- Jacob Frenkel, and Morris Goldstein
- Published Date:
- April 1996
Jacob A. Frenkel
International Monetary Fund
© 1996 International Monetary Fund
David D. Driscoll of the External Relations Department of the International Monetary Fund was the volume editor of this work.
Cataloging-in Publication Data
Functioning of the international monetary system / edited by Jacob A. Frenkel and Morris Goldstein. — (Washington, D.C.) : International Monetary Fund, (1996) 2v. cm.
1. International finance 2. International economic relations 3. Foreign exchange 3. Europe—Economic integration I. Frenkel, Jacob A. II. Goldstein, Morris, 1994–HG3881.F86 1996
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jacob a. frenkel, morris goldstein, and paul r. masson
atish r. ghosh and paul r. masson
jacob a. frenkel, morris goldstein, and paul r. masson
jeroen j. m. kremers and timothy d. lane
carlos a. vÉgh and pablo e. guidotti
a. lans bovenberg, jeroen j. m. kremers, and paul r. masson
paul r. masson and guy meredith
charles adams and bankim chadha
robert p. flood and peter m. garber
guillermo a. calvo
jacob a. frenkel and morris goldstein
james a. boughton
17. Should the International Monetary System Be Reformed?
jacob a. frenkel
18. Exchange Rate Variability and Slow Growth of Trade
paul de grauwe
19. Financial Market Integration and Exchange Rate Policy
donald j. mathieson and liliana rojas-suÁrez
20. Real Exchange Rate Dynamics in a Small, Primary Exporting Country
mohsin s. khan and peter j. monteil
21. Exchange Rate Policies in Developing Countries
bijan b. aghevli and peter j. montiel
22. Currency Convertibility and Economies in Transition
joshua e. greene and peter isard
Foreign Exchange Markets, Central Bank Intervention, International Reserves
23. Exchange Rate Forecasting and the Foreign Exchange Market
jeffrey a. frankel and kenneth froot
24. Options on Foreign Exchange and Exchange Rate Expectations
eduardo r. borensztein and michael p. dooley
25. Effectiveness of Foreign Exchange Intervention, 1985-88
26. Transactions Costs and Vehicle Currencies
stanley w. black
27. International Use of Currencies: The Deutsche Mark
george s. tavlas
28. In Search of a Monetary Anchor
warren l. coats, jr.
29. Currency Composition of Foreign Exchange Reserves
michael p. dooley, j. paul lizondo, and donald j. mathieson
30. Impasse on the Role of the SDR
jacques j. polak
The fiftieth anniversary of the Bretton Woods Conference has not surprisingly served as an opportunity to reappraise the role of the International Monetary Fund. Among the appraisals done outside the Fund, a popular theme has been the desirability of strengthening the Fund’s role in overseeing the functioning of the international monetary system. Whatever the design of the exchange rate system and the arrangements for the provision of international liquidity, it is widely accepted that such oversight, if it is to be effective, must rest on a strong analytical foundation.
These two volumes present analytical work done in the Fund on the international monetary system over the 1987–91 period.1 Most of the articles were written by Fund staff, but the book also contains a number of contributions by academic consultants to the Fund. The aim is to provide not a comprehensive collection of work done in the Fund (the list would be too long for that), but rather to bring together a set of papers that conveys the flavor of those live issues about the system that commanded close attention in the research program. Consistent with this orientation, the book is divided into the following four sections: international economic policy coordination; European monetary and exchange rate issues (the EMS, EMU, and German unification); exchange rate determination, alternative exchange arrangements, and reform of the system; and foreign exchange markets, exchange market intervention, and international reserves.
To place the individual papers in some perspective, a brief commentary on each is perhaps useful for the reader.
International Economic Policy Coordination
With the jettisoning of “benign neglect” of exchange rate policy by U.S. authorities and with the conclusion of the Plaza Agreement among the Group of Five countries in September 1995, interest in international economic policy coordination surged. Attention was directed at theoretical and operational issues alike. What is the most appropriate way to define policy coordination? What is the rationale for it? Under what circumstances could policy coordination be expected to produce better or worse outcomes than uncoordinated policy actions? If coordination is to be undertaken, what guidelines should govern its use?
In the first paper, Frenkel, Goldstein, and Masson examine the scope, methods, and effects of international economic policy coordination. Following Wallich (1984), they interpret coordination as a significant modification of national policies in recognition of international economic interdependence. They see coordination as essentially a mechanism for internalizing the international spillover effects, or externalities, associated with national policy actions. The authors outline a variety of circumstances—drawn from the theoretical literature—when coordination can be beneficial, but also underline the sometimes formidable obstacles to its implementation. Turning to the methods of coordination, they conclude that despite the many attractions of rule-based systems, there may not be an attractive alternative to conducting coordination in a judgmental way. They also argue that coordination is apt to be more successful when a multi-indicator approach is used (relative to single-indicator approaches, including those that employ the exchange rate as that single indicator), and when it is a regular ongoing process (rather than an episodic practice).
The second paper by Crockett takes a close look at the role of international institutions in surveillance and policy coordination. After studying two earlier efforts to institutionalize cooperation, namely, the creation and operation of Working Party Three in the Organization for Economic Cooperation and Development in the 1960s, and the development in the mid-1970s of principles for the guidance of exchange rate policies in the Fund, Crockett argues that some key lessons emerge. He maintains that effective international economic policy coordination requires three elements: first, a framework of rules and obligations; second, a set of generally agreed guidelines by which the rules can be interpreted; and third, a process of multilateral surveillance whereby countries can meet regularly to discuss the economic situation and agree on remedies for emerging imbalances. He finds that it is in the second area—the development of policy guidelines—where the least progress has been made.
The third paper deals with the requirements for successful international coordination of fiscal policies. In it, Tanzi emphasizes the many practical difficulties that arise in any attempt to implement coordination of fiscal policies among the industrial countries. In this connection, Tanzi stresses the problem of obtaining jointly agreed, reliable forecasts of major macroeconomic variables, the particularly long time lags associated both with enactment of fiscal policy changes and their impact on the economy, and the wide range of fiscal policy multipliers that emerge from existing multicountry models. In addition, he concludes that longer-term considerations, particularly the rising share of general government debt as a share of GNP in the industrial countries, argue against generating fiscal policy deficits in pursuit of shorter-term stabilization goals. He gives coordination of fiscal policy higher marks when it is restricted to structural aspects, including tax reform.
In the fourth paper, Ghosh and Masson take a critical look at the oft-cited objection that coordinated policies could be inferior to uncoordinated policies if policymakers choose their policies on the basis of the “wrong” economic model. Ghosh and Masson argue that such an argument suffers from two weaknesses: first, it attributes irrationality to policymakers since they should recognize the reality of model uncertainty; and second, it is not peculiar to policy coordination but rather applies to any activist policy (coordinated or uncoordinated) when the effects of this policy are unknown. Going further, they recall a lesson of the literature on policy choice in the presence of parameter uncertainty, namely that policy instruments should be used more conservatively. Indeed, they show that when model uncertainty is taken explicitly into account, it may provide an additional incentive to coordinate macroeconomic policies.
A continuing issue of contention over the effects of policy coordination is whether the performance of the world economy during the 1970s and early 1980s would have been significantly different if the major industrial countries had adopted a more coordinated set of macroeconomic policies than they in fact did. In the last paper in this section, Frenkel, Goldstein, and Masson employ the Fund’s multiregion econometric macroeconomic model (MULTIMOD) to conduct experiments in comparing the effects of alternative policy regimes. They compare one set of uncoordinated policies that envisages monetary policy being aimed at either the monetary base or nominal GNP, with a second set of coordinated policies that assumes that monetary policy is used to target either a nominal or real exchange rate. Simulations are conducted both for individual types of shocks and for shocks applied to successive periods where the variances of the shocks reflect their relative importance (so-called stochastic simulations). On the whole, the authors do not find that simple rule-based coordination policies perform better than uncoordinated ones, although they stress that this finding should not be used to draw inferences about the effects of judgmental coordinated policies (the latter are, of course, much harder to model).
European Monetary and Exchange Rate Issues
As with international economic policy coordination, European monetary and exchange rate issues were high on the policy agenda during the second half of the 1980s and the beginning of the 1990s. This was after all a period in which the European Monetary System (EMS) evolved from an adjustable peg system to a fixed rate system based on the nominal anchor of the deutsche mark, in which plans for European integration moved beyond the single market to embrace full-scale monetary union (cum agreement on the establishment of a European central bank and a common currency, as laid out in the Maastricht Treaty of December 1991), and in which the Exchange Rate Mechanism (ERM) faced the challenge of accommodating German unification. All of this provided grist for the research mill.
In the first paper of this section, Kremers and Lane investigate whether a stable demand function for narrow money can be identified for the countries participating in the ERM. As integration of goods and capital markets among ERM countries increased, one might suspect that the degree of substitutability of money and other assets denominated in the various participating currencies would increase with it. This increased currency substitution in turn could well render individual-country money demand functions more unstable than an aggregate demand function (since in the latter such currency substitution would presumably cancel out in the aggregate). Working in the other direction is the potential for traditional aggregation bias, that is, subjecting all countries to the same specification could be unduly restrictive if cross-country differences in the determinants of money demand were important. Using a two-step error-correction framework, Kremers and Lane show that a stable, ERM-wide demand function for M1 can be found, and that it displays some characteristics that make it preferable to single-country estimates. Their results also suggest to them that a European central bank might be able to implement monetary control more effectively than individual national central banks.
The second paper in this section is likewise empirical: this time a quantitative estimate by Gros of the impact of integration of European financial markets and lower inflation in the EMS on the revenue from seigniorage for member countries of the European Community (EC). Particular focus was given to those countries that then had relative high inflation rates, under the reasonable expectation that losses of seigniorage for these countries could be relatively large. Both flow and stock definitions of seigniorage are employed, and account is taken of intercountry differences in required reserves. Estimates of seigniorage are provided for 1982–87, and projections are made for 1988–92. In the end, Gros concludes that as inflation rates and required reserve ratios converge at lower levels in the EMS, revenue from seigniorage is likely to be substantially reduced for four EC countries that had relatively high inflation rates and higher required reserve ratios, but that from an overall point of view, the loss would be substantial for only two countries.
Végh and Guidotti, in the third paper in this section, offer a theoretical framework for asking how the constraints imposed by the EMS might affect the optimal way in which governments finance their spending. They focus in particular on the taxation policy implications of a common nominal interest rate and of equalization across countries of consumption taxes. Using a two-country model of public finance and simulating it for reasonable parameter values, they find that the constraint of a common nominal interest rate imposes only small costs. The picture that emerges from equalization of consumption taxes, however, is more mixed; for example, depending on the initial parameter configuration, such tax equalization could lead to divergences in national inflation rates.
Fiscal policy is also the subject of the fourth paper in this section. Here, Bovenberg, Kremers, and Masson consider whether the European Economic and Monetary Union (EMU) would make it desirable to institutionalize constraints limiting the freedom of national budget policies. The issue is approached from three angles: the influence of EMU on budget discipline, intergenerational equity and intertemporal efficiency, and macroeconomic stabilization. After weighing the arguments, the authors come to the view that various practical considerations, along with the need to pay heed to the subsidiary principle, argue against institutional constraints on deficits and debts or a tax on public borrowing. They also conclude that firm institutionalization of the European Central Bank’s commitment to price stability and of the no-bailout clause would be desirable, that policies that enhance the supply-side flexibility of EC economies would pay dividends in reducing the temptation to use expansionary policies to boost domestic output and employment, and that an intra-EC surveillance process for budgetary policies would provide a mechanism for internalizing the externalities associated with undisciplined budgetary policy.
The last paper in this section, by Masson and Meredith, analyzes the domestic and international macroeconomic consequences of German unification. Again, the analysis is aided by simulations based on the Fund’s multicountry macroeconomic model, MULTIMOD. The approach treats the excess of spending over saving in eastern Germany as the main “shock” to the global economy stemming from unification. Masson and Meredith illustrate that the global effects depend in good measure on the size of the shock from a global perspective, interest elasticities of saving and investment, real exchange rate elasticities of net exports, the distribution of increased demand in eastern Germany across countries, the formation of expectations of exchange rate changes, and the speed of the capital accumulation process. Among other results, the simulations suggest that the international effects of unification are not likely to be very large, as the negative demand effects of higher interest rates roughly offset the positive stimulus from higher imports of eastern Germany. There would be negative but relatively small output effects on other ERM countries and slightly positive output effects on non-ERM countries.
Exchange Rate Determination, Alternative Arrangements, and Possible Reform
The second half of the 1980s and the early part of the 1990s were marked by renewed reflection on the design of the international monetary system. The main stimulus for that thinking was the large misalignment of the U.S. dollar in 1984–85—no doubt the largest misalignment of a major currency during the period of managed floating and probably over the entire postwar period as well. Enough to say that many interpreted this misalignment of the dollar as evidence that floating exchange rates could, or even would, be subject to serious bandwagon effects, and concluded that the exchange rate system should therefore move in a more managed (less flexible) direction. The relatively good performance of the hardened EMS during this period—not yet confronted with large, country-specific shocks and before the exchange rate crises of 1992–93—added to the impetus for reform, including proposals for hybrid systems along the lines of target zones. Meanwhile, empirical research on exchange rate determination suggested that structural exchange rate models (be they of the monetary or portfolio balance variety) could do no better in explaining the out-of-sample behavior of major currency exchange rates than various so-called “naive” models (including a random walk model or the forward exchange rate). Beyond the industrial countries, many developing countries were examining their own exchange arrangements to determine if they were optimal, given their structural characteristics and particular circumstances. As the 1990s arrived, the transition economies also faced tough exchange rate policy issues, including the question of how fast to introduce convertibility.
In his paper, Isard attempts to draw the lessons from the poor empirical performance of exchange rate models. As a starting point, he notes that recent theoretical and empirical work has put into perspective some elements of truth about the relationships between exchange rates, national price levels, interest rates, and international balances of payments. For example, this work has demonstrated that the assumption of continuous or short-run purchasing-power-parity (PPP) can be firmly rejected, and that the assumption of long-run PPP seems very difficult to support empirically. Similarly, the weight of the evidence suggests that observed deviations from covered interest rate parity typically reflect transactions costs, the influence of capital controls, or data limitations that cloud asset comparisons and also suggests that uncovered interest rate parity does not hold. Isard goes on to argue that development of better exchange rate models will require analyzing exchange rates within complete macroeconomic frameworks, as well as employing exchange rate expectations mechanisms that are consistent with the structural models or that are based on whatever information can be easily extracted from the time-series of relevant variables. In addition, he recommends that further research be undertaken on the appropriateness of assuming perfect asset substitutability.
The second paper in this section, by Adams and Chadha, addresses a number of issues about the time-series processes followed by exchange rates, with a view to shedding light on the factors behind the mysterious permanent or longer-run movements of the U.S. dollar during the 1980s. Adams and Chadha demonstrate that most structural exchange rate models (including flexible and sluggish price monetary models and portfolio balance models) generate departures from a random walk, even when all shocks are expected to be permanent. The random walk in exchange rates can therefore be viewed neither as an implication of market efficiency, nor as a guide to the kinds of shocks that have been important in moving exchange rates. After examining the univariate time-series properties for exchange rates, the authors conclude that dollar exchange rates are indeed statistically indistinguishable from random walks. Moreover, they find that the forcing variables in structural exchange rate models (for example, money supplies and interest rate differentials, government spending, fiscal deficits, and outstanding stocks of public sector debt, current account balances, and net foreign asset positions) have only limited ability to explain the nonstationary behavior of exchange rates, or to predict changes in these exchange rates.
The likely behavior of exchange rates within a target zone (in which authorities direct policy to other goals while the exchange rate is within the boundaries, but direct policy to maintaining the zone once the boundaries are reached) has generated considerable interest among theorists and policymakers alike. The basic idea is that anticipation of bumping into the boundaries can generate important nonlinearities in the behavior of the exchange rate that would not be captured by models that assume linear expectations. Early treatments were able to characterize the behavior of the exchange rate within such a zone under the assumption that exchange rates were driven by regulated Brownian motion. In their paper, Flood and Garber generalize the target zone, exchange rate model to include discrete-sized exchange market intervention of uncertain magnitude, and also show how recent developments in the theory of target zones are the mirror image of the theory of speculative attacks on asset price-fixing regimes.
The fourth paper in this section, by Calvo, also takes up the economics of speculative attacks. More specifically, Calvo studies the case in which the central bank sets a rate of devaluation at a level inconsistent with fiscal constraints, and only reverts to a targets-consistent rate of devaluation when the reserves constraint is binding. He employs a model that is more general than earlier models of balance of payments crises in the sense that Calvo’s model examines the behavior of the current account and the real exchange rate rather than the balance of payments alone. He finds, inter alia, that as soon as the inconsistent policy is announced, the level of absorption will take an upward jump, generating both a current account deficit and an appreciation of the real exchange rate. Once the crisis occurs, the system returns to a steady state with a permanently higher real exchange rate. Also, during the transition, as the current account deficit and the appreciation of the real exchange rate are greater, the more inconsistent (overly ambitious) is the stabilization program.
The next three papers in this section address issues associated with the design and functioning of the exchange rate system. Frenkel and Goldstein look at various trends in the world economy that will condition the feasible evolution of the international monetary system in the period ahead. They emphasize the trend toward greater symmetry in economic size between the largest industrial economies of North America, Europe, and Asia, the trend toward increasing international use of currencies other than the U.S. dollar, the superior relative inflation performance of the three largest industrial economies, the relatively high variability of major currency exchange rates under floating, the large share of intraregional trade in the total trade of three potential currency areas, and the increasing integration and globalization of capital markets. They argue that it would be desirable for the international monetary system to evolve in the direction of a two-tier exchange rate policy, where exchange rate commitments were “looser” and “quieter” across the three major currencies than within budding regional currency areas. Finally, they employ the optimal currency area framework to evaluate plans for a single currency in Europe (EMU) and conclude that the record is mixed: Europe comes out well on some criteria, but poorly on others.
The Boughton paper delves into an issue that has a long and distinguished pedigree in international economics, the so-called assignment problem. Here, Boughton asks what assignment of monetary and fiscal policies to the objectives of internal and external balance is likely to work best when countries care about exchange rates but do not wish to adopt hard exchange rate commitments. One answer to this question—given prominence in the blueprint for economic policy coordination proposed by Williamson and Miller (1987)—is to assign monetary policy to external balance (the exchange rate cum current account) and fiscal policy to internal balance (nominal domestic demand). Boughton’s analysis, however, suggests that the reverse assignment would produce better results. Specifically, he argues that assigning monetary policy to control the current account via the exchange rate is problematic because the relative-price effect is likely to be offset by the effect of monetary policy on aggregate demand. Instead, fiscal policy should be given the task of limiting shifts in the current account (while the exchange rate is not directly managed), and monetary policy could then be directed at maintaining internal balance.
Should the international monetary system be reformed? In his paper, Frenkel reviews the sources of disenchantment with the existing system. He argues that the unpredictability of exchange rates is not a fault of the system but rather an intrinsic characteristic of efficient asset markets. Moreover, he notes that there is little convergence of views about the characteristics of the desired system, and that this lack of convergence reflects, inter alia, disagreement about the relevant alternative to the present system, different concepts of the equilibrium exchange rate, different shocks to different countries, and intercountry differences in the criteria that govern the choice of optimal currency areas. In Frenkel’s view, faulty policies—especially a lack of synchronization of fiscal policies in the major industrial countries—are at the root of most exchange rate misalignments. Reforming the system without reforming policies would do no good, and he is dubious of the ability of fixed exchange rates to deliver better policies in these countries.
A hotly contested issue in the debate on the optimal exchange rate system is the effect of exchange rate variability on the volume and conduct of international trade. The paper by De Grauwe in this section considers whether the marked decline in the growth rate of international trade that has accompanied the switch from the Bretton Woods to the present regime of managed floating can be reliably ascribed to an increase in exchange rate uncertainty and variability. To begin with, De Grauwe finds that on theoretical grounds it cannot be taken for granted that higher exchange rate variability will lead to a decline in the supply of exports. One needs special assumptions about the nature of the utility function to generate this outcome. Similarly, he notes that higher exchange rate variability will produce an increase in protectionism only if there is some asymmetry in protectionist tendencies (that is, only if protectionist measures instituted during the overvaluation cycle are not scrapped in the undervaluation one). De Grauwe then attempts to estimate the effect of exchange rate variability on industrial-country trade flows (holding other determinants of trade constant). In contrast to many earlier studies, he uses pooled cross-section, time-series data (for ten industrial countries) and allows relatively long lags for the effects of exchange rate variability on trade. Unlike most other tests of the variability hypothesis, he finds a significant, negative effect of exchange rate variability on trade.
In their paper, Mathieson and Rojas-Suárcz consider whether and how a country’s exchange rate should be adjusted when the degree of integration between domestic and external financial markets increases. As the authors point out, Europe and North America might be said to have supplied different answers to this question in the sense that the Delors Report (1989) recommended a system of fixed exchange rates for EMS countries (so as to enjoy the full benefits of financial market integration), whereas Canada and the United States maintain a flexible exchange rate policy in the face of increased integration of their two economies. The analysis of Mathieson and Rojas-Suárez suggests that as the financial structure is liberalized, the optimal scale of exchange market intervention changes in response to the relative impact of domestic and foreign shocks on output and price stability.
The 1980s represented a difficult external environment for developing countries: worsening terms of trade, slow growth in industrial-country export markets, sharp changes in the availability of foreign financing, and dramatic increases in real interest rates on external borrowing. In many cases, the adverse effects of these external shocks were compounded by weak domestic policies. Taking the view that getting the real exchange rate right is a central element in a successful adjustment effort, Khan and Montiel ask what are the dynamic effects of external shocks and of domestic policy actions on the real exchange rate of a small, primary-commodity exporting country. To answer this question, they construct a model that can gauge the dynamic effects on the real exchange rate of devaluation, fiscal and trade policies, and changes in both the terms of trade and foreign real interest rates. Since the real exchange rate will respond differently to alternative types of shocks, and since the short-run response will often differ from the long-run response, these dynamics need to be taken into account in the design of policy.
Aghevli and Montiel provide a broad overview of exchange rate regimes and movements of exchange rates in developing countries from the mid-1970s through the end of the 1980s. They attribute the evolution of exchange rate regimes in developing countries toward more flexible arrangements and more frequent use of the exchange rate as a policy tool over the past 15 years to greater fluctuation of industrial-country exchange rates, to an upsurge of inflation within developing countries themselves, and to an unusally adverse set of external shocks that required exchange rate depreciation as a key component of adjustment programs. That being said, they confirm that many developing countries continued to show reluctance to undertake discrete adjustments in their exchange rates. Aghevli and Montiel do not find convincing the argument that devaluation in a developing-country context is likely to be contractionary with respect to economic activity. They regard as more serious the concern that the pursuit of real exchange rate targets (via a rule that links nominal exchange rate adjustment to domestic inflation) can push an economy toward hyperinflation. They argue that the nominal exchange rate should retain a role as nominal anchor, and that the burden of external adjustment should be shared by both the exchange rate and financial policies.
The last paper in this section, by Greene and Isard, extends the analysis of appropriate exchange arrangements to the special problems of the transition economies. Their paper analyzes when these economies should introduce currency convertibility for current account transactions; it also discusses capital account convertibility and internal convertibility. Greene and Isard emphasize that successful introduction of current account convertibility requires the preconditions of adequate international liquidity, an appropriate exchange rate, sound macroeconomic policies (including the elimination of any monetary overhang), and the ability and incentives to respond to market prices. Once these preconditions are established, the move to convertibility for current transactions and transactions conducive to long-term capital inflows can be rapid.
Foreign Exchange Markets, Central Bank Intervention, and International Reserves
The large swings in the value of dollar, the increasing role of both the deutsche mark and the yen, the overburdening of monetary policy, and the uneven access of developing countries to international liquidity were all prominent features of the financial landscape of the 1980s. The search for their causes and consequences brought to the fore yet another set of research issues surrounding the operation of foreign exchange markets, the effectiveness of exchange market intervention, the evolution of vehicle and reserve currencies, and the need for a reserve asset that was not the liability of any national government. If the foreign exchange market is subject to overshooting, what could account for it? Could policy authorities lessen the overburdening of monetary policy by making more active use of sterilized exchange market intervention, and if so, does it matter whether intervention is announced and concerted? What determines the currency composition of foreign exchange reserves? What causes some vehicle and reserve currencies to gain ground relative to others? Is there still a case for a new monetary standard, and if so, what factors have thus far prevented the SDR from assuming a role closer to what was intended at the time of its creation?
In the first paper of this section, Frankel and Froot use survey data to shed light on the dynamics of the foreign exchange market. The authors argue that use of survey data is revealing since such data allow one to circumvent some of the problems that plague other efforts to uncover the characteristics of exchange rate expectations. Their empirical results suggest (1) that variation in the forward discount does not primarily reflect variation in the exchange risk premium; (2) that exchange rate expectations are biased; (3) that investors’ tendency to extrapolate recent trends at shorter-time horizons is likely to be profitable, but that the tendency to expect reversion to the mean at longer-time horizons is not; (4) that conflicting forecasts may well lead to noise trading; and (5) that the large overvaluation of the dollar in 1984–85 may have reflected the rising importance of chartists relative to fundamentals traders.
Borensztein and Dooley also examine the operation of the foreign exchange market and the behavior of exchange rate expectations, but they focus in their paper on option prices. The advantage of studying option prices is that these models are independent of investors’ degree of risk aversion and the process by which asset prices are determined in the economy (since these factors are summarized by the current exchange rate and security prices); in addition, option prices provide information on the expected volatility over time of exchange rates (not just on an expected value parameter). Their empirical results show that a model of option pricing that assumes that exchange rates follow a process admitting jumps or discontinuities along its path performs markedly better than the (standard Black-Scholes) model that assumes that there are no such jumps. Borensztein and Dooley also conjecture from the superiority of the jump model that market participants took seriously the possibility of a sudden depreciation of the U.S. dollar between 1983 and 1985.
The next paper in this section examines the nature and effectiveness of central bank intervention in the foreign exchange market. Obstfeld’s paper looks at the practice and effects of foreign exchange intervention over the 1985–88 period by the United States, the Federal Republic of Germany, and Japan. To isolate the pure effects of intervention on exchange rates, he concentrates on sterilized intervention. Obstfeld’s main conclusion is that monetary and fiscal policies, and not intervention per se, were the main policy determinants of exchange rates during this period. Pure intervention does seem to have played a signaling role when promptly backed up by other, more substantive policy adjustments. But the portfolio effects of pure intervention have been elusive enough to question its role as a policy instrument in its own right. In the end, he concludes that sterilized intervention does not offer much help in resolving open-economy policy dilemmas.
The paper by Black develops a simple model of transactions costs, so as to help explain why certain currencies are preferred to others as “vehicle” currencies. Black’s model focuses on the interaction between increasing use of the vehicle currency and falling transactions costs. The impact of volume on bid-ask spreads is estimated from cross-section, time-series data on seven currencies, and the hypothesized negative influence of volume on transactions costs receives support. Black also finds evidence that between 1980 and 1987 the share of the U.S. dollar in world trade declined somewhat—mainly attributable to the increased use of the deutsche mark and, to a lesser extent, of the French franc.
The Tavlas paper assesses the role of the deutsche mark as a key international currency. He argues that the internationalization of a currency will be aided by a relatively low rate and variability of inflation; a relatively stable external value; open, deep, and broad financial markets at home; a large share of world exports; and a large share of manufactured goods in its exports. In this light, recent developments presage an expanding international role for the deutsche mark, and Tavlas finds that the data corroborate this expectation. In his view, this expanding international role of the deutsche mark has stemmed in large measure from its importance as a key currency in Europe. The increase in deutsche mark invoicing by European countries has more than offset any lessening of invoicing in deutsche marks that may have resulted from the declining share of Germany’s trade with developing countries.
The next paper in this section, by Coats, explores an old but still relevant question of how to ensure the value of money. To provide an answer to that question, Coats explores and clarifies ideas (associated with Black, Hall, Fama, Greenfield, and Yeager) for establishing monetary systems in which the unit of account is not money. He discusses the importance of a common unit of account for reducing transactions and information costs, explains the role of arbitrage in controlling the quantity of money for both direct and indirect redemption of money, and considers the reasons why constant real value units (like those of Fisher and others) have not been adopted in the past. Coats suggests that giving the IMF’s SDR a constant real value would make it more likely that a constant real value unit would be widely adopted.
The final two papers in the section examine the composition and provision of international reserves. The first of those, by Dooley, Lizondo, and Mathieson, analyzes the factors influencing the currency composition of foreign exchange reserves in both industrial and developing countries over 1976–85. In contrast to earlier studies that relied on currency composition data for country groups, the authors’ empirical analysis uses individual-country data in pooled cross-section, time-series regressions. Their results suggest that for industrial countries, currency composition has been influenced by each country’s exchange rate arrangements, its trade flows with reserve-currency countries, and the currency of denomination of its debt service payments. For developing countries, a country tended to hold a greater share of its foreign currency reserves in assets denominated in a particular reserve currency, if its exchange rate was pegged to that currency, if a larger share of its exports and imports was with the country issuing the reserve currency, and if a higher share of the interest payments on its external debt was denominated in that reserve currency.
In the last paper in the book, Polak examines the reasons why, contrary to expectations at the time the SDR was created in 1970, allocations of SDRs have been few and far between (none since 1979–81), with the result that the share of SDRs in world non-gold reserves has continued to decline (to 5 percent at the time of Polak’s article), and its intended role as “the principal reserve asset” of the international monetary system has been unfulfilled. Polak notes that whereas a resumption of allocation of SDRs has been favored by the great majority of Fund members, it was opposed (during this period) by most of the major industrial countries. He explains that in the past 20 years, important structural changes have taken place that, among other things, have gone a long way toward facilitating the supply of reserves and of equalizing countries’ ability to acquire reserves; in particular, commercial bank credit to sovereign debtors (an exception in the 1960s) became widespread. He regards as unconvincing the arguments that SDR allocation (in the relevant amounts) would operate as a serious disincentive to adjustment, and that the creation of reserves ought to be the privilege alone of the private sector (commerical banks). Polak also presents several ways in which the attractiveness of the SDR could be enhanced. In the end, he concludes that a change of climate on allocation of SDRs depends on governments in industrial countries manifesting either a greater concern for the welfare of the disadvantaged countries, or a greater concern about the risks of the multicurrency reserve system.