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The Elusive Benefits of Flexible Exchange Rates

There is no denying that flexible exchange rates provide valuable monetary-policy independence. But, in a dollar-dominated global trade environment, the ability of a floating currency regime to support full employment is severely limited.

CAMBRIDGE – In 1953, Milton Friedman published an essay called “The Case for Flexible Exchange Rates,” arguing that they cushion an economy from internal and external shocks by bringing about just the right price changes required to keep the economy at full employment. But after almost half-a-century of floating exchange rates, the reality is more complicated than that.

To understand Friedman’s logic, consider a scenario in which productivity in the United States rises. In an efficient system, this should reduce the price of US goods relative to those of the rest of the world, with US exports becoming cheaper than imports. As America’s terms of trade (the ratio of export prices to import prices) deteriorate, demand is shifted toward US goods, keeping the economy at full employment.

If prices are “sticky” (in the producer’s currency), however, a potential hitch emerges. Say the prices of US imports from Japan are sticky in Japanese yen and the prices of US exports to Japan are sticky in dollars. The terms of trade will thus remain unchanged, as long as the exchange rate does as well.

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