Introduction
Importance of the Flexible Exchange Rates
Flexible exchange rates offer an automatic partial cushioning against export demand shocks. When export revenues drop, the national currency starts to depreciate.
This depreciation will generate some new demand for national product. Exporters will find that foreign demand for their product is buoyed up by the fact that their prices denominated in the depreciated home currency now look cheaper to foreign buyers.
Import-competing industries will also tend to win a larger share of domestic markets now that the competing foreign goods look more expensive. These effects of the exchange-rate depreciation do not erase the effect of initial loss of export incomes, which is still being transmitted through the economy, but they do help to offset that effect with demand stimuli, helping to stabilize the economy automatically.
Flexible exchange rates also make it easier to shield the domes tic money supply from an external money drain, by bringing the net international flow of money back to equilibrium after any issue. (The case of unanticipated rises in export demand is symmetrical to the case of demand drop mentioned here with the threat of excessive inflation rather than excessive unemployment and real income loss).
Another external shock to which economies are subject is the unpredictable shifting, of internationally mobile funds in response to such events as rumors about political changes or new restrictions on international asset holding.
This dilemma threatens to upset the domestic economy by causing a surge or 'plummeting of the money supply'. A sudden capital inflow threatens to raise the money supply that can be lent, driving down interest rates and expanding spending, with inflation as a possible end result.
A sudden capital outflow, conversely, threatens to drain off part of the money supply, triggering a recession.
To determine which exchange-rate system offers the most stability in the face of such capital-flow issues, take the case of a sudden capital flight from the country. It is easy to see that the much stable exchange-rate system in this situation is that of a fixed exchange rate with sterilization of all payments imbalances.
If the authorities can succeed in keeping the capital outflow, with its transfer of money into the hands of foreign borrowers, from affecting the domestic money supply, the shock will have no effect at all on the domestic economy. The central bank will just make up the loss of some money into foreign hands by lending more money to domestic residents,
On the other hand, if the money outflow cannot be offset, the resulting contraction of the money supply will cut national income.
Flexible exchange rates yield an intermediate outcome in the face of capital-flow shocks.
They clearly cushion the economy relative to the case of fixed exchange rates without sterilization, which allow the capital outflow to bring an equal reduction in the money supply available to domestic residents. With flexible rates, the capital outflow is allowed to depreciate the nation's currency in the foreign exchange markets.
This depreciation makes it easier for the nation's producers to compete with foreign producers, improving the trade balance and shifting the IS curve to the right. This stimulative effect is not possible with fixed exchange rates in the absence of sterilization. With flexible exchange rates, however, the net effect of the capital-flow shock on income depends on what happens to the money supply.
With flexible rates, it should be easy for the central bank to offset the initial effect of the capital outflow on the money supply by an expansion of its domestic lending.
If the central bank does sterilize the money outflow in this way, then the effect of the capital outflow is the stimulative effect just described, and the capital outflow actually adds an expansionary shock to the economy.