A floating exchange rate is one where the monetary authorities neither intervene in the foreign exchange market, nor do they adjust the domestic money supply to smooth exchange-rate fluctuations.
Under the conditions prevailing in the commodity and asset markets of the major industrial economies, I show that a floating rate is an inefficient mechanism for balancing international payments. The comparative political or economic riskiness of holding financial assets in different countries changes continually. But domestic money supplies and national interest rates cannot vary to provide the necessary offsetting risk premia demanded by international investors. The result is inherently high exchange-rate volatility -"overshooting"- that distorts the flow of international commodity trade and causes cycles of unanticipated inflation and deflation in any open economy.
