Private speculation is stabilizing
The advances of floating exchange rates argue that private speculators are a stabilizing rather than destabilizing force.It is in the interests of speculators to move the exchange rate to its fundamental economic value.Speculators will attempt to buy the currency at a low value and sell it at a high value and in so doing they reduce the gap between the low and high values.Of course, occasionally, speculators will make mistakes and buy a currency which they think has depreciated sufficiently and find that it continues to depreciate, but such destabilizing speculation will involve losses.This being the case, there is every reason to suppose that private speculators will move the exchange rate towards its fundamental equilibrium value.
Many of the preceding arguments advanced for and against the two regimes are extremely difficult, if not impossible, to prove.No doubt there are elements of truth on both sides of the arguments; speculation can at times be stabilizing and at other times destabilizing.Fixed exchange rates can provide a stable framework for international trade, but so too can floating rates by ensuring that countries maintain their international competitiveness.Economic policies can be more or less stable under a fixed exchange rate regime as compared to a floating one.
Since the traditional advantages/disadvantages approach leaves plenty of scope for disagreement, this has stimulated an alternative more modern approach to evaluating the two regimes.In this approach, the relative merits of the two regimes are evaluated within the context of a formal macroeconomic model.We now look at the insights provided by this alternative approach by using a relatively simple macroeconomic model.