Adopting The Flexibility of Exchange Rates

Is it really possible for a country to adopt a policy of flexible of exchange rates?

It could be done unilaterally, although this would be in violation of the IMF articles.

In such a case, the country would refrain from foreign exchange market intervention (or intervene only on a limited scale), or in the case of the United States, would refuse to buy and sell gold at a fixed price.

The international repercussions of individual countries opting for exchange flexibility would depend on the magnitude of the involvement of each country in international financial relationships.

But still another prerequisite concerning the behavior of countries is necessary if flexible exchange rates are to prove beneficial.

Given a relation between political power and international economic prestige, political pride could play a role in a flexible exchange rate system.

The 'strong currencies', which normally means those of surplus countries, have a big voice in international matters, and the weak currencies sometimes speak in muted and humble tones despite, as in the case of the United States, considerable economic power.

Pride might dictate that the United States and United Kingdom have currencies which do not depreciate vis-a-vis the foreign currencies.

This very political pride would impose some sense of discipline (internal deflation) required today under the gold exchange standard.

In this case, flexible exchange rates will have lost most of their economic value from the viewpoint of a nation's internal policy since the policy measures followed would be essentially those required of a country with fixed exchange rates and limited reserves.

On the other hand, if pride is less a factor, and if the pound and dollar are freed, certainly the pound, and probably the dollar, would decline in value vis-a-vis other currencies.

In this event, there would be no gold outflow and no need to inhibit growth; but there would be a political 'crisis' in the sense that the dollar and the pound would be cheaper.

How great a crisis depends on how much pride. At the same time, the international cheapness of the dollar and the pound would equilibrate the balance of payments of the United States, the United Kingdom, and the surplus countries as well.

For all their apparent virtues, flexible rates are not popular with traders, bankers, or the IMF--- in short, with 'practical people'.

Of course, such a risk arises to a degree under the present system because exchange rates may vary within one percent on each side of the par rate.

At the present time, short-term exchange rate risks may be hedged in the forward exchange market by the purchase or sale of foreign (or domestic) currency to be delivered in the future, at a price set now.

The cost of cover--- the difference between the spot price of foreign exchange and the price of foreign exchange for future delivery--- is the explicit cost of foreign transactions.

With flexible exchange rates, the spot rate can fluctuate, theoretically without limit, and presumably (although by no means certainly) the cost of cover would be higher, thus tending to make foreign trade more costly. In addition, foreign investment of a longer-term nature could not be covered for exchange risk, since limited forward markets in foreign exchange exist for maturities over one year.

Even so, this element of risk is fairly small. The advantage of a one percent higher rate of return on a twenty-year foreign investment can be offset only by a large exchange rate change.