against-internation… 10/26
directly interfere through pegging or exchange

controls and regulations. But there can still be
indirect government intervention through the
impact of monetary and fiscal policies. The
imposition of additional excise duties raises costs
and prices of the products and has a discouraging
effect upon exports.
The subsidies, on the opposite, may facilitate an

increase in exports. The changes in interest rates,
essentially for dealing with internal inflation and
deflation can have effect on capital flows and
exchange rates. The government borrowings and
investments abroad too can have effect on the
rates of exchange. In view of indirect effects of
government policies on the rates of exchange,
there is never a freely flexible system of exchange
rates.
(iii) Not Practical:
It is advocated in this system that the exchange

rate should be allowed to be determined by the
free working of demand and supply forces in the
market. All the governments in the present day
world exercise controls upon the prices of goods,
services, capital and all other assets in varying
degrees.
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In the regime of price controls, e.g., control over

commodity prices, wages, interests, rents, profits
etc., there can be no justification of letting the
price of foreign exchange to be determined by the
market forces. Such a system of exchange rates is,
therefore, not consistent with the actual realities
of practical life.
(iv) Exchange Risks and Uncertainty:
The flexible exchange system causes frequent

variations in the rates of exchange which create
exchange risks, breed uncertainty and impede the
international trade and capital movements. If an
Indian makes imports from the U.S.A. and is to
make payments in terms of dollars, the exchange
risk arises, when the rupee price of dollar rises
above the expected levels.
There can be exchange risk to theTop

American
exporter, when the dollar price ofEveryday
rupee falls
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below the expected levels. Given the exchange
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risks, the importers or exporters may be Privacy - Terms
disinclined to enter into transactions and

international trade is likely to be impeded. These
exchange risks are likely to have even more
serious consequences for long-term capital
movements. The borrowers and lenders may be
discouraged from entering into long-term capital
contracts.
Sodersten has analysed how the flexible exchange

rates increase the uncertainty for traders and that
has a dampening effect upon the volume of
international trade. It is assumed that a country
has a regime of flexible exchange rates. The price
level is supposed to be stable in that country. It is
further assumed that the balance of trade of the
country was originally in equilibrium. A decrease
in the demand for exports perhaps due to a
change in tastes in foreign country results in the
depreciation of home currency.
The imports get reduced and the marginal

importers will be unable to compete on account of
higher import prices and they go bankrupt. The
exporters may gain because of higher prices
abroad but that gain is offset on account of
reduction in the volume of exports. The net result
will be determined by the elasticities of demand
and supply functions. Sodersten holds that the
flexible exchange system involves an extra risk
compared with the system of fixed exchange
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In the latter case, the import prices remain stable

and there is no change in the volume of imports.
Under the flexible exchange system, the
importers are hurt by exchange rate variations for
no fault of their own. Thus there is greater
exchange risk in case of flexible exchange rates.
In this regard, Sodersten remarks, “Under flexible

exchange, import and export prices will show
greater variation. An increased risk will be
connected with foreign trade, and resources will
be reallocated to a greater degree than under
fixed exchange rates. Marginally profitable
exports and imports will be out-competed and the
volume of foreign trade will be smaller than it
would be under a system of fixed exchange rates.”
This may be illustrated with the help of Fig. 23.3.

In this Fig., time is measured along the horizontal
scale and rate of exchange is measured along and
Top 24 Richest the Poorest Countries of Africa -
vertical scale. The horizontal lineEveryday
EE shows Chimp
the
exchange rate under a fixed exchange system and Continue Reading
EF is the curve representing the flexible exchange Privacy - Terms
rate. The exchange rate, to begin with, is exactly

the same regardless of the system. At the time t1,
the home currency has depreciated relative to
foreign currency.
Given the depreciated exchange rate at point A,

compared with fixed exchange rate at point A, the
imports will be discouraged while the exports will
get encouraged. At time t2, there is an
appreciation of exchange rate under the flexible
exchange system at B. In this situation, the
exports will be adversely affected whereas
imports will be stimulated.
At the time t3, the home currency has again

depreciated relative to foreign currency. Thus the
fluctuation of exchange rate around a trend value
will cause an increased risk for exporters and
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importers. It will have a dampening effect |upon
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the foreign trade. It is, of course, true that the Continue Reading
exchange risk can be averted through hedging. Privacy - Terms
But all risks associated with flexible exchange

rates cannot be off-set. Therefore, this system of
exchange rates is likely to have considerable
adverse effect on the external trade.
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(v) Destabilizing Speculation:
A very strong objection against the flexible

exchange system is that continuous variations in
exchange rate greatly stimulate the activities of
speculators in the foreign exchange market. The
speculators take the decline in the exchange rate
as a signal for a further decline and will thus tend
to make the movements in the exchange rate
sharper than they would be in the absence of
speculation.
There is strong opinion that the speculation

under flexible exchange system isTop
highly
destabilizing, i.e., it tends to widen the fluctuation
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in exchange rate.
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The evidence in support of such a contention was

provided by the exchange rate instability during
1920’s, 1930’sand after 1973 periods. Although
Milton Friedman pointed out that speculation is
stabilising, the writers like R.Nurkse and S.C.
Tsiang held that speculation was destabilizing.
Since 1973, many of the leading currencies have
been floating against one another, either
independently or in groups and the fluctuations
in the rates have been quite substantial. There are
instances when currencies fluctuated up and
down by 20 percent or more within a few months.
It is difficult to disentangle the speculative motive

from other factors influencing the exchange rate
variations. The large changes in exchange rates
that took place in post-1973 period could not be
ascribed to other economic forces. In the words of
Salvatore, “The amplified fluctuations in
exchange rates with destabilizing speculation
increase the uncertainty and risks of international
transactions and reduce the international flow of
trade and investments.”
(vi) Inflationary Impact of Flexible

Exchange Rates:
Critics of flexible exchange rates put forward a

forceful argument that this system has a strong
inflationary bias. If there is exchange
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depreciation, there can be a rise in the domestic
price level. Depreciation of exchange rate makes Continue Reading
imports more expensive. As the import prices Privacy - Terms
rise, the use of imported inputs raises the cost of

production in a number of home industries. This
leads to cost-push inflation in the home country.
The appreciation of the exchange rate, on the

opposite, is not likely to cause a fall in internal
prices because it is not likely to be passed on
further by the importers. Any extra profits
accruing from lower import prices are cornered
by them. In this connection, a counterargument is
given that the exchange depreciation can
encourage import-substitution.
If that happens, the transmission effect of import

prices will not take place. But there is very limited
possibility of import-substitution. Consequently,
the exchange variation is likely to strengthen the
inflationary pressures.
According to Triffin, a ratchet effect is associated

with the flexible exchange rates. A depreciation in
exchange rate will push up wages and prices. The
appreciation of exchange rate, on the other hand,
will not cause a comparable fall in wages and
prices because these are rigid in the downward
direction. Thus there is an asymmetry which
causes a sustained upward pressure upon the
domestic prices.
In the case of flexible exchange rates,

Top 24there can
Richest andbe
Poorest Countries of Africa -
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a vicious circle of depreciation-inflation-
depreciation. As there is depreciation of exchange Continue Reading
rate, the internal price level may go up. The Privacy - Terms
higher price level can discourage exports and

encourage imports. Consequently, BOP deficit
can appear. The excess demand for foreign
currency can cause depreciation of home
currency again. That can, in turn, cause
inflationary again.
The inflationary strains can also arise because the

flexible exchange rates bring about reallocation of
resources. The larger exchange rate variations can
cause frequent attempts at reallocation of
resources. If some cost is connected with the
reallocation of resources, the domestic prices are
likely to increase. In this respect, the flexible
exchange system is likely to be worse than the
fixed exchange system.
The continuous and uncontrolled variations in

the exchange rates can have disruptive effect on
the long terra foreign investment in the home
country. It can place a restraint upon the
productive capacity. The slowing down of the
growth of output can give rise to the inflationary
trends.
The fluctuating exchange rates invariably provide

opportunities to the speculators to make profits
through their anticipations about the future. The
speculation in rates of exchange not only affects
the exchange rates and capital flows but
Top 24 also and Poorest Countries of Africa -
Richest
Everyday Chimp
leads to inflationary consequences due to greater
uncertainty. Continue Reading
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Another line of reasoning in this connection is

that the exchange depreciation induces an
expansion in exports. There is an enlargement of
incomes of the exporters. Given an inelastic
supply of output, the increased income will
produce a demand-pull and consequent rise, in
domestic prices.
In addition, an increase in exports, consequent

upon the depreciation of exchange rate, will
reduce the domestic availability of goods, given
the less elastic supply function. This can again
lead to inflationary consequences.
Under the fixed exchange system, the monetary

and fiscal authorities remain in a state of
readiness to enforce the monetary, fiscal and.
exchange controls to ensure the internal and
external stability. Such a policy discipline is non-
existent in the flexible exchange system. All
adjustments are supposed to be made through
free flexibility of exchange rates.
The government and monetary authority are not

supposed to intervene. In the absence of anti-
inflationary policies, the society is likely to face
strong inflationary pressures. Inflation may be
the cost of maintaining the flexible exchange
system.
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(vii) Fragmentation of the World Market:
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One of the major shortcomings of flexible

exchange system is that there is an absence of a
stable medium of exchange, a stable unit of
account, a stable store of value and a stable
standard for deferred payments. The world
commodity, capital and exchange markets get
split into several small units. In such a situation,
there is sub-optimal allocation of resources and
lesser international specialization.
Consequently, the world trade and welfare of a

community get adversely affected about BOP
adjustments in the advanced countries, but it is
not suited to the LDC’s.
(viii) Not Suited to the Less Developed

Countries:
The flexible exchange system may efficiently

bring flexible exchange rates were examined
separately. In case of the latter, the necessity of
maintaining a rate of investment higher than that
of savings and difficulty in reducing imports,
while the capacity to export is limited, there are
persistent BOP deficits.
Sufficiently large flows of autonomous or

accommodating capital are not available to them.
In these conditions, the BOP deficits can be
removed through this system only if 24
Top there is and Poorest Countries of Africa -
Richest
continuous currency depreciationEveryday
almost Chimp
indefinitely. Such a situation is shown through Continue Reading
Fig. 23.4. Privacy - Terms
In Fig. 23.4, the demand curve for foreign

currency is originally D1. Given the supply curve
S, the equilibrium rate of exchange, to begin with,
is R1. In a LDC, there is continuous increase in
the demand for foreign exchange .for financing
development programmes and to offset the
persistent BOP deficit. That can cause continuous
shifts in the demand curve from D1 to D2, D3, D4
and so on. Since BOP deficit continues to exist,
there will remain a continuous tendency for
foreign currency to appreciate and for the
currency of LDC to depreciate.
If there is continuous currency depreciation,

there will be a serious loss of confidence in the
currency of this country resultingTop
in 24
a grave
Richest and Poorest Countries of Africa -
adverse effect on its trade and overall growth.
Everyday Chimp
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Flexible Exchange Rates - Arguments For and Against - International Economics

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1/26/2021 Flexible Exchange Rates: Arguments for and against | International Economics

The debate concerning the fixed versus flexible

Arguments for Flexible Exchange Rates:

flexible exchange rates are as below: Continue Reading

(i) Simple Mechanism:

The system of flexible exchange rates operates in

(ii) Continuous Adjustments:

Under a fixed exchange system, there are periodic

(iii) No Need of Accommodating Gold or

Unlike the fixed, exchange system where the

(iv) No Necessity of Adjustments through

In the fixed exchange system the BOP

(v) Removal of the Problem of

In a system of flexible exchange rates, a deficit

Therefore, the countries under the latter system

The flexible exchange system is very economical.

flexible exchange system can make an optimum

(vii) Beneficial for International Trade:

There is a wrong impression that the instability of

In such situations the trade is seriously

(viii) No Need of International

for maintaining exchange rate parities and for

(ix) Autonomy in Domestic Policies:

Under a stable exchange system, conflict may

In case of flexible exchange system, the

(x) No Necessity of Controls:

The BOP adjustments under a system of fixed

tendency to screw up the whole system more and

In contrast, the flexible exchange system can

In the past, under the system of fixed exchange

Top 24 Richest and Poorest Countries of Africa -

If a country is faced with inflationary conditions Continue Reading

along with a BOP deficit, a restrictive monetary Privacy - Terms

policy of higher discount and interest rates may

The higher interest rate policy will induce inflow

The exchange depreciation will encourage

Arguments against Flexible Exchange Continue Reading

Rates: Privacy - Terms

The main objections which are raised

(i) Possibility of Disequilibrium:

In case of flexible exchange system, it is believed

(ii) Indirect Government Intervention:

directly interfere through pegging or exchange

The subsidies, on the opposite, may facilitate an

(iii) Not Practical:

It is advocated in this system that the exchange

In the regime of price controls, e.g., control over

(iv) Exchange Risks and Uncertainty:

The flexible exchange system causes frequent

There can be exchange risk to theTop

disinclined to enter into transactions and

Sodersten has analysed how the flexible exchange

The imports get reduced and the marginal

In the latter case, the import prices remain stable

In this regard, Sodersten remarks, “Under flexible

This may be illustrated with the help of Fig. 23.3.

EF is the curve representing the flexible exchange Privacy - Terms

rate. The exchange rate, to begin with, is exactly

Given the depreciated exchange rate at point A,

At the time t3, the home currency has again

exchange risk can be averted through hedging. Privacy - Terms

But all risks associated with flexible exchange

(v) Destabilizing Speculation: