Forex: The Flexible Exchange Rates

Economists essentially play a major role on advocating flexible exchange rates.

But the reception that flexible exchange rate proposals have received from central bankers, government treasury authorities, and the IMF can at best be described as cool.

Indeed, in international discussions of proposals for reforming the international payments system, rate flexibility has been effectively dismissed as a relevant alternative.

Yet the appeal of flexible exchange rates for many academicians persists. The root of its appeal lies in two areas. First, balance of payments adjustment under flexible exchange rates is automatic.

Potential surpluses or deficits are automatically eliminated by exchange rate changes emanating from changes in the supply of or demand for foreign exchange in the foreign exchange market.

Under a flexible rate system, the price, or exchange rate, adjusts so as to keep supply equal to demand without any, or only minimal, official sales and purchases.

Thus, balance of payments equilibrium is insured.

Second, this automatic adjustment occurs without the traumatic changes in domestic prices, incomes, or commercial policy associated with fixed exchange rates. With flexible exchange rates, few international reserves are needed since the primary function of reserves is to finance a deficit at a fixed rate of exchange.

With no deficit to finance, reserve losses cannot compel domestic deflation; therefore economic policy is freer to pursue domestic objectives.

More than one type of flexible exchange rate system is possible. At the extreme, the exchange rate may be allowed to seek its own level without any intervention by governmental authority (say, a completely free foreign exchange market).

In this situation, international reserves serve no function; gold would lose its 'international' role and become simply another metal.

On the other hand, governmental agencies, while allowing the exchange rate to find its own level, may smooth exchange rate movements through official purchases and sales of foreign exchange in the market.

This practice was followed by Canada when that nation allowed dollar to float.

If official intervention is the practice, some reserves like gold or foreign currencies, are necessary to carry out the official operations.

To install a world system of flexible exchange rates would require an international agreement among the major countries to effect that no country would interfere in the market for foreign exchange, or, at least the agreement would set standards to limit intervention.

In addition, a procedure for liquidating some or all of the present holdings of gold and foreign exchange reserves would have to be provided, so as to minimize the distortions of exchange rates that otherwise result from liquidation of excess reserves.

Furthermore, either the International Monetary Fund would be eliminated or its function would be reduced in magnitude; say, to assist underdeveloped countries with their foreign exchange problems.

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