National Inflation, International Currency Speculation, and
Currency Controls
December 8, 1998
The Relative Exchange Value of a Nation's Currency
In a system of free international and domestic trade and flexible exchange rates, the relative value of any nation's currency would depend, in the long run, on the quantity of money issued by the banks relative to the quantities of money issued by other nations. If nation A doubles its quantity of money, while nation B holds its money steady, then roughly speaking, nation A's currency will fall to one half of its exchange value in relation to B's currency. One reason why this occurs is that in such a world, each country's wealth would grow at about the same rate. As a result, differences in rates of growth in the quantities of money would be manifest in differences in the growth of purchasing power.
Under these circumstances, a nation that systematically interferes with its economy when there is no sound benefit-cost reason does not grow like others; and its currency does not maintain its relative value. What assures that this will happen? The most important assurance is the presence of currency speculators. When they expect the purchasing power of A's currency to rise relative to B's currency, they buy A's and sell B's. By doing this, they cause exchange value of A's currency in terms of B's to rise sooner than it otherwise would have.
Currency Controls
Suppose that an inflating nation suddenly makes speculation in its currency difficult by means of secretive currency policies. Suppose further that it uses foreign currency reserves to prop up its currency's relative value. If these measures can outwit the speculators, then the nation may be able to temporarily prevent reductions in its currency's value. However, unless the nation reverses its inflation policies -- or becomes extremely productive relative to the other countries -- while it is propping up its currency, it will eventually see its currency devalue anyway. But it is not likely to accomplish either of these objectives. Government leaders who aim to conceal their loose currency policies of the past are unlikely to discipline themselves very much in their current money creation. And a nation that intervenes in currency markets will not be able to attract foreign capital.
Of course, the modern world is not one of free international trade and flexible exchange rates. Nations intervene in trade in a variety of different ways. However, international trade and money markets today are relatively free. And if a country wishes to participate in this relative free trade, it must subject itself to the uncertainties and discipline that success in markets requires.
Gunning’s Address
J. Patrick Gunning
Visiting Professor
U.S. Coast Guard Academy
Management Department
15 Mohegan Avenue
New London, CT 06320
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