Journal Issue

Toward a more orderly exchange rate system: Exchange rate instability and how to reduce it

International Monetary Fund. External Relations Dept.
Published Date:
March 1983
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Jacques R. Artus

There is, at present, a widespread feeling of dissatisfaction with the exchange rate system born out of the 1971–73 crisis, in particular because of the large movements of floating exchange rates. These movements have often exceeded 30 per cent over a period of two to three years, a variability much greater than the variability of the relative national price levels (see chart). Some contend that such extremely large differences between exchange rate movements and prices were justified—by changes in international comparative advantage, by the underlying determinants of domestic saving and investment, or simply by the stickiness of domestic prices. But it is difficult to accept these views; structural factors cannot have changed so much, so fast, and so frequently, and exchange rates have been much more variable than relative money stocks, which are not subject to any stickiness problem.

Reasons for this instability give grounds for concern. The first reason is that an unanticipated disturbance affecting the supply or the demand for money tends to have a larger initial effect on the exchange rate than is ultimately necessary to offset the effect on relative national price levels. That is, the exchange rate “overshoots.” An unanticipated reduction in money growth, for example, is followed by an initial period during which prices keep rising as fast as before because of built-in rigidities in the goods and labor markets. The ratio of available money to nominal income declines and the real interest rate rises. The exchange rate then has to appreciate to offset the favorable international differential in real interest rates and the time these are expected to persist.

When the overshooting related to the interest-rate effect was first emphasized (Dornbusch, 1976), it was thought to account for small and brief changes in the exchange rate as monetary shocks were supposed to have only small and brief effects on real interest rates. Now, data on short-term real interest rates suggest that a major monetary contraction may cause short-term real rates to rise by as much as 5 percentage points and that the effect may last for several years. As an illustration, a 5 percentage point increase in the short-term real interest rate expected to last for three years should cause an initial exchange-rate overshooting of 15 per cent.

A second reason for the instability is that an unanticipated disturbance that affects the current account balance also tends to have an initial effect on the exchange rate that exceeds the ultimate change. For example, an adverse change in the terms of trade will lead to a worsening of the current account and a period of adjustment during which private wealth is shifted from domestic residents to nonresidents. These nonresidents have to be compensated for the exchange and political risks of holding the weakening currency and will bid down the exchange rate to a level that is below the one expected to prevail in the longer run. It is difficult to assess the size of the overshooting arising from a current account imbalance, but there is evidence that even a small international transfer of private wealth may at times imply a significant depreciation of the currency. This is particularly the case when the share of assets denominated in this currency in the portfolios of nonresidents is small.

The third reason for longer-run instability is that the future is highly uncertain. The size of overshooting from unanticipated disturbances on the real interest rate, or on the current account, is related to the expected duration of their effects, which, in practice, are extremely difficult to forecast. Forecasts are therefore revised on the basis of current developments, and these revisions lead to exchange rate movements. Such uncertainty also leads to indeterminate expected long-run equilibrium exchange rates. Private market participants have fairly limited information on what underlying economic conditions are going to be a few years ahead and change their views frequently. This is particularly true at present, as it has been during most of the 1970s, because practically all industrial countries are engaged in efforts to reduce stagflation, efforts whose ultimate success is highly uncertain. In addition, national authorities are at times directly responsible for exchange rate swings because they let economic conditions and expectations deteriorate gradually to a point where the exchange rate has been pushed so far that they feel obliged to shift suddenly to a policy of strict monetary restraint.

Nevertheless, over the past ten years, relative gross national product deflators or relative money stocks in the three main industrial countries—the United States, Japan, and the Federal Republic of Germany—have often followed relatively regular trends with fluctuations of limited amplitude. It is difficult to see why such trends would lead to wild gyrations in expectations, unless political factors were as important as economic factors in affecting exchange rate expectations, in part because they affected the perceived riskiness of the physical assets located in, or the financial assets issued by, the various countries.

These influences on long-run instability have nothing to do with market inefficiencies. Indeed, the view is that because exchange rates reflect all available information, they often tend to overshoot and to vary considerably from year to year. Whether it should also be recognized that, at times, private market participants are victims of speculative crazes or other “bandwagon forms” of behavior is more controversial. It seems that there is no scientific way to prove or to disprove the existence of such forms of behavior. For example, one may find it difficult to believe that the change in the outlook for underlying economic and political conditions in the United States and the Federal Republic of Germany from January 1980 to August 1981 was so large that it justified a 54 per cent appreciation of the U.S. dollar vis-à-vis the deutsche mark in real terms. But that is a matter of judgment. Possibly the information available in January 1980 suggested that the United States was on the verge of runaway inflation. Possibly the information available in August 1981 suggested that the situation in Eastern Europe was on the verge of dealing a deadly blow to the German financial system. Neither explanation seems plausible, but it cannot be proved that they were inconsistent with the information available at the time.

Bilateral exchange rates, relative prices, money stocks, and relative current account positions, 1973–811

Source: IMF, International Financial Statistics.

Note: Indices 1973–81 = 100.

1/ The bilateral real exchange rate is calculated as the bilateral nominal exchange rate (period average) adjusted for changes in GNP deflators expressed in local currencies. The data on relative prices also refer to the GNP deflators. The data on money stocks refer to M2 (average of end of month series). The relative export/import ratios refer to goods and services. All data except for bilateral exchange rates are seasonally adjusted.

The costs of instability

The static welfare loss from exchange rates that are out of line with long-run needs is probably small. From a welfare standpoint, far more important are the actual costs of moving resources. Given existing rigidities in goods and labor markets, such shifts will lead to transitional unemployment of both labor and capital, and perhaps also to a permanent loss of resources as some workers are forced to go into early retirement and some capital equipment is scrapped. There may also be inflation when the industries that start to expand bid for the necessary resources. These sectoral shifts, with the accompanying loss of resources, can be on a fairly large scale. Fluctuations in nominal and real exchange rates of 30 per cent or more in two or three years have been frequent. Such fluctuations can have major effects on the structure of production. (See the table for estimates of the effects of a 30 per cent appreciation.)

Effects of a 30 per cent appreciation of the effective exchange rate1(In per cent)


Export volume
Semi-finished manufactures–16.5–13.7–7.2–23.0–26.4
Finished manufactures–22.4–17.8–12.5–31.1–31.5
Other goods–14.1–9.1–5.0–23.5–18.2
Import volume
Semi-finished manufactures15.615.
Finished manufactures24.324.717.933.330.4
Other goods4.
Terms of trade11.310.
Volume of production
Semi-finished manufactures–10.3–9.6–10.1–6.8–1.8
Finished manufactures–7.2–9.5–7.6–7.7–6.3
Other tradable goods–3.2–2.1–1.1–6.4–4.3
Nontradable goods3.
Consumption deflator–16.2–15.2–18.8–9.6–10.1
GNP deflator–6.8–6.5–8.0–4.1–4.6

The estimates presented here are derived from the Fund’s Multilateral Exchange Rate Model (see Artus and McGuirk (1981)). They refer to medium-term effects (three to four years) of an appreciation of the exchange rate over and above the exchange rate change corresponding to the differential in underlying rates of inflation. In the simulations used to derive these estimates, the level of real GNP is constrained to remain unchanged in order to focus attention on the effects of the appreciation on the structure of the economy.

The estimates presented here are derived from the Fund’s Multilateral Exchange Rate Model (see Artus and McGuirk (1981)). They refer to medium-term effects (three to four years) of an appreciation of the exchange rate over and above the exchange rate change corresponding to the differential in underlying rates of inflation. In the simulations used to derive these estimates, the level of real GNP is constrained to remain unchanged in order to focus attention on the effects of the appreciation on the structure of the economy.

Another source of concern is that the uncertainty concerning longer-run changes in real exchange rates that is generated by the type of instability considered here may lead to a shift of resources away from the more exposed traded-goods sectors. The consequences may be slower growth of foreign trade, a weaker competitive climate, and decreased incentives for growth and productivity. Such consequences are quite complex and difficult to measure. The main problem is that this uncertainty cannot be easily hedged in the forward markets. Other forms of hedging have to be used, and some of them may be quite costly in terms of resource allocation. Firms may, for example, set up separate production units in each of their major national markets to minimize the risk of sudden movements in the ratio between costs and product prices. They may also try to decrease their net risk position by importing more from countries to which they are exporting, or by exporting more to the countries from which they are importing.

As a result, the decrease in the volume of international trade could be small, but the move away from a full exploitation of comparative advantage could be quite significant. Similarly, even if the level of foreign direct investment is sustained, resource allocation may be impaired by excessive diversification of production units among countries. More relevant in the present context is that, if investors are risk-averse, an increase in exchange rate uncertainty should, in itself, generate a decrease in the amount of savings transferred among countries. There could also be a fragmentation of the international capital markets, so that the comparative advantage of each market over different types of transactions and maturities could not be fully exploited. The econometric evidence available thus far casts little, if any, light on the issues concerning the effects of exchange rate uncertainty, particularly on long-term international capital flows. Available surveys of how businesses view exchange rate developments are also inconclusive on these points.

A further cost of exchange rate instability is that it can make it more difficult for the authorities to achieve stable domestic economic conditions. One reason is that, as discussed above, a disturbance in a major country may push its exchange rate to overshoot because of its effects on real interest rates and the current balance. The overshooting will present authorities in trading partners with a dilemma: to accept the changes in their exchange rates, with their accompanying effects on domestic costs and prices, or to change their monetary policies. Both alternatives may be extremely costly.

To be fair, exchange rate instability in an inflationary world has certain advantages. It favors authorities that are inclined to follow a policy of monetary restraint, because the appreciation of their exchange rates will help the domestic fight against inflation, and it similarly penalizes loose monetary policies. The problem is that there are countries such as Japan, and to a lesser extent Germany, that have already largely reduced their domestic inflation—in part thanks to relatively well-functioning labor markets. These countries do not appreciate the choice given to them between exchange rate depreciation and abnormally high interest rates.

Policy remedies

Given the costs of instability in real exchange rates, major changes in real rates that are not needed from the standpoint of adjustment in the goods markets should be viewed with concern. The issue is how they can be reduced without introducing equal or even greater costs.

It is a truism, but one that cannot be repeated too often, that the important prerequisite for more exchange rate stability is to have national authorities follow more stable, credible, and balanced domestic policies to deal with their inflation problems. First, stable expectations are necessary for the floating exchange rate system to function properly, and these depend on market participants having some reliable information on where exchange rates are likely to be a few years in the future. Second, only stable and credible domestic policies can lead to the gradual winding down of inflationary expectations that must take place if inflation is to be reduced.

Domestic policies must also be balanced. This does not only mean that a restrictive monetary policy should be accompanied by a restrictive fiscal policy. The overshooting that occurs with a program of monetary restraint in the main reflects the failure of prices and nominal factor incomes to adjust quickly to changes in monetary policies, as well as to changes in supply and demand in the goods and labor markets. There are only two ways to facilitate the decline in inflation and reduce overshooting: (1) to rely on market forces, which assumes that most of the rigidities that limit the role of these forces are eliminated; or (2) to rely on incomes policy, which assumes that a suitable social and political framework is established.

National authorities should also keep an eye on the exchange rate in conducting their monetary policy. Technological and regulatory developments in financial markets are currently affecting the meaning of the various monetary aggregates in a number of countries. In addition, in countries such as the United Kingdom where residents are free to substitute assets denominated in foreign currencies for domestic money holdings, shifts in expectations about exchange rates or relative interest rates can affect the normal relationship between the monetary aggregates and domestic nominal demand. Even in other countries, this normal relationship can be affected by changes in foreign demand for the local currency. Thus, seeking a constant rate of growth of certain monetary aggregates may, at times, destabilize the real economy and the exchange rate. On such occasions, movements in the exchange rate can be viewed as a useful indicator of shifts in money demand that should be offset by shifts in domestic money supply. (The interest rate can also be used as an indicator to detect such shifts, but there is a risk that a change in the nominal interest rate may reflect a change in inflationary expectations rather than a shift in money demand. This can lead to costly policy mistakes; in particular, an expansion of domestic money supply may feed the rise in inflationary expectations at a time when they should be subdued by a contraction.)

However, the use of the exchange rate as an additional indicator of monetary policy requires careful judgment. Exchange rate movements that are needed to offset inflation rate differentials and other changes in underlying economic conditions do not call for changes in domestic money supply. Similarly, the authorities may rightly hesitate to change domestic money supply when the instability of the exchange rate reflects the instability of monetary policies abroad. Finally, even if a convincing case can be made that an exchange rate appreciation reflects an increase in money demand, the authorities must assess whether allowing a sustained expansion in domestic money supply will not be misinterpreted by private market participants as an indication that the monetary authorities are giving up the fight against inflation.

There are cases where exchange rate instability results from a difference of interests between countries. For example, there can be a difference of interests, at least in the short run, between countries where deeply embedded wage rigidities make it necessary to maintain high real interest rates for a sustained period in order to reduce inflation, and countries where, thanks to more flexible nominal wages, there is no such need. Some reconciliation must take place, and some exchange rate instability may be unavoidable in the short run to achieve a reduction of inflation in countries with inflexible nominal wages. But, in the longer run, there is no doubt that the domestic and international objectives would best be reconciled by a gradual elimination of wage rigidities.

Intervention and currency blocs

Although more stability could be introduced into the system through more efficient domestic policies, it would be unrealistic to expect that such a change would completely solve the problem of exchange rate instability. In any case, progress on this front will be difficult and slow. Both intervening in foreign markets and forming currency blocs could help control exchange rates, but only under certain conditions that are not easy to satisfy in practice.

Intervention can be financed from owned reserves, use of swap facilities, or borrowing from private international markets. Directives or incentives given to state agencies or private banks to lend or borrow abroad are also forms of intervention. (It is assumed here that the effects of intervention on high powered money are being offset to prevent domestic impact.)

First, it must be recognized that countries differ substantially as to how much the authorities can rely on intervention to control their exchange rate. There is a whole spectrum, ranging from countries that have primitive domestic trade and financial markets completely isolated from world markets that can keep the exchange rate fixed for many years by direct controls (although a black market may develop), to countries with large and highly developed domestic markets fully integrated with world markets, where intervention is unlikely to have a sustained effect.

Recent experience also suggests that the effectiveness of intervention depends on whether it has specific objectives (either a specific rate or a lower or upper limit) over the short run, or aims only to influence the evolution of rates that are basically floating. In the first case, members of the European Monetary System (EMS) have demonstrated that countries can maintain exchange rates within narrow bands for substantial periods of time, even though they have widely different domestic policies and inflation rates. In the second case, the experiences of countries such as Germany (with respect to the deutsche mark/dollar rate), Japan, and the United Kingdom suggest that intervention as part of a managed float tends to have a limited effect. There are two main reasons for this difference in effectiveness. First, a major factor influencing the exchange rate is the expectation of a significant and persistent change in the shares of domestic and foreign securities in private portfolios at home and abroad. If there is no clear intervention policy, intervention on any given day is unlikely to give rise to such an expectation. Second, if the authorities have a specific exchange rate commitment, and this commitment is credible because it is realistic, private speculators will greatly enhance the effectiveness of intervention by moving funds in the same direction.

This evidence would suggest that an effective way to avoid the instability of a floating rate system would be to use some form of flexible pegging. This is what practically all developing countries, as well as the countries that participate in the exchange rate arrangements of the EMS, have done. But the major risk is that it becomes a system that postpones needed exchange rate changes. A further problem is that, in the longer run, currency blocs such as the EMS can work well only if member countries are able to adjust their rates of growth of labor costs to levels that are consistent with the rate in the least inflation-prone country. This requires countries to be willing to adopt financial policies that foster the achievement of this target within a few years. It also requires a certain flexibility of nominal wage rates if restrictive financial policies are not to lead to a vicious circle of profit squeeze, low investment, and declines in productivity calling for reductions in real wage rates.

There are, therefore, a number of approaches that can be used to reduce exchange rate instability. By far the most promising is to move toward more stable, credible, and balanced domestic policies. Given the present inflationary conditions, of particular importance would be policy measures that would reduce rigidities in labor markets in order to enhance the effect of monetary restraint on the growth of nominal wages. This would shorten the period of high real interest rates and reduce the overshooting of the real exchange rate. However, progress in this direction is likely to be slow. Another approach is to rely more heavily on official intervention. No doubt, there are clear limits to the effectiveness of intervention, as well as clear dangers, but the usefulness of intervention under certain circumstances should not be dismissed. In this context, regional monetary blocs could contribute to a more orderly global system, but only if member countries are able to adjust their rates of growth of labor costs to the rate in the least inflation-prone country. Finally, a subject not considered here, coordination of reserve policies among important central banks, will have to continue in order to prevent potentially destabilizing changes in the composition of their portfolios of foreign currencies.

This article is based on a paper presented at a conference on the Evolving International Monetary Arrangements, at Wingspread in Racine, Wisconsin U.S.A. in July 1982.

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