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International Trade and Finance

Notes 7. Again, according to Sohmen, the system of flexible exchange rates re-inforces the effectiveness
of monetary policy. If a country wants to increase output, it will lower interest rates under a
regime of flexible exchange rates, the lowering of interest rates will result in an outflow of
capital, a rise in the spot rate for the currency which will, in turn, cause exports to rise and
imports to fall. The increased exports will tend to rise domestic prices, or income or both. Thus
a favourable trade balance will reinforce the expansionary effects of lower interest rates on
domestic spending, thereby making monetary policy more effective. The above process will be
reversed if the country wants to fight inflation by raising interest rates.
8. A system of flexible exchange rates does not require the introduction of complicated and
expansive trade restrictions and exchange controls. Thus the cost of foreign exchange restrictions
is removed.
9. Again, as a corollary to the above, the world can get rid of competitive exchange rate depreciation
and tariff warfare among nations and there shall be no need of forming custom unions and
currency areas which are the concomitant results of the system of fixed exchange rates.
Demerits of Flexible Exchange Rates
The advocates of fixed exchange rates advance the following arguments against a system of flexible
exchange rates :
1. Critics of flexible exchange rates point out that market mechanism may fail to bring about an
appropriate exchange rate. The equilibrium exchange rate in the foreign exchange market at a
point of time may not give correct signals to concerned parties in the country. This may lead to
wrong decisions and malallocation of resources with the country.
2. It is difficult to define a freely flexible exchange rate. It is not possible to have an exchange rate
where there is absolutely no official intervention. Government may not intervene directly in
the foreign exchange market, but domestic monetary and fiscal measures do influence foreign
exchange rates. For instance, if domestic saving is more than domestic investment, it means
that the country is a net investor abroad. The outflow of capital will bring down the exchange
rate. All this may be due to the indirect impact of government policies. Further, in the absence
of any understanding among governments about exchange rate manipulation, the system of
flexible exchange rates might lapse into anarchy, for every country would try to establish
favourable exchange rates with other countries. This may lead to retaliation among nations and
result in war of exchange rates with disruptive effects on trade and capital movements. Thus
some sort of understanding or agreement concerning exchange rates is implied in a regime of
flexible exchange rates.
3. Another disadvantage of this system is that frequent variations in exchange rates, create exchange
risks, breed uncertainty and impede international trade and capital movements. For instance,
an Indian who imports from Japan and promises to pay in yen runs the risk that the rupee price
of yen will rise above expected levels. And the Japanese exporter who sells for rupees runs the
risk that the yen price of rupees will fall below expected levels. Similarly, exchange risks may
be even more serious for long-term capital movements. This is because under a system of flexible
exchange rates borrowers and lenders will be discouraged to enter into long-term contacts and
the possibility of varying burden for servicing and repayment may be prohibitive.
Bo Sodersten has shown how flexible exchange rates increase uncertainty for traders and have
a dampening effect on the volume of foreign trade. Assume that a country is under a regime of
flexible exchange rates, the general price level is stable and the balance of trade is in equilibrium.
Suppose the demand for the country’s exports decreases, this leads to depreciation of the
country’s currency which, in turn, raises import prices and brings a fall in imports. Consequently,
importers will be adversely affected. At the same time, exporters will gain with the increase in
the prices of export goods. But the volume of exports will decline whereby they will also be
losers. Opposite will be the consequences when currency appreciates. Suppose there is an
abnormal inflow of short-term capital to country A which tends to raise its exchange rate. This
will, in turn, increase the cost of A’s exports in terms of foreign currencies, thereby lowering the

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