Besides the effect which exchange rate volatility can have on the decisions of individual economic agents in a given macroeconomic environment, exchange rate factors can themselves influence the environment in which the international economy functions. They can influence the transmission of price and income effects across national economic boundaries; they can change the constraints on domestic macroeconomic policy formulation; and they can give rise to changes in the climate of protectionist pressures.
Inflation
It is well known that changes in exchange rates have implications for the price level. A depreciation, by increasing import prices and exerting upward pressure on the price of domestically produced traded goods, tends to bring about an increase in the overall domestic price level; conversely, an appreciation in the exchange rate exerts downward pressure. This in itself is not sufficient to conclude that fluctuations about a given trend in the exchange rate will cause the rate of inflation to be different than if no such fluctuations took place. In order to reach such a conclusion, it is necessary that exchange rate appreciations and depreciations have asymmetrical effects on prices. This could cause the price level to ratchet upward, if increases in prices that resulted from depreciation were less than fully reversed during subsequent appreciations.
This proposition has been attributed to Laffer and Mundell (see Wanniski, 1975), who apparently see it as a likely consequence of the “law of one price.” The argument goes as follows: the increasing integration of world markets tends to produce a similar price level for traded goods in all markets; this means that relative price levels in local currencies must adjust to offset movements in nominal exchange rates; and because of an institutionally induced downward inflexibility of prices, this adjustment takes place mainly through an upward movement of local prices in countries whose currency is depreciating.
Others (e.g.. Shields, Tower, and Willett, 1975; Kenen, 1979) have noted another mechanism by which exchange rate volatility might produce a systematic tendency toward inflation. If countries with depreciating exchange rates accept the stimulus to domestic demand caused by improved competitiveness while countries with appreciating currencies try to offset demand effects through stimulating domestic demand, the net result could be an increase in global demand relative to global supply. Nowadays, however, it seems less likely that governments would use demand management policies in such an overt way to maintain nominal aggregate demand at the expense of price stability objectives.
Goldstein (1977) provides tests of these possible asymmetrical effects using data for the period 1958–73 for five major industrial countries, both separately and on a pooled basis. His conclusion is that “… the empirical tests … are not supportive of the hypothesis that negative changes in import prices have a significantly different proportionate effect on domestic prices than do positive changes.” Of course, it should be noted that Goldstein’s analysis is based on data for a period before floating exchange rates, and when variability of real and nominal exchange rates was considerably less than in the more recent period. It could be the case that the large changes in foreign trade prices that have characterized the past ten years or so have had more than proportionate effects on domestic price levels. There does not appear to be any direct evidence bearing on this proposition, but indirect evidence does not suggest that the elasticity of response to exchange rate changes is systematically different when the change is large than when it is small. Goldstein and Khan (forthcoming) found no evidence that demand elasticities or response lags for imports were affected by the absolute size of price changes for imports; and in an earlier study of price behavior in the United Kingdom, Goldstein (1974) found that large changes in import prices did not have a greater proportionate effect on retail prices than did small changes.
It is also possible that, by generating shifts in the structure of demand, exchange rate movements result in more inflation for a given level of aggregate demand, since prices will tend to rise by more in sectors where demand increases than they will fall in sectors where demand declines. The argument has been advanced by Witteveen (1974, pp. 113–14) as follows:
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Exchange rates influence the distribution of demand between domestic and foreign products, and rate fluctuations will involve demand shifts which will later in some measure be reversed. These demand shifts may well exert a ratchet effect on inflation. …[S]hifts in purchase patterns brought about by the exchange rate changes, or even the expectation of such shifts, may tend to raise prices in the countries of depreciating currency without effecting a corresponding price reduction in the countries of appreciating currency.
It is also possible that institutional arrangements for administered prices (e.g., under the European Economic Community’s Common Agricultural Policy) may impart an upward bias to particular prices as a result of exchange rate changes (Marsh and Swanney, 1980).
Empirical testing of the influence of exchange rate variability on inflation has usually proceeded by indirect means. Direct tests of such a relationship require one to “control” for other factors affecting the inflation rate. This is particularly difficult to do, not least because of difficulties in identifying the channels by which inflation is generated and sustained in an economy. For example, if an external disturbance, say an unforeseen decline in the exchange rate, causes an increase in the domestic price level, this may cause workers to seek wage increases to protect real incomes. The authorities may allow this kind of inflationary pressure to be accommodated (at least to some extent) by an increase in the money supply. This in turn will tend to perpetuate the inflationary process set in motion by the initial disturbance. It is not clear how much the continuance of inflation should be blamed on the initial disturbance, or on the reaction to it of the monetary authorities. While in principle it can be said that over the long run the price level in domestic currency is under the control of domestic monetary authorities, disturbances in the economic environment can worsen the short-term trade-off between price stability and other economic objectives, thus causing the authorities to acquiesce in a higher rate of price increase than they would have accepted in the absence of such disturbances (Bond, 1980).
Bearing these caveats in mind, it is of interest to consider whether in practice there appears to be any broad association between exchange rate instability and the level of inflation. This is done in Appendix I, by specifying equations that attempt to measure the effect on inflation of domestic and external policy developments (specifically monetary growth and the level of the exchange rate) and adding a variable designed to capture exchange rate variability. Of the seven countries for which results are presented in Appendix I, six exhibit a positive association between exchange rate variability (defined as the standard deviation of the exchange rate during the previous five quarters) and inflation. In no case, however, is this association statistically significant at the 95 percent confidence level.
Policy Constraints
From the discussion in the previous section, it is clear that, if exchange rate variability has systematic effects on inflation, it is through its adverse implications for the constraints facing economic policymakers. That is, a worsening in the trade-offs among economic objectives could cause national authorities to opt for policies that could lead to higher rates of price increase. By the same logic, it follows that such a deteriorating trade-off could lead to a retreat from other objectives also, for example, in the field of the level and rate of growth of economic activity.
One of the initial arguments in favor of a system of flexible, rather than fixed, exchange rates was that economic policy would be freed from the requirement of stabilizing the exchange rate and authorities would be able to concentrate on objectives more directly related to economic welfare (Johnson, 1969). Of course, this argument depended on exchange rates being free to move, not on their actually moving by significant amounts. The relevant question for the subject of this paper is whether actual fluctuations in exchange rates have had adverse implications for macroeconomic policy formation.
One such effect has already been discussed: that on inflation. Another concerns the related possibility that exchange rate movements can become self-perpetuating, and give rise to vicious or virtuous circles. The “vicious circle” hypothesis, as set out in Section II above, argues that in the short run an exchange rate depreciation will both push up the domestic price level and worsen the balance of payments (the latter because initially the price effects on the trade balance will more than offset volume effects, which are subject to lags). Higher prices will push up wage costs (especially when wage contracts have cost of living provisions or indexation clauses), while balance of payments weakness will exert further downward pressure on the exchange rate. Thus a vicious circle is set in motion from which, it is argued, it is very hard to escape. For countries with strong currencies, a “virtuous circle” of low inflation and balance of payments strength results.
If countries do not fix their exchange rates, it is maintained, the only way the adverse consequences of a vicious circle can be avoided is through strong action affecting domestic demand. Since J-curve effects cause an exchange rate depreciation to have an initial adverse effect on the trade balance, countries will have to have relatively greater resort to demand deflation to improve their payments balance, and arrest the vicious circle.
While there is little reason to doubt that economic disturbances generate a momentum that carries their effects beyond the initial direct consequences, it is harder to maintain that exchange rate variability alone can start, and then maintain, a vicious circle of substantial proportions. In the 1977 Annual Report of the Bank for International Settlements, it was observed that
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The…striking fact…is that both the United Kingdom and Italy got into the vicious circle because of domestic developments. …one need not be an orthodox monetarist to regard the 30 per cent rise in the money supply (M3) in 1973 as the main factor behind the sharp decline in the value of sterling during the same year.
Regarding the perpetuation of vicious circles, most studies suggest that a depreciation of the exchange rate, even in countries with substantial indexation in wage contracts, does not cause a fully offsetting increase in domestic costs in the short term (Bond, 1980). Thus, the competitive advantage provided by exchange rate depreciation tends to endure long enough for volume effects on trade flows to exceed price effects, and thus to bring about an improvement in the balance of payments.
Protectionism
One of the most disturbing trends in recent years has been the increase in protectionist pressures and actions, particularly in a number of the major industrial countries that had previously been in the vanguard of the movement toward more liberal trade.
During the fixed exchange rate period, it was often contended (e.g., Friedman, 1953; Bergsten, 1972) that greater flexibility of exchange rates would work to reduce protectionist tendencies by weakening the balance of payments justification for import restrictions. Nowadays, however, it is recognized that the actual behavior of exchange rates has had domestic consequences that may have substantially increased pressure for protection on the part of domestic industries. Bergsten and Williamson (1983), for example, note that when a currency is overvalued employment in traded goods industries is threatened, and political realities make governments receptive to requests for protection. When the exchange rate shifts toward undervaluation, there is no comparable focus of disadvantaged interest groups to press for the removal of trade barriers. Not only is there relatively weak pressure for easing restrictions, there may also be a shift of resources into temporarily competitive industries. These activities may cease to be competitive as the exchange rate moves back once again, creating pressure for further measures of protection. Thus, prolonged deviation of exchange rates from fundamental equilibrium generates protectionist pressures, and asymmetrical responses compound the problem by failing to produce countervailing pressures. From this, Bergsten and Williamson conclude that the prevalence of equilibrium exchange rate levels is an essential ingredient in trade liberalization. While the interrelationship between an open and stable exchange and trade system is well recognized, some other observers take the argument further, and view the introduction of restrictive trade measures as an inevitable consequence of inappropriate exchange rate levels.
Most observers would agree that exchange rates have implications for the strength of protectionist pressures, though the argument is usually couched in terms of the exchange rate level rather than its variability. An over-valued exchange rate can adversely affect the balance of payments, or domestic employment opportunities, or both, and trigger demands for protection from sectors adversely affected by these developments. An appreciating exchange rate will hurt, ceteris paribus, export and import competing industries in relation to foreign competitors. While a given exchange rate, or change in the exchange rate, is the same for all sectors and firms in the economy, its impact on the individual firm/sector’s competitive position will differ according to the initial profitability position, supply elasticity, etc. Sectors suffering from the severest protectionist pressures may be those with long-standing problems of structural adjustment, which recession and/or exchange rate changes tend to aggravate.
There are, however, difficulties in establishing an un-equivocal relationship between exchange rates and the stance of trade policy. Apart from the problem of determining the exchange rate that would correspond to “fundamental” equilibrium, it is generally difficult to separate the effects on trade policy of swings in exchange rates from other factors affecting competitiveness, such as demand shifts, technological changes, and sensitivity to the business cycle. Many of the current protectionist measures have been sector or country specific, rather than across the board, and influenced by more fundamental and long-lasting shifts in competitiveness arising from factors other than exchange rate shifts. In the textiles and clothing sector, for example, restrictions have been directed specifically against developing countries with a comparative cost advantage in this sector, and have persisted for a quarter of a century during which they have become progressively more severe, irrespective of the abandonment of the par value system and the swings in exchange rates among major currencies that have taken place during this period.
Restrictions may be introduced to protect domestic industries suffering from overcapacity or depressed demand; an additional motivation may have been the perceived “unfairness” of subsidization practices or import restrictions maintained by exporting countries. The steel sector is a case in point; the restrictiveness of trade policy in this sector has been increasing in both the United States and the European Community since the mid 1970s, notwithstanding the exchange rate fluctuations experienced by their currencies over this period. Protection of the agricultural sector is fairly well entrenched in most industrial countries and is to a significant extent motivated by sociopolitical reasons. The exchange rate relationships observed in the past two decades among the U.S. dollar, the Japanese yen, and the key European currencies do not appear to explain the relatively high and, some observers would argue, increasing agricultural protection in many of these countries. In the automobile sector, a shift in U.S. demand to smaller, fuel-efficient cars following the energy crisis was an important factor in the loss of market shares of U.S. automakers, which culminated in the introduction of the export restraints by Japan on shipments to the United States; the widening of the restraints to the Canadian market was prompted importantly by Canadian concerns about trade diversion in this sector.
Strategic considerations appear to be the main factors in determining the stance of trade policies in the field of high technology. Examples of protectionist actions can be cited for periods of exchange rate shifts as well as for other periods; during the former, the exchange rate argument (which often emphasizes bilateral exchange rates) is, understandably, played up by the industry seeking relief from foreign competition, particularly because the industry itself cannot be “faulted” for loss of competitiveness owing to exchange rate factors.
There are counterexamples where moves toward liberalization were introduced despite exchange rate variability and associated trade uncertainties. Measures to improve market access have been negotiated or implemented during periods when exchange rate developments would appear to militate against a more liberal trade policy. For example, the Multilateral Trade Negotiations took place during a period (1973–79) of major swings in exchange rate relationships. The Generalized System of Preference was phased in by the industrial countries over a ten-year period beginning in 1966 which, at least in its latter stages, was similarly characterized by major exchange rate fluctuations.
A further point is that not only economic considerations but also institutional and political factors play an important role in determining the extent to which protectionist pressures translate themselves into restrictive trade policies. For example, industries can use the existing legislative provisions for protection from foreign competition more or less intensively, depending in part upon their perception of the government’s attitude in accommodating or rejecting requests for protection. Accommodation of the political pressure for protection in one sector can trigger heightened demand for protection in other sectors, and prompt criticism of “unfairness” in trade policy if the other sectors are denied protection. To the extent that an exchange rate is above its trend or equilibrium value, the coalition of interests supporting protectionist actions will tend to broaden.
On the other hand, restrictive trade measures can be delayed or avoided if governments can argue convincingly that such measures would be detrimental to national welfare and international economic cooperation. For example, the U.S. Trade Act of 1974 authorized a four-year suspension of countervailing duties on subsidized imports where this was needed in order to promote the ongoing trade negotiations on a GATT subsidies code. Thus, it would be a fallacy to assume that governments inevitably succumb to protectionist pressures. In the final analysis, the openness of markets depends critically on the strength of a government’s adherence to free trade principles. Although exchange rate factors can provide industries seeking protection an additional argument for countering deteriorating market shares of the domestic industry, a government’s trade policy is likely to be influenced by its assessment of the political risk of not accommodating the demand for restrictions, against the likelihood of retaliatory restrictions by other countries and greater demands for protection from other domestic industries.
Another point to be borne in mind is the capacity of inappropriate exchange rate movements and protectionist tendencies to be mutually reinforcing. An exchange rate shift that leads to deteriorating competitiveness inevitably leads to protectionist pressures from the industries most seriously affected. Government acquiescence in such pressures tends to validate the exchange rate movement that has occurred, since restrictions take the place of market forces in ensuring payments equilibrium at the new exchange rate. The process can be carried further if those industries that have not gained protection, and have thus experienced an erosion in competitiveness, press for equal treatment. Additional import restrictions will then make for an even higher exchange rate level.