Forex: Adopting Flexible Rates

Why adopt flexible rates?

If, even with flexible rates, international coordination and internal restraint are still necessary--- the basic issue remains.

The answer must lie in the lesser degree of coordination necessary, a degree tolerable even to nations unwilling to surrender much sovereignty.

Moreover, this is the only system that will restore appropriate international price relationships automatically when they get out of line without inducing domestic price changes.

Aside from the basic economic arguments against flexible rates advanced above, there remain a number of operational complexities and practical problems attaching to a system of flexible rates would pose the problem of many currencies fluctuating against each other.

Theoretically without limit, thus making calculations of the cheapest way to make international payments a complicated procedure.

For example, if France, England, and the United States each had flexible rates, there would be a dollar/sterling pound, dollar/franc and a sterling pound/franc rate in New York.

Furthermore, for each of these 'spot' rates, there would be one or more 'forward' rates for each currency to be considered, all fluctuating against each other, with no limits to the range of fluctuation.

If all world currencies were so cross-connected, foreign exchange dealings would become complex indeed.

It is true that even under the present system, there are similar considerations, but the rates are fixed within narrow limits and the loss (or gain) from a miscalculation cannot be large.

In addition, most international transactions today are carried out in one or two 'vehicle' currencies which serve as international units of account. It is possible, but not certain, that this convenient device would continue under flexible rates.

Moreover, private speculators will give traders the opportunity to hedge foreign exchange transactions--- at a cost--- and it may well be that more sophisticated forward exchange markets would develop and reduce the fluctuations of currency cross-valuations.

Second, should a flexible exchange rate system be adopted in which official institutions engage in operations to smooth exchange rate movements, the very important possibility exists that two countries' operations would be at cross purposes and either cancel each other out or compound the amount of intervention.

Thus, if both the pound and the dollar were appreciating the United States might find itself buying pounds for dollars while the United Kingdom was buying dollars for pounds.

To avoid this, a high degree of coordination between central banks (or other institutions) would be necessary.

Third, for a country with heavy involvement in international transactions, fluctuating prices of foreign exchange may prove to be intolerable to traders and others.

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