The Foreign Sector

Transactions with foreign countries give rise to a market for foreign exchange, since both domestic and foreign parties want to pay and be paid in their own currency. The price of foreign exchange in terms of the domestic currency is called the foreign exchange rate.

Under fixed foreign exchange rate systems, governments announce levels at which they intend to maintain foreign exchange rates, and they maintain these rates by a variety of means, including intervention in the market with reserves of foreign exchange and gold. Foreign exchange rate adjustments are reserved for fundamental changes in balance of international payments positions.

Under completely flexible foreign exchange rate systems, the foreign exchange rate is left free to respond to the forces of demand and supply in the market and automatically balances international payments.

The Bretton Woods system of fixed foreign exchange rates, on which the world operated from 1946 to early 1973, developed the basic flaw of being unable to produce the adjustments in foreign exchange rates needed to accommodate fundamental changes in balance of payments positions among major trading nations. This meant, on the one hand, that the system was not durable, and it eventually collapsed. More important, it meant that nations which developed chronic deficits under the system, such as the United States and the United Kingdom, were led, before the collapse, to improve their payments positions by means which compromised full employment, economic growth, and free trade.

In 1973, the United States moved to a more flexible foreign exchange rate system, a system often termed managed float. This system is not completely flexible, since the Federal Reserve and foreign central banks regularly intervene in the market with supplies of foreign exchange to influence foreign exchange rates. However, there is no commitment to maintain fixed foreign exchange rates, as with the Bretton Woods type of system, or even to maintain fluctuations in rates within a specified range.

The great advantage of managed float and flexible foreign exchange rate systems is that they can produce the adjustments in foreign exchange rates needed to accommodate fundamental disturbances to international payments positions.  This eliminates the need for compromises of full employment, economic growth, and free trade by nations whose currencies weaken over time. Nations in these circumstances can still compromise these goals in favor of an overvalued currency if they choose to do so in order to avoid the terms-of-trade and inflation effects of a depreciating currency.

Completely flexible foreign exchange rate systems have the disadvantage that they may produce very wide short-term fluctuations in foreign exchange rates. Such fluctuations are disruptive to activity levels in export, import, and import-competing industries, since they affect the price-competitiveness of the firms engaged in these industries. If participation in export and import industries is discouraged as a result, the level of international trade declines, and a portion of the gains nations can make from international trade is lost. In addition, sharp short-term currency depreciations produce terms-of-trade and inflation effects not required by the nation's fundamental international payments position. Managed float systems diminish these problems to the extent the managers are able to smooth out short-term fluctuations in foreign exchange rates.