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William Vickrey, 1996 Nobel Award In Economics

October 5, 1996

The value of the national currency in terms of foreign exchange (or gold) is held to be a measure of economic health, and steps to maintain that value are thought to contribute to this health. In some quarters a kind of jingoistic pride is taken in the value of one's currency, or satisfaction may be derived from the greater purchasing power of the domestic currency in terms of foreign travel.

Reality: Freely floating exchange rates are the means whereby adaptations are made to disparate price level trends in different countries and trade imbalances are brought into line with capital flows appropriate to increasing the overall productivity of capital. Fixed exchange rates or rates confined to a narrow band can be maintained only by coordinated fiscal policies among the countries involved, by imposing efficiency-impairing tariffs or other restraints on trade, or by imposing costly disciplines involving needlessly high rates of unemployment, as is implied by the Maastricht agreements. Attempts to restrain foreign exchange rates by financial manipulation in the face of a basic disequilibrium usually break down, eventually, with large losses to the agencies making the attempt and a corresponding gain to agile speculators. Even short of breakdown, much of the volatility of foreign exchange rates can be traced to speculation over possibilities of massive central bank intervention.

Restraints on exchange rates, such as are involved in the Maastricht agreements, would make it virtually impossible for a small open economy, such as that of Denmark, to pursue an effective full-employment policy on its own. Much of the increase in purchasing power generated by a stimulative fiscal policy would be spent on imports, spreading the stimulating effect over the rest of the monetary union so that Denmark's borrowing capacity would be exhausted long before full employment could be achieved. With flexible exchange rates the increased demand for imports would cause a rise in the price of foreign currency, checking the import increase and stimulating exports so that most of the effects of an expansionary policy would be kept at home. The danger of wild speculative gyrations under freely floating conditions would be greatly diminished under a well-established full-employment policy, especially if combined with a third dimension of direct control over the overall domestic price level.

Similarly, the main reason states and localities cannot pursue an independent full employment policy is that they lack an independent currency and are constrained to have a fixed exchange rate with the rest of the country