15 The Balance of Payments

16.9
Fixed Versus Flexible Exchange Rates
Which exchange rate system fixed or flexible is better? Both exchange rate systems have advantages and disadvantages, so that an answer to this question depends on the particular situation.
If every city in the United States had its own currency, economic activity and productivity in the United States would be severely curtailed. Commercial transactions involving firms in different cities would have currency-exchange-rate risks to contend with, people would have to bear costs of changing currencies every time they visited a different city, and long-term investment would be inhibited by exchange-rate uncertainty, for example. The same would be so, but to a lesser degree, if every state had its own currency, so there are tremendous benefits associated with having a common currency (a fixed exchange rate) among all U.S. cities and all U.S. states. The advantages of fixed exchange rates constitute the rationale behind the creation of a common currency in Europe.
Suppose, however, a fall in oil prices caused a major recession in Texas. Adjustment in Texas might take the form of an eventual fall in the wage of Texans, but primarily it would take the form of labor and capital moving out of Texas to other states. If Texas had its own currency, the adjustment could be facilitated by a fall in the value of the Texas currency, plus adoption of an appropriate Texas monetary policy. This is the advantage of flexible exchange rates: Flexing of the exchange rate and adoption of suitable monetary policy neither possible under a fixed exchange rate (recall that under a fixed exchange rate an independent monetary policy is not possible) can facilitate adjustment to recessions and booms.
There is a major difference between the Texas example and a world consisting of different countries, however. With different countries, labor and capital are usually not allowed to move across borders freely, suggesting that the main mechanism whereby Texas adjusts to its recession does not work across countries. This difference markedly increases the importance of having a flexible exchange rate across separate countries, and explains why within a single country it is advantageous to have a fixed exchange rate (a common currency), but across countries it is better to have a flexible exchange rate.
Unfortunately, exchange rates can flex for reasons other than the need to facilitate adjustment to recession or boom. History has shown exchange rates to be much more volatile than experts had predicted in 1971 when the world moved away from a predominantly fixed exchange rate system. As activity in financial assets markets has come to dominate the short-run determination of exchange rates, we have discovered that speculators can affect exchange rates dramatically, turning them from a stabilizing force into a destabilizing force. This possibility has caused central banks to modify the flexible exchange rate system by using monetary policy or direct intervention to stabilize exchange rates. In doing so, they must be careful to allow exchange rates to change to reflect fundamental forces such as inflation-rate differences, productivity-growth-rate differences, and natural-resource discoveries.

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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