Flexible Exchange Rates: On the Move
A final reservation concerning flexible exchange rates is of prime importance.
This kind of argument is that internal and external economic matters are so inextricably entwined, that even flexible exchange rates will not insulate the domestic economy from happenings abroad over which no single nation has control.
The argument underscores the need under any financial arrangement for international cooperation.
When international movements of capital flow freely changes in the domestic level of interest rates relative to those abroad affect the volume and direction of capital flows.
Most capital movements also affect the supply or demand of foreign exchange and therefore the level of the exchange rate which in turn affects the current account balance.
Consider country 'A' in 'internal balance' with full employment and reasonable price stability. If interest rates abroad rise, capital outflows from country A to foreigners will increase.
This causes a depreciation in country A's currency. The depreciation in turn causes an increase in net exports, thereby raising demand in country A and inducing inflation.
The country's monetary policy must react to the exchange rate movement to stop the inflation.
In other words, the domestic policy of country A is not independent or isolated, but must be coordinated in a very basic sense with policies abroad over which A has no voice or control.
Opponents of flexible exchange rates generally use one or more of the arguments to show that flexible exchange rates will be unstable exchange rates.
Indeed, flexible exchange rates can be unstable rates, since the demand and supply of foreign exchange depend on among other factors.
Relative international prices, relative rates of growth in national incomes, and international interest rates differentials--- a prolonged movement of one or more of these variables for a country which is out of step with the rest of the world will introduce prolonged one-way movements in the demand or supply of foreign exchange and of the exchange rate.
Once it is clear that the movement in the exchange rate will be in one direction only, private speculators will line up on one side of the market only.
Moreover, this forces a more rapid and destabilizing movement in the rate which can only be stopped by massive contra-speculation by the country's monetary authorities and by fundamental changes in domestic policies.
But the advantage of flexible rates lies in meeting once-and-for-all changes in international relationships.
To cope with a bout of inflation which is eventually stopped in the country of origin, a flexible exchange rate will realign international price relationships without a deflation of equal magnitude to bring the foreign balance back into equilibrium.
It appears then, that so long as a country's prices, growth rate, and interest rates do not get flagrantly out of line with those of its trading partners, a flexible exchange rate will be a basically stable one, and will ease the adjustment to once-over changes with economic conditions abroad.
But coordination of policies with those abroad is a necessary factor in keeping the exchange rate stable.