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It is believed that this exchange rate system leads to instability on the market and does not stimulate the development of trade and production; floating exchange rates destabilize economical situation and lead to economical crises. The instability of exchange rates after the end of Bretton-woods system and the whole depression in world economy at that time illustrated this point of view; however, with the flow of time the economists started regarding this system from a different point of view: the work of Milton Friedman in 1953 opposed the common belief that instability was caused by the float of exchange rates. Friedman stated that instability was caused by wrong economical policy of the governments and other factors, not depending on the exchange rates mechanism. Indeed, the effects of flexible exchange rates on the stability of prices and production have appeared to be much smaller than they were expected to be; for example, in Germany in 1980s the purchasing power of DM shifted from 20% above the purchasing power of USD to 25% below this level, and then returned to 25% above USD purchasing power. According to the predictions, this shift has to cause significant disbalance in German economy; but contrary to these assumptions, the changes were very modest. It has appeared that most producers chose to keep up with the strategy of “pricing to market”. This means that the prices of the goods remained stable in the currency of importing country, and therefore they were not heavily destabilized by the shift in exchange rates.
The instability of exchange rates is the main argument of floating exchange rates opponents. However, besides Friedman’s explanations, there have been other attempts to explain this great instability. For example, Dornbush in 1976 suggested that there existed a phenomenon of “over-shooting”. This means that to be successful in the long run the economy needs to depreciate its currency, in order to reduce inflation and stimulate economical growth. However, in the short period depreciation will cause the decrease of interest rates and the fall of activity; in order to stimulate the activity of firms, the currency needs to be expected to rise in future. The only variant that can provide depreciation in the long run together with the expected rise of the purchasing power of the currency is the fall of the currency lower than it’s needed in the long run; for example, if the money supply of the country rises by 5%, its currency needs to be depreciated by 5% in the long run – but to stimulate economical activity, the currency needs to be depreciated by 15% with expected rise by approximately 10% (the so-called mechanism of “over-shooting”).
Another advantage of floating rate system is that it allows the government to introduce separate monetary and fiscal policies, which is rather difficult under the conditions of a fixed exchange rate system. In general, the arguments between the supporters and opponents of floating exchange rate system lie in the relation between the price paid for the instability of exchange rates and the possibility to introduce independent monetary and fiscal policy, and therefore to adjust quickly to changing economical conditions.

4. Examples of exchange rate management

Exchange Rate Arrangements as of December 31, 1997
Pegged
Single currency Currency composite
U.S. dollar

Angola
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