The Exchange Rate System
There are several weak assumptions implicit in such process.
First, it was assumed that the fear of losing gold or other international reserves is required to induce the monetary managers to control inflation.
But there is no a priori reason why price stability will be abandoned as a goal simply because flexible rates are adopted.
Actually, fear of a falling currency value may act as a similar prod. Second, it is assumed that the erst of the world controls inflation, while the country in question does not.
It is only in the event of significantly different rates of price change among countries that exchange rate depreciations induce cumulative upward pressure on domestic prices.
Indeed, one of the advantages of flexible exchange rates is that changes in international cost-price relationships are equilibrated automatically, rather than requiring domestic adjustments in income and prices, or prolonging the maladjustment until an exchange crisis or devaluation occurs, as is the case under the present adjustable peg system.
Nevertheless, fear persists that these runaway trends may prevail if the flexible system is tried. For this reason, some advocates of flexible rates have suggested that limits of flexibility be set.
A somewhat more fundamental criticism of the flexible exchange rate system charges that inefficient reallocation of economic resources will be induced.
If the exchange rate varies by substantial amounts periodically, such as over the course of the business cycle, there will be an incentive to move resources into or out of the export industries and those industries which compete in the home market with imports.
For example, if the domestic currency should depreciate in an expansion, the profitability of export and import competing industries would be expected to rise vis-a-vis the industries producing for the domestic economy, and labor and capital would tend to move toward the profitable measure.
A subsequent appreciation--- in a recession, would reverse the process.
Designating resources is absolutely expensive. Costs are incurred just to move resources from one industry to another, and if the incentive for the movement reverses itself later, two costly movements may be made.
Reversible exchange rate movements cause temporary market disruption domestically and impair economic performance. An extension of this argument is even more damaging.
If business find their profits fluctuating in an unpredictable way, the incentive for new plant and equipment expenditure to modernize production processes may be retarded.
Thus, the country may lag behind the technological and productivity growth of its trading partners.
If reserves are large enough, a fixed rate country running a deficit simply uses its reserves to ride out the deficit.
But if reserves are small relative to expected deficits. As for example, the United Kingdom's have been, a deficit and reserve loss causes policy makers to adopt 'stop' policies, say, to deflate domestically in order to achieve external balance.
Here, not only does one have the adverse cost required by a temporary reallocation of resources, but in addition the country pays a further price by inhibiting the growth of the whole economy.
The 'stop' policy stops all industries; only tho turn to 'go' policies as the deficit is reduced or eliminated.
Thus, in the case of the United Kingdom and in other cases which could easily be assembled, the alternative to flexible rates may be more wasteful than flexible rates themselves.