Financial Markets, Money and the Real World
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Financial Markets, Money and the Real World

Paul Davidson

Paul Davidson investigates why the 1990s was a decade of financial crises that almost precipitated a global market crash. He explores the reasons why the global economy still struggles with the aftermath of these crises and discusses the possibility that volatile financial markets in the future will have real impacts on whole industries and national economic systems.
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Chapter 10: International Liquidity and Exchange Rate Stability

Paul Davidson


THE FACTS VERSUS THE THEORY OF FLEXIBLE EXCHANGE RATES Since the breakdown of the Bretton Woods system in 1973, orthodox economists have promoted the conventional view that freely fluctuating exchange rates in a laissez-faire market system are efficient. Every welltrained mainstream economist, whose work is logically consistent with classical theory ‘knows’ that the beneficial effects of a freely flexible exchange rate are: 1. 2. the impossibility of any one country running a persistent balance of payments deficit; that each nation may pursue monetary and fiscal policies for full employment without inflation independent of the economic situation of its trading partners;1 and that the flow of capital will be from the rich creditor (that is, developed) nations to the poor debtor (that is, less-developed) nations. This international capital flow from rich to poor nations depends on a classical belief in the universal ‘law of variable proportions’ that determines the real return to both the capital and labor factors of production. Since rich countries have larger capital to labor ratios than poor nations, the law of variable proportions indicates that the real return to capital should be higher in the poor nations where capital is relatively more scarce. Capital, therefore, should flow into the poor nation until the return on capital is equal in each country. The effect of this hypothetical classical international capital flow is to encourage more rapid development of the less-developed countries (LDCs) and, in the long run, a more equitable global...

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