It must be noted that the volatility of flexible exchange rates has a counterpart in fixed exchange rate systems. Even if the exchange rate is fixed at its appropriate long-run level, speculative forces and capital flight can cause a huge drain on a country's foreign exchange reserves, as happened during the Asian crisis in the late 1990s. Only if a country has an equally huge stock of foreign exchange reserves can such foreign exchange crises be overcome without a currency devaluation.
Media Illustrations
Example 1
Then there's the state of the dollar, which has been bleeding steadily despite transfusions from borrowings and foreign reserves. Will the higher interest rates stop the hemorrhage?
What does "bleeding steadily" mean in this context?
It means that the value of the dollar has been falling.
What does "transfusions from borrowings" mean, and how do borrowings tend to stop the bleeding?
The borrowings are bond sales to foreigners. Such sales mean either that foreigners buy dollars to buy the bonds, or that we convert the foreign currency proceeds of these sales into dollars, both of which increase the demand for dollars on the foreign exchange market, putting upward pressure on the dollar.
What does "transfusions from foreign reserves" mean, and how do foreign reserves tend to stop the bleeding?
This phrase refers to the government using some of its foreign exchange reserves to buy dollars on the foreign exchange market. This extra demand for the dollar puts upward pressure on its price.
What will happen if the "transfusions from foreign reserves" method is employed over a long period of time?
The government will run out of foreign reserves, a currency crisis will develop, and the dollar will be devalued.
What logic lies behind the idea that higher interest rates might "stop the hemorrhage"?
The higher interest rates should induce capital inflows, increasing the demand for U.S. dollars and putting upward pressure on its price.
Example 2
Furthermore, current monetary policy appears to be conducted as if we were on a fixed exchange rate. Policy is effectively geared to maintaining the exchange rate at the expense of a domestic recovery.