Tuesday, March 31, 2009

Do Fixed or flexible Exchange rates provide for greater "discipline" on the part of policymakers?(2)

Note that the result in the preceding discussion is a tendecy for deflation in the deficit country and inflation in the surplus country .Therefore ,if prices are flexible in bot directions ,it is likely that prices will be relatively stable in the world as a whole .IN practice ,the world could have some inflation if prices are less flexible downward than upward.however,the inflation will probably not be as rapid as it would be if the discipline of fixed rates did not exist .
In addition to this emphasis on the discipline of fixed exchange rates ,proponents of such a system stress that flexible rates could actually aggravate inflationary tendencies in a country .the point is made that,under flexible rates ,inflation in a country becomes self perpetuating ;this argument is sometimes called the vicious circle hypothesis.Suppose that a country is undergoing rapid inflation because of an excess supply of money and excess demand in the economy.The inflation will cause the country is currency to depreciate in the exchange markets ,which will add to aggregate demand in the economy and generate further inflationary pressure.in addition ,the rise in prices will lead to correspondingly higher money wages,which also induces more inflation .thus ,inflation will cause depreciation, but the depreciation itself will cause further inflation .this sequence of events continues until the monetary authorities put a stop to the monetary expansion.

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