Exchange-Rate Flexibility and the Efficiency of the Foreign-Exchange Markets

Prior to the recent experience with relatively flexible exchange rates, there was much concern that a high degree of exchange-rate flexibility might somehow overburden the institutions of the foreign-exchange market, particularly the forward market, with disruptive consequences for international commerce. While seldom clearly stated, the reasoning underlying this concern usually proceeded along the following lines. Substantial exchange-rate flexibility would lead business management to expect greater exchange-rate variations, with the result that businesses would seek to cover much more of their foreign-exchange exposure (i.e., would seek to “insure†against the greater exchange-rate risk) by purchasing or selling foreign currency forward. However, foreign-exchange traders either could not accommodate this greatly increased demand for their services, or could accommodate it only at substantially higher cost. Consequently, business firms would significantly reduce the volume of their international transactions.