Abstract

The last few years have witnessed a resurgence of calls for a re-examination, or perhaps even a reform, of the international monetary system. This paper contributes to the ongoing debate on that subject in three ways: (1) it suggests a set of criteria for evaluating alternative exchange rate systems; (2) it provides a comprehensive appraisal of a decade of experience with the present exchange rate system in terms of those criteria; and (3) it selects some key issues as a basis for discussion on how the evolution of the exchange rate system might best be managed over the medium term.

The last few years have witnessed a resurgence of calls for a re-examination, or perhaps even a reform, of the international monetary system. This paper contributes to the ongoing debate on that subject in three ways: (1) it suggests a set of criteria for evaluating alternative exchange rate systems; (2) it provides a comprehensive appraisal of a decade of experience with the present exchange rate system in terms of those criteria; and (3) it selects some key issues as a basis for discussion on how the evolution of the exchange rate system might best be managed over the medium term.

To keep the paper within manageable proportions, two restrictions have been placed on its scope. The first restriction is that the paper does not deal with the issue of international liquidity. In a sense, therefore, the paper confronts only half of the international monetary system. This is not meant to imply that no serious problems exist in this area. Clearly, while some of the “confidence” and “liquidity” problems, as highlighted so effectively by Triffin (1960), have subsequently been reduced by the creation of an internationally managed reserve asset—the special drawing right (the SDR)—and by the increased flexibility of exchange rates,1 other problems still remain,2 and new ones have arisen.3 A thorough treatment of such liquidity questions would go beyond the feasible range of a single paper, but many issues in the evolution of the exchange rate system can still be profitably discussed within the bounds of current reserve and liquidity arrangements.

The second restriction is that in discussing both the past performance of managed floating and the broad options for modifying the exchange rate system, the emphasis is on the larger industrial countries.4 This emphasis is not intended to deny the importance of the exchange rate system to the smaller industrial countries or to the developing countries; nor does it question the desirability—indeed the necessity—of their full participation in any restructuring of that system. Instead, it reflects the following factors: (1) the larger industrial countries account for a large share of total international trade and capital flows;5 (2) much of the trade of other countries (particularly in primary commodities) is denominated in the currencies of the large industrial countries (see Magee and Rao (1980)); (3) most developing countries and many of the smaller industrial countries have adopted some form of currency peg or limited flexibility in their exchange arrangements; (4) structural factors limit the feasible set of exchange rate system options for these countries,6 and (5) it is the variability of large-country currencies that has prompted calls for re-examination of the system.

The plan of the rest of the paper is as follows. Section II contains a background description of both the present exchange rate system and the global environment of the past ten years. The description of the exchange rate system covers the nature of exchange arrangements and of international codes of conduct for exchange rate behavior, as well as the extent of both exchange rate variability and official intervention in exchange markets. The environment is described not only by the performance of the seven largest industrial countries with respect to inflation, unemployment, economic growth, and labor productivity, but also by the combination of external disturbances and structural and institutional changes that contributed to that unfavorable macroeconomic performance.

Section III provides a comprehensive evaluation of the present exchange rate system, drawing not only on the past ten years of experience with managed floating but also on the accumulated experience with earlier exchange rate systems (especially with the adjustable peg system). The evaluation is guided by four criteria, applicable to all exchange rate systems, namely:

(1) How does the system help or hinder macroeconomic policy in pursuit of fundamental domestic economic objectives?

(2) How effective is the system in promoting external payments adjustment?

(3) How does the system affect the volume and efficiency of world trade and investment?

(4) How robust or adaptable is the system to changes in the global economic environment?

The main lessons to be learned from the experience with floating rates, as well as a summary of the present system’s principal strengths and weaknesses, are presented in Section IV.

Finally, Section V considers some possible directions for the managed evolution of the exchange rate system. Its purpose, however, is not to draw firm conclusions but rather to offer a focus for analysis and a basis for future discussion on how the present exchange rate system might be altered in ways that are both desirable and feasible.

Lessons of the Past and Options for the Future