Exchange rate flexibility is commonly justified as an
efficient method for adjusting the trade balance to some
desirable net international capital flow. In this orthodox view,
fluctuations in a country's terms of trade or its saving-
investment balance would continually upset its balance of
payments equilibrium if the nominal exchange rate remained
But this prevailing doctrine favoring exchange flexibility is
only correct when economies are "insular", ie. have limited trade
and financial arbitrage with the outside world. With the spread
of exchange controls and trade restrictions in the 1930s into the
1950s, the industrial countries became somewhat insulated from
each other. A devaluation could them have the conventional
effect of reducing a trade deficit because monetary and exchange
rate policy were separable.
Among the open industrial economies of the 1980s, however,
financial arbitrage is uninhibited and trade is fairly free.
Monetary policy, both current and prospective, now dominates
what happens to the exchange rate. Because a devaluation today
reflects an easier money policy in the present., or an expected
easing in the future, it no longer has any predictable impact on
the monetary value of the net trade balance. Exchange rate
flexibility loses its usefulness in controlling net exports while
becoming highly disruptive to the economy's macroeconomic
For example, the American dollar's downward float over the
past three years should not be expected to improve the U.S.
current account. However, allowing the dollar to depreciate below
its purchasing power parity greatly increases the inflationary
potential in the American economy.