Policies with Floating Exchange Rates

The main argument put forward in favor of floating rates is that they remove the burdens of policies to deal with deficits from the domestic economy. There is no need for a country to hold large reserves of foreign currency and no need to depress home demand when there is a deficit on the balance of payments. But floating rates do not remove bal­ance of payments problems so neatly as the theory indicates, neither do they isolate the economy from external forces. Surpluses and deficits, it is true, will change the relative prices of imports and exports via changes in the exchange rate, and this movement will bring about an equilibrium in the balance of payments. This latter situation will only come about if the volumes of imports and exports change by the correct amounts, and this depends upon the elasticities of demand for, and supply of, exports and imports. In any case, changes in the volumes of exports and imports take time, and the time lag between the change in the exchange rate and the changes in the quantities of exports and imports could be long enough for adverse effects to be felt in the home economy.

Let us take a deficit situation as an example. The depre­ciation of the currency will make imports dearer, and if the demand for them is inelastic, this could give rise to cost-push inflation. This inflation will eventually remove any price advantage which the depreciation had given to exports. More seriously the cost-push pressures could reduce profitability, weaken confidence, and cause invest­ment to fall. This is a sequence which leads to a rise in unemployment. A cost-push spiral, once set in motion, might lead to a sequence of currency depreciation — rising import prices — further cost-push pressures, and so on. If this did happen, the authorities would be obliged to inter­vene in the foreign exchange market, resort to foreign bor­rowing and perhaps, take some steps to limit imports by direct methods. But these are the same measures as would be taken with fixed exchange rates!

In other words the success of floating exchange rates in liberating domestic economic policies from the restraints of the balance of payments situation depend very much on the mobility of the factors of production. When the currency depreciates, the volume of exports must be capable of responding very quickly to the increased demand brought about by the lower prices, and home producers must also be able to substitute domestically manufactured products for the relatively dearer imports.

A further point is that the depreciation of a currency will only remedy a balance of payments deficit when the problem is one of relative prices. If the imports are largely essential goods which cannot be produced at home, and if exports are non-competitive in terms of quality, design or performance, then changing relative price cannot really solve the problem.