The Advantages and Disadvantages of Flexible Exchange Rates - dummies

The Advantages and Disadvantages of Flexible Exchange Rates

By Ayse Evrensel

During wars and other military conflicts, the gold standard was abandoned. During these times, fiat currency and, consequently, flexible exchange rates ruled. Therefore, the post–Bretton Woods era starting in 1973 with its fiat currency and flexible exchange rates is no stranger to the international monetary system.

The only difference is that, although the fiat currency/flexible exchange rate combination was implemented as a transition policy during wars under a metallic standard, this combination became the norm after 1973.

A perception problem crops up with the gold standard. Because the gold standard is associated with fixed exchange rates and renders monetary policy ineffective, the gold standard means stability. However, history has seen no continuous gold standard period. The impossibility of conducting independent monetary policy under a metallic standard prompted countries to go off the standard during wars, independence wars, revolutions, and similar events.

In terms of how the Bretton Woods period went, the problem of selective memory is at work. Especially in the U.S., some people prefer to remember the mid-1940s portion of the Bretton Woods era, when the U.S. and the U.S. dollar seemed strong. This memory is reflected over the entire Bretton Woods era, describing it as a stable period.

In reality, only the first five or six years of the era were good for the U.S., with a strong U.S. economy and dollar. Starting in the 1950s, the conditions worsened steadily for the U.S. until 1971, when the Bretton Woods system broke down.

When the Bretton Woods system ended in 1971, the U.S. was a country with a higher inflation rate, a large current account deficit, and a weaker currency, none of which happened overnight.

The flexible exchange rate system has these advantages:

  • Flexible exchange rates as automatic stabilizers: The necessity of maintaining internal and external balance under a metallic standard is based on the fact that a metallic standard leads to a fixed exchange rate regime. If the relative price of currencies is fixed and a country’s output, employment, and current account performance and other relevant economic variables change, the exchange rate cannot change.

    This fact causes friction in the entire economic system. However, if exchange rates are allowed to change, they change in the appropriate direction, given the nature of changes in the variables affecting the exchange rates. The monetary policy and growth performance of a country affect exchange rates.

    For example, when foreigners’ demand for a country’s exports declines, output also decline and the country’s currency depreciates. This situation helps improve the country’s export performance because depreciation makes the country’s goods cheaper to foreigners. If the same initial shock happened under the fixed exchange rate regime (decline in the demand for the country’s exports), then because the exchange rate can’t change, the country must reduce the money supply, which further decreases the output.

  • Monetary policy autonomy: Under the flexible exchange rate regime, countries can implement autonomous monetary policies to address problems with inflation and output. Because monetary policies affect inflation rates, countries can decide on their long-run inflation rate and don’t have to import their trade partners’ inflation rate, as is the case under a fixed exchange rate.

    A larger divergence among inflation rates has occurred during the post–Bretton Woods era. Clearly, the extent of monetary policy in either direction (expansionary or contractionary) affects the exchange rate under the flexible exchange rate system. An increase (decrease) in the money supply leads to the depreciation (appreciation) of a currency.

The main disadvantages of the flexible exchange rate system follow:

  • Exchange rate risk: The main disadvantage of flexible exchange rates is their volatility. In the post–Bretton Woods era, one of the characteristics of flexible exchange rate is their excess volatility. The changes in exchange rates are more frequent and larger than the underlying fundamentals imply.

  • Potential for too much use of expansionary monetary policy: The downside of being able to conduct autonomous monetary policies is the ability to create higher inflation rates. Under a flexible exchange rate regime, expansionary or contractionary monetary policies can address recessionary or inflationary pressures, respectively. Especially when expansionary monetary policies are frequently used, higher rates of inflation follow.

  • Questionable stabilizing effects: Previously, automatic stabilizing was mentioned as an advantage of the flexible exchange rate system. Exchange rates change in the appropriate direction when the country’s inflation rate, output, and current account balance change. Especially in terms of current account imbalances, exchange rates determined in the foreign exchange markets are supposed to change to prevent the occurrence of persistent and large current account deficits and surpluses.

    However, some countries have deficits (such as the U.S., Spain, Portugal, and Greece), and some countries have a surplus (such as Germany and China). Moreover, the data indicate long swings in major exchange rates, which are called misalignments.

    Therefore, it seems that flexible exchange rates do not change frequently enough to eliminate current account imbalances. An adverse effect of these misalignments is that they give deficit countries the motivation to impose trade restrictions.