Chapter 10: International Liquidity and Exchange Rate Stability
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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