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International Trade and Finance

Notes trade deficit, the central bank will be obliged to intervene to defend the exchange rate. Given finite
holdings of foreign reserves, market participants will recognize that the central bank will eventually
run out of foreign reserves with which to conduct this defense. At this stage, market participants may
start selling to get out before the central bank runs out of reserves and is forced to devalue. As a
result, the collapse can be brought forward in time, even when a central bank still has large reserve
holdings. More importantly, speculators may begin to speculate against any currency they believe
“subjectively” to be weak. In modern financial markets, speculators can raise enormous amounts of
leverage that dwarf the foreign reserves of the central bank. Therefore, they can engage in a war of
attrition that they can win as long as the central bank with weak currency is the one forced to defend
the exchange rate. In effect, fixed exchange rates offer speculators a form of “one-way” option. If they
speculate and win, they reap the huge reward of devaluation : if the central bank fights off the
speculative attack, all they have lost are the transactions costs and interest for a short period, and
these transaction costs are increasingly small due to technological innovations in electronic commerce.
The upshot is that fixed exchange rates are fragile in a world with international capital mobility. This
means that there is always a risk of speculatively induced collapse, and reducing that risk requires
that countries hold large quantities of costly foreign reserves.
A final problem with fixed exchange rates concerns their impact on private-sector borrowing decisions,
particularly in developing countries. Fixed exchange rates create a moral hazard, whereby agents
think there is no currency risk associated with foreign currency borrowing. Agents, therefore, over-
borrow foreign currency, and sudden collapses of the exchange rate can leave them saddled with
huge debt burdens measured in domestic currency terms. At this stage, a country can be plunged
into a cycle of debt deflation and economic contraction, as happened in East Asia and Argentina.
17.3 Flexible Exchange Rates

In a flexible system, the exchange rate is determined by market forces of demand and supply for a
currency. Among economists, there is a generic presumption that markets are stable, and that the
actions of agents as represented by demand and supply are based on rational decisions predicated on
“economic fundamentals,” and that market economies (i.e., the full network of individual markets
that make up the economy) have a propensity to adjust smoothly and rapidly to full employment
equilibrium in the absence of market impediments (i.e., inappropriate regulations and restrictions on
price adjustment). This generic presumption predisposes economists to look favorably on flexible
exchange rates.
The principle advantage of flexible exchange rates concerns their ability to insulate and stabilize
economic activity. With regard to external shocks, the exchange rate can adjust to maintain trade
balance. Thus, if export demand declines, the exchange rate can depreciate to lower export prices and
restore demand. In effect, the external sector can be balanced by adjusting one price (the exchange
rate) rather than adjusting thousands of prices, which would be necessary if restoring balance through
downward aggregate price and nominal wage adjustment. In addition, a flexible exchange rate can
help in the adjustment to internal demand shocks. Thus, a domestic boom will tend to raise domestic
interest rates, thereby attracting financial inflows and driving up the exchange rate. This appreciation
will tend to reduce export demand and switch consumption away from domestically produced goods
to imports, thereby reducing aggregate demand and cooling the boom.
A second major advantage of flexible exchange rates is that they strengthen the power of monetary
policy, which can be used to ensure domestic economic balance. Thus, in recession, the monetary
authority can lower interest rates, thereby causing financial capital to exit, which depreciates the
exchange rate and stimulates net exports.
Balanced against these advantages are some disadvantages. First, flexible exchange rates imply
exchange-rate uncertainty that raises the cost of international trade to the extent that firms hedge this
uncertainty. The greater the volatility of exchange rates, the greater the uncertainty and cost. Perhaps
even more important is that exchange-rate uncertainty may cause firms to diversify sources of
production internationally to protect against exchange-rate changes that can adversely affect their
costs and competitive positions. This hedge-driven diversification is inefficient, being driven by

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