Forex: Selective Switching Devices
The cost of selective switching devices too will vary considerably depending on existing economic relationships.
Restrictions, subsidies, and exchange control mainly generate costs at the microeconomic level, since they rely on selective price changes that can distort the pattern of resource allocation.
Traditional economic theory assumed that these costs, in the form of reduced resource productivity, would necessarily be quite high.
However, more recent theoretical developments tend to suggest that such selective distortions may actually improve economic welfare if they offset other distortions attributable to governmental or other interferences in the marketplace.
These developments are summarized in what has become known as the theory of the second-best (or theory of distortions).
The general theorem for the second-best optimum states that if there is even a single distortion in the environment to prevent attainment of a global welfare maximum, then there is no longer any a priori presumption against the introduction of further distortions.
Economic welfare should be maximized if no distortions at all are present (the first-best optimum).
But in second-best optimum may actually require that governments to add to existing distortions in the environment.
Like expenditure-changing policies, devices can actually generate welfare gains rather than losses.
This will certainly be true if the theory of the second-best obtains in the particular situation; it will also be true if adjustments takes the form of removal of existing restrictions, subsidies, or exchange control by surplus countries when first-best conditions obtain.
In certain circumstances, a general price adjustment through the foreign exchange market will be far less costly than either expenditure-changing policies or more selective switching devices.
For instance, in dilemma situations, a formal change of the exchange rate will enable the authorities to approach both internal and external balance simultaneously without aggravating the domestic macroeconomic problem.
In case of deficit (surplus), a devaluation (revaluation) or depreciation (appreciation) will improve the balance of payments while also reducing domestic unemployment (inflation).
Likewise, in situations where the theory of the second-best does not obtain, a general price adjustment would avoid introducing undesirable distortions into the pattern of global resource allocation.
It is for these reasons that a single currency (or its equivalent) would not necessarily be the optimal organizing principle for international monetary relations.
Unalterably fixed exchange rates do reduce transactions costs to a minimum. But in circumstances such as these, that particular benefit may be far outweighed by the economic cost of inapposite adjustment policies.
An efficient monetary order could not entirely forgo the advantages of exchange rate flexibility.