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Forex: A World of Floating Rates

The introduction of floating exchange rates in the early 1970s was a vote in favor of market forces as the best solution available at the time.

Floating exchange rates were progressively introduces during the 1970s amid high expectations, in many quarters, of their efficacy. It was thought that after an initial flurry, the world would adjust to floating rates and a desirable state of equilibrium in exchange rates would prevail.

Such optimism proved ill-conceived, largely because it was based on the premise that exchange rates are mostly influenced by shifts in countries' current accounts, whereas in reality exchange rates are manipulated by short-term capital flows representing a large pool of mobile funds chasing the best rates.

It is easy, with hindsight, to be wise about the optimism surrounding a move to floating exchange rates. In the early 1970s, floating was the preferred alternative to a system of fixed rates that was no longer effective. At the core of the debate about the appropriate degree of exchange-rate management--- a debate that is far from over--- is the question of where best the economic managers should tolerate any volatility; that is, should exchange rates or domestic interest rates suffer the effects of instability? In an ideal world, countries would operate with totally stable exchange and interest rates.

But we live in an imperfect world, and instability is part of life.

The best the economic managers can do, is to steer the volatility to a point where it causes least disruption to importers and exporters, investors and the general community.

Focusing volatility on the exchange rate leaves the volatility visible to all the exchange rate fluctuates, but allows greater stability in, say, domestic interest rates. Conversely, holding the exchange rate stable, as under a fixed or heavily managed system, pushes the volatility off into other less-visible but equally important areas of economy. Things may look better on the surface, but in reality the problems have been swept under the carpet and left to fester.

It would seem that the economic world does not enjoy freely floating exchange rates; rather, it is a subject to various forms of currency regulation which are designed to mitigate the discipline that a free float would impose.

By the late 1980s, the exchange rate, being the relative price of two currencies, was determined in a way similar to that of financial asset prices in, for example, stock markets. Equilibrium is achieved when the existing stocks are willingly held, and when one of the important determinants of current prices is expectations of the future course of events.