Chapter 3: The aim of monetary stability





01st Galloping inflation versus creeping inflation

02nd Should the level of commodity prices be stabilised or rather the wage level?

03rd Which price indices can be distinguished?

04th Is a short-term stabilisation desirable?

05th How does the inflation affect the factor allocation?

06th Can inflation be justified in an allocative way?

07th Growth policy justification for stability

08th How does inflation affect recipients of fixed income?

09th Which influence has inflation on wage incomes?

10th How does inflation change the asset position?

11th Conflicts between stability and current account compensation



06th Can inflation be justified in an allocative way?


The thesis coined by Charles Schultze is - quite in contrast to the previous conclusions - that inflation can even improve the allocation (the allocation of scarce resources to the individual types of use). Here, he assumes the observation that prices are rigid downwards in general. Therefore, adjustments of the price relations to data changes are only possible by means of price increases. Thus a slight inflation was quite desirable for allocation-political reasons.


However, this justification for inflationary processes is faced by criticism: this argument applies namely only to a nominal rigidity of prices, but the real prices are de facto also subject to rigidity.


For example, the agreement on index wages shows that unions are also trying to prevent real wages (not just the nominal wages) from reducing. When agreeing on index wages, the bargaining partners decide to adjust the wage rates automatically to the extent of the inflation rate. With the result, that not only the nominal wages are unchangeable downwards during the duration of a collective agreement, but rather that also real wages can not be adjusted downwards any more.


But if such rigidity exists in relation to real prices, then this means that price relations can no longer be adjusted to the development by help of raising the prices. Let us suppose that the wage-interest ratio no longer corresponds to the scarcity condition of labour and capital and that due to trade union efforts the wage rates reached levels where it is no longer possible to employ all workers.


If the attempt was made to correct this undesirable development now by means of allowing general increases in the prices of goods by help of an expansionary monetary policy, then this would not lead to a correction of the wage-interest ratio in the long term. The unions would indeed not tolerate the reduction in their real wage income due to general price increases and would force an increase in wage rates, due to which the (suboptimal) wage-interest ratio would occur then again. Indeed, there is even the risk that the wage-interest ratio would differ further from its optimal size, since an expansionary monetary policy results also in a rate cut, with the result that the wage-interest ratio will increase even further.


The attempt to achieve an adjustment of the price relations to data changes via inflationary processes represents a cure for the symptom. A lasting solution to economic problems can only be achieved, though, by first asking the question as to what caused the present problem and why, and on the basis of this knowledge, one searches to eliminate these causes.


If the factor-price relations deviate from the scarcity ratios, then this is mostly due to the fact that monopolistic behaviours are present on the markets, which must be corrected politically. On the labour markets we find the market form of the bilateral monopoly, which quite allows monopolistic behaviours. Since labour markets can not be converted into the market form of complete competition, it is necessary to set the rules for the conflicts of the collective bargaining partners in such a way that the power relations are reasonably balanced. In the FRG, the highest labour courts try to introduce such rules.


Thus, the power of the collective bargaining partners finds its limit where the interests of the general public are seriously violated. However, this policy only leads to success, if there is also the willingness to follow these rules of the game and to punish disregard of these rules by judicial means. Obviously, this willingness is largely missing nowadays.



07th Growth policy justification for stability


The neoliberal economic theorists defend the demand for monetary stability partly also with growth policy aims.


Growth was only achieved by innovation; but innovations would only take place at intense competition. In the case of inflation, however, demand surpluses would be present which do not allow competition. Therefore, long-term growth could only be expected with the presence of monetary stability.


As we have already seen, the growth policy aim can relate to the domestic product as well as to the per capita income; growth is only accompanied by welfare gains, though, if not only the total domestic product increases, but also the per capita income respectively the productivity can be increased at the same time. If the domestic product rises namely only because more workers are employed, then the welfare level of the individual citizens has not changed. Although more has been produced, this increased amount of goods must now be divided among more individuals, too.


Even if, in the course of a domestic output increase, the per capita income increases because the average work time has increased, it is questionable to speak of a real welfare gain always. Since the increase of the quantity of goods corresponds to the reduction of the leisure time in this case. Only if in this case the benefit loss due to the reduced leisure time is estimated to be lower than the benefit increase due to the increased number of consumer goods, it can be spoken of a real welfare gain.


If we measure the growth aim in terms of the productivity, both alternatives are considered. An increase in productivity improves welfare namely in both cases, if more goods are produced at a constant work effort, and also if more leisure time can be taken since by reason of the productivity increase the present amount of goods can now be produced with fewer working hours.


Productivity improvements are in general (with certain exceptions) only to be expected when the entrepreneurs are ready to innovate. But when prices rise generally, entrepreneurs are able to price all costs, and there is no more need to look for cost reductions.


This means that price increases will then become possible when demand surpluses are present, but in this case entrepreneurs are not under competitive pressure anymore. They can enforce any price increase without running the risk that their customers are switching to their competitors. In this respect, an inflation climate prevents the precondition for sustained growth.


In the framework of Keynesianism, however, a slight (creeping) inflation was even defended for reasons of growth policy. Growth required sufficient investments. But the capital market would not work as it is assumed by the classical theory. According to the classical theory, the interest rate mechanism ensured an automatic compensation between saving and investment. If the willingness to invest was too low, i.e. the savings amount exceeded the planned investment amount, then the interest rate decreases and this interest rate reduction would lead automatically to the fact that the investment deficit and thus the excess supply on the capital markets was reduced.


Keynes doubted that a free capital market was capable of doing so. A part of the savings was hoarded, thus not fed into the capital market at all. As part of his liquidity theory, Keynes has shown that temporary hoarding of money can even be quite rational, since potential price losses may outweigh interest-rate gains.


Moreover, Keynes also considered the capital market inappropriate to provide automatic compensation for saving and investment because entrepreneurs had free capacity in times of economic recession, and for that reason were unwilling to invest and thereby to even increase production capacity This was true even in the case of interest rate cuts.


In such a situation, a slight inflation would be helpful. In a climate of permanent slight price increases, the profit expectations of the entrepreneurs improved, and with the profit expectations also the willingness to invest improved. However, the increase in the investment volume was the most important precondition for growth.


Milton Friedman has criticised this thesis. Such a policy of allowing for a slight inflation would be a success at best in the short term. In the long run, the trade unions demanded a wage adjustment to the price increases, which in turn leads to a reduction in the profits and thus in the production.


But if entrepreneurs are worried that the initial price and profit increases would only be temporary, then the entrepreneurs would not be ready to hire new workers, too. They feared namely that they would not be able at all to dismiss these workers because of strict dismissal legislation, if production has to be reduced sooner or later due to lack of sales.


A slight inflation as a means of growth would thus only be an appropriate means if we could assume that the trade unions would not demand for adjustment of wages to the changed situation. But just this can not be expected, though.


The situation of employees deteriorates in two ways to the extent that entrepreneurs increase their profits. On the one hand, real wages decline as long as the nominal wage rates are not adjusted to the increased prices of goods. On the other hand, the relative position of the employees in the income structure deteriorates also. If the profits increase and the wage incomes remain unaffected, then the share of wage incomes in the domestic product decreases automatically. The trade unions will therefore strive to win an adjustment of wages as soon as possible - and this is after the expiry of the valid collective agreement. And in general, the trade unions are strong enough to force this adjustment.


However, this eliminates the precondition for that a slight inflation process helps to increase the profit expectations and thereby the increase of economic growth. Price increases will increase profits only if costs are not raised to the same extent. At the same time, it should also be remembered that the profits could rise very well or be maintained even if prices are constant respectively even falling, provided that the costs are reduced due to increases in productivity and these cost reductions are not completely used again to increase wage incomes to the same extent as the productivity.



08th How does inflation affect recipients of fixed income?


Our previous reflections have shown that inflation can negatively affect both allocation and economic growth. Nevertheless, the most important reason that inflation has negative effects is that inflation processes influence income distribution in an undesirable way. Firstly, inflation disadvantages recipients of fixed income.  Secondly, it can have a negative impact on the wage share. And thirdly, it affects the single wealthy individuals quite differently depending on the asset position.


Let us start first with the disadvantage of the fixed income recipients. A fixed income is always present if no adjustment of the nominal income to general price increases takes place. The real income of the fixed income recipients thus decreases due to constant nominal incomes in the event of inflation. The income rate of the recipients of fixed income declines with increasing domestic product even though prices remain constant!


One could ask the question, if there are fixed income recipients still today? Certainly, the number of fixed income recipients has declined significantly in comparison with the past. In former times (before 1957), old-age pensions in particular were considered as fixed income. Unlike e.g. the wages, the pensions were not adjusted to the price increases every year. Politicians granted pensioners an increase in their incomes only immediately prior to the elections, thus encouraging pensioners to vote for the governing party.


Since the reform of the old-age insurance in 1957, pensions have been adjusted in principle to wage developments and thus indirectly to price developments. A complete automatic was decided indeed only for the access pensions (i.e. for the first pension after leaving the working life). But at least, governments have been willing to adjust existing pensions (pensions in the years after retirement) to the wage developments with few exceptions. In the following years, other pensions such e.g. the accident pensions have been dynamised, too.


Nevertheless, it was until recently still possible to say that pensioners did not receive a full adjustment to inflation, since until the 1990s pensions were not adjusted to wage incomes of the same period but to past wage incomes with a three-year delay. In addition, there are also non-dynamic transfer incomes such as e.g. the housing allowance.


There is no obvious reason for recipients of fixed income not to be involved in general growth. Basically, there is a fundamental decision as to how productivity gains are passed on to the population. A passing on of increases in productivity can be achieved either by reducing the prices of goods in line with the cost reductions, or by increasing nominal incomes to the extent of increases in productivity.


In reality, almost only the second-mentioned way is applied. In this case, however, it complies with the general distribution principles that no population group may be exempted from this transfer. There is no convincing reason that a part of the population is excluded from general welfare increases.


The solution to this problem is, of course, that an attempt is made to reduce the number of those who receive a fixed income as far as possible.



09th Which influence has inflation on wage incomes?


Let us now turn to the question of whether the recipients of wage income are disadvantaged due to inflation processes, and if so on what conditions. Often the thesis is supported that the collectively agreed wages are only adapted delayed to price increases (thesis of the wage lag). The standard wage applies for the duration of the collective agreement and thus usually for one to two years, while price increases take place continuously. For this reason, the real wage income diminishes to the extent to which wages are adjusted only in a delayed manner to the general price increases.


Now we can assume that the trade unions will strive to adjust the nominal wage rates to the general price development as soon as possible. This adjustment is made in the collective agreements that trade unions conclude with employers (respectively with employers organisations). Collective agreements, however, usually have certain minimum running times or notice periods. The trade unions can therefore enforce an adjustment of the wage rates to general price increases only delayed, after expiration of the previous collective agreement. The longer the term of a collective agreement is the larger is the real income loss of the employees.


And if we take into account that in reality inflation is not a one-off event, but rather a permanent one, appearing year after year, then by way of inflations the real wage income  can by reduced and with it the wage share. Here again, the same applies to what we have already ascertained for the fixed income recipients, that there is no justification for disadvantaging workers at the passing on of welfare gains.


However, wage lags could not be proven empirically, national economies with high inflation rates do not show a lower wage share. This empirical finding can be explained by the fact that compensations in wage income are possible in the meantime by way of wage payments above the standard rate. Even though tariff-based wage rates can only be adjusted to price developments with a delay because of the terms of the collective agreements, it is possible in the meantime to adjust the income of employees to inflationary processes thereby that employers grant wage payments above the standard rate.


In fact, entrepreneurs have made repeated use of this possibility in the past. These payments are voluntary, though, and there is no possibility for employees to enforce such payments.


On the other hand, the thesis is sometimes also supported that in reality we are dealing less with a wage lag than with a wage lead: According to this, trade unions are demanding wages to be adjusted not just for the past price increases, but for the price increases that are to be expected in the coming period. Precisely because the trade unions know that they can enforce the subsequent adjustment of wage rates to general price increases only delayed, they are already attempting in the previous collective bargaining agreements to consider the price increases expected for the next period in their wage claims.


If the unions succeed in this attempt and the employers are willing to consider the expected price increases in their wage offer, then indeed not only a wage lag is avoided, quite the contrary, the profits are now adjusted delayed to the price development. Namely, if employers accept these trade union demands, their real profit is reduced initially, and this does not increase before they have adjusted their nominal profit income to the general income development by further productivity increases and thus cost reductions.



10th How does inflation change the asset position?


According to general belief, inflation favours debtors over creditors. Debt agreements are generally concluded in nominal terms. If the debtor A receives from the creditor G a 10-year credit of 100,000 €, then after 10 years he has to repay just this 100,000 €. However, if in the meantime the price level has risen to a total of 25% due to a permanent inflation rate, then the real value of the loan repaid after 10 years is no longer equal to the value of this nominal amount 10 years ago. The value of the money has fallen by a quarter, so that the creditor can buy with the lent money only 3/4 of the value of goods of 10 years ago after ten years. And the higher the inflation rate is, the higher is the loss of the creditor and thus the debtor's profit. Again, there is no justification for these distribution political effects.


It must be added critically that this thesis is valid only under certain restrictive assumptions, though. There must be no anticipation of price increases in the interest rate. In fact, interest rates include, among other things, the inflation rate that is to be expected. In general, it can be assumed on functioning capital markets that the level of the interest rate depends on two factors: firstly on the level of inflation and secondly to the extent of the involved risk.


On functioning capital markets the interest rate corresponds to the inflation rate in case of stores of value and fixed-income securities for investments in which there is almost no risk, i.e. it can be expected with a high degree of security that the debtor can repay his loans. The precondition for this is, though, that the central bank does not pursue an expansionary monetary policy with the aim of raising the inflation rate. Here, the creditor receives a complete value adjustment in case of inflation, and thus is not disadvantaged either.


In the case of high-risk capital contributions, in particular for stock shares, the interest rate also includes a risk premium, which increases the higher the risk incurs. Equity funds are characterised by the fact that the fund is a mix of different shares, whereby the attempt is made to include shares with different levels of risk wherever possible. In this way, a certain amount of protection against stock price losses can be achieved. However, this protection is never perfect; risks associated with the economic cycle can not be covered fully in this way, since most of the enterprises are affected by cyclical influences.


A second way to avoid the inflation-related loss of capital is to provide indexation clauses at the granting of credit. Thus, the debtor may be obliged to pay a premium for inflation-related loss of value in addition to the nominal loan amount. And this loss of value could in fact be measured e.g. by the actually occurred inflation rate.


To what extent the value of assets is reduced by inflation depends furthermore on the type of asset investment. Tangible properties do not basically lose their value as a result of price increases, whereas financial assets lose their value by definition to the extent of inflation, unless the above-mentioned compensation mechanisms have been chosen. Even if tangible assets are not affected by definition by the price increase rate, a hedging against loss of value is only partially successful in this way. It has to be expected always that tangible properties will lose value over time, either because demand has shifted to other goods or because the same goods can be produced more cheaply due to technological progress.



11th Conflicts between stability and current account compensation


Probably the most important conflict with which the aim of monetary stability can come into conflict is the conflict with the aim of currency stability. While in the scope of the aim of monetary stability it is about to maintain the value of domestic money when buying goods, the aim of currency stability is about to ensure that the own currency remains as stable as possible in comparison to the currencies of foreign countries, this means that the value of the own money does not decrease in comparison with the value of foreign money (foreign exchange). And since, by definition, the fall in one currency always means a valorisation of another currency, a valorisation of one's own currency contradicts the aim of currency stability.


Both aims (monetary stability and currency stability) thus pursue the same aim. It is intended to ensure that the value of one's own money remains reasonably stable both towards the goods that can be acquired with the money and towards the foreign money that can be exchanged for one's own money.


Nevertheless, there is also a significant difference between the two aims. We have seen in the preceding sections of this chapter that the price level compared to the individual prices is actually irrelevant to solving the economic problems. In a market economy, the unit price is intended to express the scarcity of just this good, and to the extent that unit prices reflect scarcity do the price relations make a major contribution to orienting production to the needs of consumers.


By contrast, the price level which reflects the absolute level of the individual prices does only in a direct way not influence the allocation of production factors. For the orientation of the production on the demand it was insignificant, if all prices would be twice as high or if they would only amount the half.


If we anyway came to the conclusion that even inflationary processes can ultimately disrupt allocation, then this is because at inflations almost never all prices are changed at the same time and to the same extent. Inflation processes begin with individual goods and spread gradually, so that the price relations are postponed at least temporarily and thus welfare losses occur temporarily. Since the adjustment process continues to proceed differently in the individual markets, depending on the adaptability of the individual market partners, it is even to be expected that the price relations will  miss their optimum in the long run due to inflation processes.


Something else applies to the aim of currency stability. Unlike the price level, the exchange rate, which determines the value of the one currency in comparison with foreign currencies, is a unit price that has a very important function in the context of international traffic. While the individual price in the domestic economy has the function of reducing imbalances between supply and demand of this commodity automatically, that is, without intervention by the state; the exchange rate on free foreign exchange markets has the task of ensuring the balance of the imports and exports of a national economy.


The foreign exchange balance, which compares the income of the export trades with the expenditures on imported goods, may have imbalances in the short-term. In the long run, however, the foreign exchange balance must be equilibrated. Anyone who exports goods expects a payment basically in the currency of his own country, but these foreign currencies acquires a national economy just thereby that  goods have been exported previously in the same value and thus foreign exchange was taken in.


It is indeed possible that the import sum exceeds the export sum temporarily. But this course can only be followed if either foreign exchange surpluses have been achieved or if the foreign country allows a credit. But credit grantors generally expect these loans to be repaid in the future.


If a country has an import surplus, this problem can not be solved simply by reducing the import volume arbitrarily. Often - especially with regard to raw materials - there is an urgent need for these imported goods, because the own economy does not have these raw materials, but these raw materials are indispensable for the production of vital goods.


As in all free markets, an imbalance can also be reduced in foreign exchange markets by changing the exchange rate. If a country has a deficit in the foreign exchange balance, this deficit can be reduced by devaluating the own currency. In this way, the price of domestically produced goods decreases for foreigners calculated in foreign currency.


For example, the price of a good produced domestically is € 10. In the foreign exchange market, the domestic currency (the euro) was 2 units of foreign currency (dollars). Therefore, a foreigner had to spend 20 dollars to buy this imported goods thus far. Because with 20 dollars he could buy 10 euros in the foreign exchange market and 10 euros were assumed to be the price of this imported good.


Now the value of the euro fell to 1 dollar because of the domestic import surplus. This devaluation has the consequence that foreigners now only have to spend 10 dollars to buy a unit of this imported good. At normal reactions of foreign buyers, it can be expected that the demand for domestic goods increases due to the price reductions in dollar.


This increase in foreign demand for imports will (under certain conditions) increase exports, thereby increase foreign exchange revenues and eventually lead to a reduction in the domestic import surplus of the inland. However, the restriction applies that this positive effect is only to be expected under certain conditions, since the devaluation of the own currency will influence the export value sum in two ways.


On the one hand, foreign exchange revenues increase because more goods can be exported. On the other hand, foreign exchange revenues are partially declining as well, since calculated in dollar, fewer dollars are earned per export good (despite constant euro prices). The desired positive effect (increase in foreign exchange earnings) can only be expected if the volume  of export goods increases more strongly on a percentage basis than the price of export goods (calculated in dollar) declines. In this case, we are talking about that the foreign demand for imported goods is elastic, and the deficit in the foreign exchange balance will only decline if the foreign import demand elasticity is greater than one.


For some time, some foreign trade theorists feared that this condition was often not met, that therefore import demand elasticities were actually smaller than one. It was spoken of import pessimism. Experience and scientific discussion have shown, however, that import demand elasticities greater than one can indeed be expected in reality, and that therefore it can be assumed that devaluations will generally lead to the desired (deficit reducing) effect.


Unlike variations in the price level, devaluations thus have a function; they serve just like the individual prices to reduce market imbalances. Since it can be assumed that due to technical progress as well as due to a change in demand, which both may develop differently in the individual countries, mismatches in foreign exchange balances will arise again and again, a mechanism is needed to reduce these deficits in turn. The most important mechanism for automatic reduction is the correction of the exchange rates, though.


But just as inflation processes lead to undesirable effects with regard to other economic policy aims, also frequent corrections of exchange rates are undesirable for general policy reasons. Frequent changes in exchange rates increase the risk associated with foreign trade exceptionally. It is often feared that this insecurity will reach such a level that foreign trade will stop for these reasons, thus severely hampering the international division of labour and with this the associated productivity increases are extensively declining.


Certainly, almost every entrepreneurial activity entails insecurity. In general, it can be expected that there are still enough entrepreneurs in a national economy who are willing to produce despite the risk. However, risks that incurred for entrepreneurs in the inland were much lower than insecurities due to frequent exchange rate variations.


Domestic insecurity refers namely to a single good, but the insecurity of foreign trade refers to all goods which are traded internationally, so that the number of necessary exchange rate corrections is significantly higher than the need to correct a single price domestically. In addition, the entrepreneur could obtain the relevant data (needs of the consumers, possible offer of competitors as well as the most varied legal regulations) a lot easier domestically than abroad. For all these reasons, it was to be feared that in free foreign exchange markets, the exchange rate variations pose such a great risk that the international division of labour appears to be endangered.


Precisely for these reasons, an attempt has been made in the past to oblige central banks to work towards stabilising the exchange rates. Such a system of fixed exchange rates was provided worldwide in the period after the World War II in the IMF (International Monetary Fund) system as well as in the EWS (European Monetary System) system. The main difference between the two systems was that the IMF system provided for the dollar as the common currency, while the EMS system provided for a new artificial currency (the ECU).


Let us consider the situation in a system of fixed exchange rates. At this, we assume a balance of payments surplus. The foreign exchange earnings from exports exceed foreign exchange expenditures from imports. The central banks are now appearing as buyers in the currency markets, in our example they ask for foreign exchange. In order to keep the exchange rate constant despite foreign exchange surplus and to prevent a valorisation, the central bank has to buy up all surplus (i.e. not necessary for the import) foreign exchange.


 As the central bank pays these foreign exchanges with domestic currency, the circulating amount of money supply will increase. According to the quantity theory, this leads ceteris paribus to price increases. The equation applies:

G * U = P * H



        G = circulating money supply

        U =circulation velocity of money

        P = price level of goods

        H = trading volume (goods quantity)


Abroad, an analogous process takes place with the opposite signs: the domestic foreign exchange surplus corresponds to a foreign exchange deficit of abroad. Here again, the central banks have to intervene. To prevent devaluation, the foreign central banks have to sell foreign exchange. Since these sales are settled with the money of the foreign central banks, foreign money is removed from the economic circuit, the amount of money abroad declines and this then leads to a reduction in the price level abroad.


In-country inflation as well as deflation abroad is causing that export declines from the domestic point of view and the import rises. And these changes are being reflected abroad with the opposite signs: foreign imports are declining, but exports are increasing. If we assume in turn elastic import demand elasticities, then the domestic balance of payments surplus (respectively the external balance of payments deficit) will be reduced by inflation and deflation processes due to interventions of the central banks.


Thus, there are only two ways to reduce balance of payments mismatches in a free market economy:


In a system of fixed exchange rates the adjustment of balance of payment is thus made via inflation or deflation processes; in a system of free exchange rates, however, the balance of payments compensation is made via exchange rate adjustments. Consequently, in a fixed exchange rate system there is a trade-off between internal stability and current account compensation.


However, if we look at the long-term effects, it can be seen that the exchange rates for free trade in a system of fixed exchange rates can not be kept stable in the long run. In the deficit country, the central bank would have to offer foreign exchange again and again. At some point, the foreign exchange reserves are exhausted, no country will be ready to grant new loans again and again, as it is increasingly unlikely that the debt can ever be repaid due to the increase in debt level.


At the same time, however, the deflation associated with this central bank policy is also causing considerable problems. Keynesians believe that deflationary processes must be avoided at all cost, since deflation necessarily leads to a decline in production and hence also in employment. If one also has to point out that deflations do by no means always lead to a recession, this is only the case, if with the price level also the profits and thus the profit expectations decline, then one must consider that deflation over a longer period can hardly be enforced politically, may the underlying hypotheses (about the impact of deflation on the economy) be still so questionable.


Now let us consider the situation in the export surplus country. In order to prevent a permanent valorisation, the central bank would have to constantly buy up foreign currency in the amount of the export surplus. This is in principle always possible, of course. But the inflation associated with this policy - as already shown in this chapter - leads to considerable impairments in allocation and distribution. Thus in the long term, such a policy will hardly be politically enforceable.


Just for these reasons countries will be correcting their exchange rate imbalances sooner or later, deficit countries will devaluate their currency, and surplus countries will allow valorisations. However, this implies that persistent imbalances in the foreign exchange balance in both systems will be offset by exchange rate variations in the long term.


The only difference between the two systems (a free exchange rate system and a fixed exchange rate system) is thus based merely thereon that these exchange rate adjustments are delayed in the so-called fixed exchange rate systems, whereas in a free exchange rate system, this rate adjustment is made shortly after each imbalance occurs.


But it is precisely this delay within a system of fixed exchange rates that involves considerable risks. If a country has obtained a foreign exchange deficit namely for a long time, it is only a matter of time when the central bank is forced to devaluate its currency. And this means that it is worth speculating on devaluation. One buys foreign currency surpluses and then repays them at a profit after the valorisation of this currency.


It is decisive now that no greater risk is associated with this speculation. One can safely assume that sooner or later the central bank can do nothing else than to devalue its currency; at most, it is up for discussion whether this devaluation is to be expected tomorrow or only after a short period has passed. This will happen in any case and the longer this devaluation is delayed, the more likely it is that this exchange rate correction takes place in the immediate future.


Even if the devaluation does not occur in the next period, the speculator does not have to fear any price loss due to this delay. The extent of the devaluation is determined by the existing foreign exchange deficit, and as the central bank waits for another period of devaluation, the need for devaluation increases always and never diminishes.


But at the same time, the very fact that this is a low-risk speculation is contributing to a destabilisation of the foreign exchange markets and thus of the entire international trade. On the one hand, course corrections become more frequent and more necessary. The speculator obviously buys the hard currency, thus reducing the opportunity to buy imports with these scarce currencies, the need for a course correction now occurs faster than usual.


On the other hand, precisely the fact that this is a speculation with almost no risk brings about that it is mainly lay people who are involved in this business. For the question of how speculation affects markets it is crucial, however, if speculation is being practised by brokers with sufficient knowledge of market developments or by laypeople who lack market overview.


Let us take the case that on the stock market an enormous price drop has occurred for more accidental reasons. Informed speculators know that this price drop can by no means be justified by the market data, thus they assume that because of the lack of a cause for this price drop sooner or later the courses will return to their previous level. This type of speculator will therefore buy these currencies and then sell them later at a profit. An unsuspecting layman, on the other hand, fears that this price loss will continue and for this reason he will reject such foreign exchange in order to avoid the threat of price losses in the near future.


By buying these foreign exchanges, the broker with background knowledge helps that the price loss is reduced. By the same token, the layman contributes by the sale of these currencies to make the price loss stronger and lasting. The fact that speculation on devaluation is absolutely secure now in the case of a system of fixed exchange rates creates the danger that lay people are involved to a particular strong extent in speculation and that therefore the speculation in this monetary system has an overall destabilising effect.