The Case of flexible Rates
Under flexible exchange rates system, the rate of exchange is free to vary in response to day-to-day changes in the demand for and the supply of foreign exchange.
The required changes in the exchange rate occur rapidly, continuously and automatically. Under fixed exchange rates systems, the malady often goes on accumulating and culminates into a serious crisis.
There arises the question as to what is to be done under fixed exchange rates system if disequilibrium arises in the balance of payments. Following are the main alternatives of rectifying a disequilibrium in the balance of payments under fixed exchange rates--- a change in the exchange rate by government action; deflation of domestic prices and incomes; and institution of trade and exchange restrictions.
The effect of changes in exchange rate by government action on commodity trade is very similar to that of the automatic changes in exchange rate under the flexible exchange rates system.
A change in exchange rate under the flexible exchange rates system differs from the change affected by government action only to the extent the change under the former system is continuous while the same is occasional and deliberate under the latter system and the equilibrium during the transitional period is maintained either by domestic price and income changes, import restrictions or the use of monetary reserves. This difference gives rise to another important difference between the two systems, viz., and their effect on the speculative transactions.
When the changes in exchange rate are occasional, the variations in the balance of payments position give rise to an expectation of a change in the exchange rate, The expectation of a change in the exchange rate leads to speculative buying and selling. Sometimes a change in the exchange rate might be necessitated simply by speculative transactions on a larger scale while there would have been no such need in the absence of speculative transactions.
Very little risk of loss is involved in such speculative transactions because the direction of change in the exchange rate, if it occurs, can be known beforehand from the balance of payments position of the country.
The risk of loss exists only to the extent of the cost of transfer and retransfer of capital from one country to the other and the difference, if any, in the rate of interest between the two countries. In contrast, under flexible exchange rates system, the sale of domestic currency for speculative purpose immediately lowers the exchange rate and thus inflicts a penalty on speculators.
Further, it is not possible for the government to know the correct rate of exchange. Government may fix it at a level either bigger or lower than the appropriate one. Correct rate of exchange can be found only by trial and error by the free operation of the market forces.