Ventures.

Terms of trade. A nation’s terms of trade will tend to be worsened by a decline in the international

Value of its currency. For example, an increase in the dollar price of yen will mean that the United States

must export a larger volume of goods and services to finance a given level of imports from Japan.

Instability. Freely fluctuating exchange rates may also have destabilizing effects upon the domestic

economy of a nation as wide fluctuations stimulate and then depress those industries producing

Internationally traded goods.

This is so for two reasons. First, the net exports component of aggregate expenditures will increase

and cause demand-pull inflation. Second, the prices of all imports will increase. Conversely,

appreciation of the currency would lower exports and increase imports, tending to cause unemployment.

Looked at from the vantage point of policy, acceptance of floating exchange rates may

complicate the use of domestic fiscal and monetary policies in seeking full employment and price

stability. This is especially so for those nations whose exports and imports may amount to 20 to

30 Percent of their gdPs (Germany, Great Britain, Canada, Netherlands, New Zealand, etc.).

Fixed Exchange Rates (Part III)

At the other extreme nations have often fixed or “pegged” their exchange rates in an effort to

circumvent the disadvantages associated with floating rates.

As demand and supply shift over time, government must intervene directly or indirectly in the

foreign exchange market if the exchange rate is to be stabilized.

There are several means by which this can be achieved. The main ones are:

Use of reserves. The most desirable means of pegging an exchange rate is to manipulate the market

through the use of official reserves. This is not a problem if deficits and surpluses occur more or

less randomly and are of approximately equivalent size. But if a nation encounters persistent and

sizable deficits for an extended period of time, the reserves problem can become critical and force the

abandonment of a system of fixed exchange rates. Or, at least, a nation whose reserves are inadequate

must resort to less appealing options if it hopes to maintain exchange rate stability.

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Trade policies. One set of policy options entails measures designed to control directly the flows

of trade and finance. Specifically, imports can be reduced by imposing tariffs or import quotas.

The fundamental problem with these policies is that they reduce the volume of world trade and

distort its composition or pattern away from that which is economically desirable. That is, tariffs,

quotas, and the like can be imposed only at the sacrifice of some portion of the economic gains or

benefits attainable from a free flow of world trade based upon the principle of comparative advantage.

These effects should not be underestimated; remember that the imposition of trade barriers

can elicit retaliatory responses from other nations which are adversely affected.

Exchange controls: rationing. Another option is exchange controls or rationing.

There are many objections to exchange controls. First, like trade controls — tariffs, quotas, and

export subsidies — exchange controls distort the pattern of international trade away from that

based upon comparative advantage. Second, the process of rationing scarce foreign exchange necessarily