The Transition from Fixed to Flexible Exchange Rates and Its Global Impact

Abstract

The shift from fixed to flexible exchange rates, which began in the early 1970s, marked a transformative period in global economic policy. This transition was driven by the need for greater national economic policy flexibility and the growing interconnectedness of global financial markets. Initially, economists anticipated that flexible exchange rates would enable governments to pursue tailored economic policies, free from the constraints of the fixed exchange rate system established under Bretton Woods. They believed this flexibility would foster economic stability and growth by allowing countries to adapt their policies to domestic conditions. However, the anticipated benefits of the flexible exchange rate system were tempered by several unforeseen challenges. The mid-1970s financial revolution, characterized by the expansion of the Eurodollar market, deregulation, and technological advancements in financial instruments, led to an unprecedented increase in international financial flows. This surge contributed to greater exchange rate volatility, as financial flows became a dominant force in determining currency values, overshadowing traditional trade flows. The phenomenon of "overshooting" exacerbated this volatility, making it difficult for exchange rates to stabilize. The increased volatility of exchange rates had significant implications for both domestic and international economics. The interconnectedness of global financial markets meant that macroeconomic policies in one country could have substantial spillover effects on others, complicating the management of national economies. In response to these challenges, regional efforts such as the European Monetary System (EMS) were established to stabilize currencies within specific regions and mitigate the impact of global economic fluctuations. Despite these regional initiatives, the international monetary system continued to face instability and inefficiencies. The ongoing debate over the effectiveness of flexible exchange rates and the need for reform underscores the complexity of managing a global economy characterized by high levels of financial integration and volatility. The pursuit of a more stable and rule-based international monetary system remains a critical issue for policymakers worldwide.