Page 211 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 18 : Merits and Demerits of Fixed and Flexible Exchange Rate

levels of output, employment and income in its export industries. The rise of exchange rate will Notes
also lower the cost of imports, thus discouraging output and employment in A’s import
competing industries. Thus importers and exporters will be at a disadvantage and the volume
of trade will decline. This is illustrated in terms of Sodersten’s diagram, shown as Figure 1. The
horizontal line S shows stable or fixed exchange rate, and the zig-zag line F shows flexible
exchange rate. At time t the exchange rate is the same E, under both flexible and fixed rate
0
systems. At t , the currency depreciates and the flexible exchange rate moves to D while the
1
fixed exchange rate is at the same level D (= E). Since import prices have risen, imports will be
1
discouraged and exports will be encouraged. At time t the currency appreciates and the flexible
2
rate moves to A whereas the fixed rate remains at the same level A (= E).
1
At A import prices fall. Imports are encouraged and exports are discouraged. So exports will be
at a disadvantage at A than at A and importers will gain at A than at A . Similar will be at time
1
1
t with fixed exchange rate at C and the flexible exchange rate at C level. Thus fluctuations of
3 1
the exchange rate around a trend value will increase risks for exports and imports that will
adversely affect the volume of foreign trade.

D C
Exchange Rate E D 1 A 1 C 1 F S

A

Time
t 0 t 1 t 2 t 3
Figgure 18.1

4. Under this system, speculation adversely influences fluctuations in supply and demand for
foreign exchange. Critics argue on the basis of empirical evidence that speculation is destabilising
which means that it aggravates fluctuations in exchange rate. “It is often said that speculators
see a decline in the exchange rate as a signal for further decline, and that their actions will cause
the movement in the exchange rate to be larger than it would be in the absence of speculation.
In such a case, speculation is destabilising. Sodersten points out that “the limited experience
from the 1920s seem to show that speculation at that time was destabilising. Since floating rates
became common in 1973, fluctuations in exchange rates have been large. It seems that some of
the excessive fluctuations have been caused by destabilising speculation.” Such fluctuations
increase uncertainties in trade and reduce the volume of foreign trade further.
5. Another serious drawback of a flexible exchange rate system is its inflationary bias. Critics argue
that under a system of flexible exchange rates, a depreciation of the exchange rate leads to a vicious
circle of inflation. Depreciation leads to a rise in import prices thereby making import goods more
expensive. This leads to cost-push inflation. At the same time, export prices rise. Consequently,
with the rise in the cost of living, money wages rise which, in turn, intensify inflation. But an
appreciation of currency is unlikely to lead to a reduction in wages and prices when imports prices
fall. This is because wages and prices are sticky downwards. This leads to an asymmetry which
produces that Triffin calls ratchet effect that imparts an inflationary bias to the economy.
6. The main case against the system of flexible exchange rates is that it breaks up the world market.
There is no one money which serves as a medium of exchange, unit of account, store of value
and a standard of deferred payment. Under it, the world market for goods and capital would
be divided. Resources allocation would be vastly sub-optimal. In fact, such a system clearly
would not last long, according to Kindleberger.

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