According to Triffin, a ratchet effect is associated with the flexible exchange rates. Exchange rate uncertainty can be thought of as placing a cost on trade and investment, and this cost discourages trade. Even if a government wanted to announce a planned devaluation to avoid crisis, the … It is similar to a fire in a crowded theater: although everyone easily entered the theater in an orderly fashion, if everyone tries to rush out at once, the doors jam and the fire becomes a catastrophe. If individuals saw all countries as being equal, to achieve portfolio diversification the average American investor would hold only about one-fourth of his wealth in American assets and about three-fourths in foreign assets because the U.S. economy accounts for that fraction of the world economy. Thus, it leaves countries unable to defend themselves against idiosyncratic shocks not shared by the country to which it has fixed its currency. This was a primary consideration behind the adoption of the euro.In a traditional fixed exchange rate regime, the government has agreed to buy or sell any amount of currency at a predetermined rate. For example, in the euro area, the business cycle of many of the "core" economies (e.g., Germany and the Netherlands, or Belgium and France) have been highly correlated.
First, it makes foreign goods cheaper for Americans, which increases the purchasing power of American income. Inflation may be the cost of maintaining the flexible exchange system. Sohmen pointed out that the flexible exchange rates will reinforce the anti-inflationary monetary policy and contribute also in removing the BOP deficit. If there is exchange depreciation, there can be a rise in the domestic price level. This has been dubbed the "bipolar view" of exchange rate regimes: growing international capital mobility has made the world economy behave more similarly to what models have suggested. Stanley Fischer, "Exchange Rate Regimes: Is the Bipolar View Correct?" For example, this claim is often leveled against China.In previous decades, it was believed that developing countries with a profligate past could bolster a new commitment to macroeconomic credibility through the use of a fixed exchange rate for two reasons.
In a system of flexible exchange rates, a deficit country is simply to allow its currency to depreciate and adjust the BOP equilibrium. As capital flows become more responsive to interest rate differentials, the ability of "soft peg" fixed exchange rate regimes to simultaneously pursue domestic policy goals and maintain the exchange rate has become untenable. In this Fig., time is measured along the horizontal scale and rate of exchange is measured along the vertical scale.
The exporters may gain because of higher prices abroad but that gain is offset on account of reduction in the volume of exports. This is a factor not considered in the earlier exchange rate literature, in part because international capital mobility plays a greater role today than it did in the past. For countries highly integrated with their exchange rate partners, this loss is small. Stable growth is impossible when the price mechanism has broken down in this way. In such a situation, there is sub-optimal allocation of resources and lesser international specialization. In practice, the primary problem with fixed exchange rates has been that countries have faced frequent changes in economic conditions that put pressure on the fixed exchange rate to change, but countries have proven unwilling to change the exchange rate promptly. The countries having flexible exchange system can make an optimum use of their entire available exchange reserves. If a fixed exchange rate became undervalued, then capital would flow into the country and the central bank would accumulate reserves. Second, how much of the euro area's money supply flows to, say, Ireland depends upon Ireland's net monetary transactions with the rest of the euro area. But because the greater demand for U.S. assets causes the dollar to appreciate, the demand for U.S. exports and U.S. import-competing goods declines, offsetting the increase in demand caused by the foreign capital inflow.Because floating exchange rates allow for automatic adjustment, they buffer the domestic economy from external changes in international supply and demand. The second category considered is fixed exchange rates, in which the link to the other currency or currencies is less direct, making them "soft pegs.
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