The Exchange Rate System : Lessons of the Past and Options for the Future

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1984
• eBook ISBN: 9781557750648

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III Evaluation of the Present Exchange Rate System

Thus far, the broad characteristics of the present system have been described and the principal changes in the global economic environment have been identified. It is now time to move to an evaluation of the present exchange rate system. That evaluation is conducted in two distinct steps. The first step is to introduce a set of criteria that can be used to evaluate not only the present exchange rate system but other exchange rate systems as well. The second step is to apply those criteria to the operation of the present system over the past ten years.

The basic reason for separating the discussion of the criteria themselves from their application to the experience of managed floating is that, even if readers disagree about the relative strengths and weaknesses of the present system, the acceptance of a common framework for evaluation at least ensures that disagreements are based on different readings of the evidence rather than on different yardsticks.

Criteria for Evaluation

The following four criteria serve in this paper as a basis for evaluating the present exchange rate system:

Criterion #1—Does the system help or hinder macroeconomic policy in pursuit of fundamental domestic economic objectives (price stability, sustainable growth, high employment)?

Criterion #2—How effective is the system in promoting external payments adjustment?

Criterion #3—How does the system affect the volume and efficiency of world trade and capital flows (and thereby resource allocation in the international economy at large)?

Criterion #4—How robust or adaptable is the system to significant changes in the global economic environment?

Because these criteria figure so prominently in what follows, it is useful to discuss first not only their rationale but also what kinds of issues each encompasses.

Internal Balance

The first criterion reflects the view that the exchange rate system is basically a facilitating mechanism for more fundamental domestic economic objectives, such as price stability, high employment, and sustainable economic growth. That is why, in sharp contrast to some earlier analyses of exchange rate systems (e.g., Williamson (1980)), the degree of exchange rate variability, for example, is not put forward here as a normative criterion. In other words, the assumption is that exchange rate variability is important only to the extent that it impinges upon (or facilitates) the achievement of more ultimate targets of economic policy.

The channels by which the exchange rate system might help or hinder macroeconomic policy are many. In this study, the focus is on the following issues—each of which has figured prominently in the ongoing debate on the merits of the present system: (1) Does the system provide the “discipline” necessary for the imposition of responsible macroeconomic policies, particularly for inflation-prone governments? (2) Do exchange rate fluctuations and downward price inflexibility combine to produce an upward ratchet effect on national and global inflation rates? (3) Does the system exacerbate intercountry inflation differentials by drawing weaker countries into a “vicious circle” of inflation and currency depreciation and stronger ones into a “virtuous circle” of price stability and currency appreciation? (4) Does the system affect unemployment rates either by adverse effects on the efficiency of the price mechanism that increase frictional unemployment, or by generating longer-term exchange rate disequilibria that foster structural unemployment in traded goods industries? (5) Does the nature of the system influence the effectiveness of monetary policy under conditions of high capital mobility? and (6) How well does the system function as a shock absorber against different types of disturbances? In seeking to answer these questions, both short-term volatility and longer-term fluctuations in exchange rates will be considered.

External Balance

Moving to the second criterion, considerations of external balance are introduced to supplement the internal balance objectives subsumed under the first criterion. By asserting that a desirable exchange rate system is one that promotes external payments adjustment, it is meant that the system should set in train an internationally acceptable adjustment mechanism, either automatic or discretionary, that eliminates balance of payments disequilibria over a reasonable time period. To make such a criterion operational, it is necessary to have some definition or concept of balance of payments equilibrium. This continues to be a thorny problem. For the purposes of this paper, it is sufficient to think of balance of payments equilibrium as a condition under which the current account position can be financed by normal capital flows without recourse to undue restrictions on trade, special incentives to inflows or outflows of capital, or wholesale unemployment.³⁰ This is essentially the definition suggested by Nurkse (1945) almost 40 years ago. It is closely related to the concepts of fundamental disequilibrium and of underlying payments equilibrium employed by Fund staff,³¹ and it forms the basis for most definitions of the equilibrium exchange rate (which is usually defined as the exchange rate that produces this type of payments outcome).³² A finding that a given exchange rate system has produced effective external adjustment would imply that observed exchange rates were, over the medium term, close to equilibrium real exchange rates.

It should be recognized that this second criterion is meant to encompass not only the question of whether the exchange rate system promotes external payments adjustment but also the question of how it does this. Specifically, the second criterion leads to consideration of the following external adjustment issues: (1) What are the respective weights of relative price changes and income movements as adjustment mechanisms in that system—and how do these two mechanisms differ in promoting adjustment? (2) What are the implications in that system of different speeds of adjustment in goods versus asset markets (or in the current account versus the capital account)? (3) Does the system promote symmetry of adjustment between deficit and surplus countries and between reserve centers and nonreserve centers? and (4) Is external adjustment in that system automatically induced or is it discretionary? Again, it is sufficient to note that each of these adjustment issues has been part of the debate on the functioning of the present system.

Volume and Efficiency of World Trade and Investment

The third criterion derives from the proposition, given explicit endorsement in the purposes of the Fund,³³ that global welfare is generally increased by an expansion of world trade and investment. This is another area where it is desirable for the exchange rate system to act as a facilitating mechanism for some more basic economic objective. This criterion deals with the efficiency of trade and investment because, in the real world where international traders sometimes are reacting to temporary relative price signals that bear little relation to longer-term changes in comparative advantage, not all increases in the volume of trade will be beneficial—that is, it is possible to have “false trading,” to borrow a phrase from McKinnon (1976).

In attempting to appraise the effects of the present exchange rate system on the volume and efficiency of world trade and investment, it is necessary to examine two additional questions: namely, (1) How does exchange rate uncertainty affect international trade and investment? and (2) Do sizable exchange rate disequilibria generate strong and effective pressures for protectionism?

Adaptability to Change

The final criterion is different from the others because it is not associated with any of the familiar economic objectives—whether foreign or domestic. The rationale for including it is that, as with political constitutions, there are nontrivial costs associated with changing international monetary constitutions, especially under crisis conditions. Other things being equal, it is therefore better to have an exchange rate system that is relatively robust or adaptable to changes in the global economic environment. For example, an exchange rate system that will work well only under conditions of low international mobility of capital is undesirable unless it is certain that capital will have low international mobility in the future. Similarly, an exchange rate system that relies on all changes in comparative advantage being slow and smooth will not be as desirable, ceteris paribus, as one that can also accommodate more abrupt changes. The same logic applies to other environmental factors, ranging from the degree of real wage flexibility to the preference for a particular reserve currency and even to the assumed behavior of one particular type of economic agent (whether the reserve center country or market speculators). This is not to say that the durability of a system is as important as how well it functions while it lasts but rather to suggest that it surely counts for something.

With these four evaluative criteria in mind, the next step is to use them in a systematic assessment of the past decade’s experience with managed floating.³⁴ In order to place that experience in perspective, comparisons will frequently be made with experience under the system of adjustable par values during its last decade. Also, references will occasionally be made to experience under even earlier exchange rate systems (e.g., the gold standard). The purpose of such comparisons and references is not to draw conclusions about whether managed floating is the best (or worst) of all past exchange rate systems, but rather to guard against holding managed floating to an unduly high or low absolute standard of performance.

Floating Rates and Macroeconomic Policy³⁵

If floating rates do affect inflation, or unemployment, or the efficiency of domestic monetary policy, or the insulation of the domestic economy from external shocks, how do they do it? The arguments of both the advocates and critics of floating rates are examined here.

Floating Rates and Inflation

Critics of floating rates have long contended that floating rates are inflationary on three principal counts: (1) because they weaken the resolve or discipline to fight inflation; (2) because they interact with downward price inflexibility to ratchet-up both country and global price levels; and (3) because they trap weaker countries in a vicious circle of inflation and currency depreciation, thereby exacerbating intercountry inflation differentials.

Discipline Hypothesis

The discipline hypothesis is based on the assumption that the balance of payments constraint under fixed exchange rates acts as a check on the pursuit of inflationary policies. Because a devaluation would be regarded by the public as an admission of the failure of government policies, a high-inflation country will sooner or later be obliged to alter its policies in such a way as to bring the inflation rate into line with that of its neighbors. The perception by the public that a given parity must be defended prompts the adoption of otherwise unpopular policies of demand restraint. Surplus countries under fixed rates are said to be subject to a weaker discipline, either because there is no similar constraint on the accumulation of reserves or because the revaluation that is necessary to avoid such accumulation carries no political liability. Under floating rates, this anti-inflationary discipline is absent because (so it is argued) the only consequence of a relatively high inflation rate is a depreciating currency.

The discipline hypothesis prompts the following observations.

(1) Whatever the differences in anti-inflationary discipline between truly fixed rates and purely floating rates, these distinctions become blurred in a comparison of adjustable par values and managed floating.³⁶

Yet the latter two regimes are the relevant ones for the observable macroeconomic policy behavior of the postwar period.

(2) The political cost of devaluation under fixed rates should not be exaggerated. From 1955 to 1971 the longest period without an exchange rate change by any of the 16 OECD countries was five years (1962–66). Likewise, the number of exchange rate adjustments by high-inflation participants since the inception of the European Monetary System in 1979, as well as the number of departures by high-inflation countries from the “snake” in an earlier period, suggest that devaluation is not viewed as a political catastrophe.³⁷ All of this is also consistent with the emerging literature on public choice that relates voting behavior and government popularity to economic variables. It is found in the literature that only the traditional domestic macroeconomic variables (real income growth, inflation, and unemployment) count and that only recent performance is important (i.e., voters have short memories) (Fair (1978); Frey and Scheneider (1978)).

(3) In those cases where there have been conflicts between internal and external balance under floating rates, these conflicts have by no means always been resolved in favor of the internal target. Black (1978), for example, after studying such conflicts over the 1973–76 period, reports (p. 626):

• In most cases, some influence of the external target on monetary or fiscal policy is evident, except for Germany in 1973, the United Kingdom in 1974, and Canada in 1974. Furthermore, the influence of external targets appears to have been rising, as the 1976 conflict cases (France, Italy, Canada, the United Kingdom, and Sweden) have all been resolved in favor of the external target over...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Prefatory Note
• I. Introduction
• II. The Present Exchange Rate System and Its Operating Environment
• III. Evaluation of the Present Exchange Rate System
• IV. Overall Appraisal of the Present Exchange Rate System
• V. Options for the Future
• Appendix: Statistical Tables
• References
• Tables
• Footnotes