FOREIGN EXCHANGE MARKETS SUMMARY

Foreign Exchange Markets Summary

Foreign Exchange Markets Summary

Introduction

The principle superiority of a fastened exchange rate system is that it (ostensibly) removes the risk of adverse exchange rate movements when arranging to purchase foreign goods, services, and investments. (Coyle, 2001). The economic case for floating exchange rates is that they facilitate more flexible management of the international economy. A fixed exchange-rate regime provides asymmetric incentives for governments to negotiate realignments in their currencies' official value. If underlying economic conditions suggest that a currency is pegged at too high a price, it is in the economic interests of both the government in question and the system as a whole for negotiations to be initiated to lead to the eventual devaluation of the currency. In this way, balance can be restored to the international economic system by reducing the price of the overvalued currency. This is likely to boost the volume of that country's exports, which would have been depressed during the period of overvaluation, and it will therefore enhance the overall level of economic activity within the international system.

By contrast, although it remains in the economic interests of the system as a whole for an undervalued currency to have its price increased relative to others, it is not in the interests of the government in question to have that realignment occur. Indeed, the government may attempt to frustrate negotiations to that end. A floating exchange-rate regime, by comparison, is likely to speed the process of adjustment. Under such a regime, the value of a currency is determined by trading on an open auction market. Investors are in a better position than are governments to respond to changing economic circumstances because all they have to do is buy or sell their currency holdings on the foreign exchange market as circumstances suggest, and they do not have a strategic interest in maintaining an undervalued currency.

 

Discussion

Regardless of the specific assumptions of the particular theory, they all advocated the concept that international trade should be free from restrictions. Thus international trade became the engine of economic growth in the 19th century. Countries dropped their restrictions on free trade, and the gold standard was used worldwide to measure the value of goods and currencies, providing a universal currency. With the rise of a global trading system at the time of European colonial expansion, a colonial division of labor emerged in which developing countries exported primary products, agriculture and minerals, while Europe and North America exported manufactured goods. The outbreak of World War I, the redistribution of the colonies among the Great Powers, the collapse of the gold standard, and the economic depression of the 1930s gave rise to economic nationalism and protectionism. Free trade gave way to government intervention and tariffs; quotas and other protectionist measures became dominant features in international trade.

The end of World War II brought about the revival of the free trade philosophy. The General Agreement on Tariffs and Trade (GATT) was formally established in January ...