Abstract

The preceding review and analysis of a decade of experience with managed floating is suggestive of some ways to improve the operation of the exchange rate system. In this section, that theme is expanded upon by considering some directions for possible restructuring of the exchange rate system. It should be emphasized that at this early stage of the debate, the purpose is not to draw firm conclusions about the best single proposal, but rather to offer a focus for analysis and further discussion on how the evolution of the exchange rate system might best be managed.

The preceding review and analysis of a decade of experience with managed floating is suggestive of some ways to improve the operation of the exchange rate system. In this section, that theme is expanded upon by considering some directions for possible restructuring of the exchange rate system. It should be emphasized that at this early stage of the debate, the purpose is not to draw firm conclusions about the best single proposal, but rather to offer a focus for analysis and further discussion on how the evolution of the exchange rate system might best be managed.

Rather than present an exhaustive taxonomy either of alternative exchange rate systems or specific proposals for change, this section is organized around a series of key issues for discussion. Each of these issues concerns a general channel or mechanism for altering the operation of the present system. As implied in Section II, however, such a list would probably be a sterile one without three ingredients: (1) a notion of what the objectives of these alterations should be; (2) at least a rough outline of the environment in which such a changed exchange rate system would likely have to operate; and (3) an indication of which countries or country groups would be the primary initiators or beneficiaries of these changes.

There are, of course, no simple or completely satisfactory answers to any of these three questions. For the purposes of this paper, however, it may be sufficient to employ three working assumptions that are consistent with the preceding analysis of the present system. The first such assumption is that a reasonable intermediate objective would be to maintain enough flexibility in real exchange rates to foster external adjustment, but at the same time, create conditions under which real exchange rates do not stray so far, so often, and so long from levels consistent with “fundamentals.”108 In capsule, the first part of that objective might be considered as the present system’s principal strength and the latter part, its principal weakness. Turning to the environment, perhaps the safest assumption to make is that the rest of the 1980s may be somewhat more hospitable than the 1973–82 period. This means that the exchange rate system may still have to contend, inter alia, with large disturbances of both a real and monetary variety, high international mobility of capital, unexpected demand shifts among alternative reserve currency assets, varying degrees of real wage flexibility across countries, large shifts in comparative advantage across countries, and serious sectoral problems that give rise to continuing demands for protection against foreign producers.

On the other hand, the mean rate of inflation, as well as its dispersion across countries, could well be lower, and there may continue to be a reservoir of goodwill that can be tapped for efforts aimed at greater coordination of policies.

Finally, although many channels for improving the operation of the system apply equally well to all country groups (e.g., the pursuit of stable, credible, and balanced underlying policies), it is probably most realistic to assume that initial efforts be directed primarily at the major industrial countries. As noted in Section II, most of the developing countries as well as some of the smaller industrial countries have already adopted some form of pegged exchange rates or limited flexibility in their exchange arrangements. As such, quite apart from the dominant role that the larger industrial countries play in international trade, more stability in the exchange rates of the major currencies would go a long way toward providing greater stability in the real effective exchange rates of the rest of the world.

Key Issues

With this rough outline of objectives, environment, and major participants in mind, it is possible to make an assessment of how the present exchange rate system might be altered in desirable and feasible directions. To aid in such an assessment, six key issues have been selected. The statement of each of those issues is accompanied by a brief commentary that sets forth some of the principal factors or arguments that bear on that issue. Many of these key issues are, of course, familiar from earlier reform deliberations, including those conducted under the auspices of the Committee of Twenty.

Issue No. 1

Is it reasonable to envisage the return of conditions under which fixity of exchange rates among the major currencies could be restored?

Commentary. A negative answer to this question rests on the following grounds: (1) that these countries would be unwilling to completely subordinate monetary policy to the dictates of a fixed exchange rate; (2) that structural differences among them are large enough to preclude the emergence of a common rate of inflation; (3) that there will be a need for real exchange rate adjustments to reflect changes in comparative advantage; (4) that prices and wages are too inflexible (particularly downward) to obtain the requisite real exchange rate movements without changes in nominal exchange rates; and (5) that there is no willing or readily acceptable candidate for the central role of the pivot or nth currency in the system. The case for a positive answer is essentially that: (1) there is already in prospect a significant convergence of inflation rates for the four largest countries in 1983–84; (2) the discipline necessary for coordination of policies among the others will be given great impetus by the establishment of fixed rates; (3) the policy autonomy under alternative systems is largely illusory; and (4) even a partial success (infrequently adjustable rates) would have a strong positive effect on domestic stability and the resumption of world trade growth.

Issue No. 2

If nominal exchange rates need to be adjusted to reflect changes in the “fundamentals” over time, is there any rule or formula that could help in determining the right structure of rates? Also, what about the merits of presumptive indicators for initiating adjustment?

Commentary. The principal argument against the use of formulas or rules for determining appropriate changes in nominal exchange rates (e.g., a crawling peg based on inflation differentials or on an average of past exchange rate movements) is that the factors calling for exchange rate changes (for example, shifts in labor productivity, permanent changes in the terms of trade, changes in tastes, natural resource discoveries, dramatic changes in expected future macroeconomic policies, etc.) or symptoms of an exchange rate maladjustment (for example, heavy capital inflows and attendant excessive indebtedness and intensifying exchange controls) are too varied, too unpredictable, and too unstable over time to be captured ex ante in any formula or rule. There is also the supplementary argument that while such a formula approach may have represented a reasonable second-best solution to the nominal exchange rate rigidities of the Bretton Woods era, this approach loses its raison d’être in today’s world where exchange rates are, if anything, too flexible. The main counterargument is perhaps that exchange rate formulas represent a reasonable middle ground between the excessive rigidity of administratively set exchange rates and the excessive volatility of market-determined rates. Furthermore, its supporters might also point out that market-based forecasts of exchange rates (e.g., forward exchange rates) have themselves proved to be very poor predictors of actual exchange rates, so that the uncertainty problem is not specific to formulas or to rules.

“Presumptive” or “objective” indicators for adjustment are less restrictive in principle because they only signal a need for adjustment but usually do not specify the combination of adjustment measures that the country should adopt. In brief, the case for them is that the regular examination of a set of multiple indicators could help to detect problems at an early stage and hence induce a more timely and more symmetrical pattern of adjustment than would occur in their absence (or at least trigger discussions of policy among countries that make coordinated surveillance workable). As with exchange rate rules, opposition to them is often based on the arguments that there is no simple indicator that will consistently transmit reliable adjustment signals and that, even if there were such an indicator, practical problems over its precise definition, measurement, and monitoring would severely limit its applicability.

It will be recalled that an objective indicator based on international reserves was a part of the Committee of Twenty’s Outline of Reform. The only exchange rate arrangement that has actually implemented a presumptive indicator is the European Monetary System (EMS). In that system, once a country’s actual exchange rate crosses a threshold of divergence from its European currency unit (ECU) central rate, it is presumed that the authorities will undertake corrective measures (e.g., diversified intervention, domestic monetary policy measures, or changes in central exchange rates). More recently, a number of economists have proposed using the movement of exchange rates as a presumptive indicator for changes in domestic monetary policy.

Issue No. 3

Would adjustable par values with narrow margins be viable for the major currency countries in today’s world of high capital mobility?

Commentary. Although similar in many respects to the first issue (i.e., the restoration of fixed exchange rates), the capital mobility issue is given special prominence here because it is widely cited as perhaps the key contributory factor to the breakdown of the Bretton Woods system. Indeed, the case against a return to adjustable par values with narrow margins is that none of the factors that made the Bretton Woods system so vulnerable to “hot money” flows would be less problematical today or tomorrow. That is to say, large and suddenly changing interest rate differentials would still arise because of the failure to harmonize monetary and fiscal policies across countries, there would be rumors of imminent parity changes due to a whole host of circumstances (e.g., changes in governments with different economic priorities), and the resources of central banks would be insufficient to cope with the larger resources of private speculators. Some would go further and say that today’s situation would be even more tenuous than under the Bretton Woods system because liberalization measures and technological advances have combined to render capital much more mobile than during the 1950s and 1960s. Hence, if such an adjustable peg scheme could work at all, it would need both wider margins and some mechanism to insure prompt adjustment of par values. The opposing view does not so much hold that these afore-mentioned problems are less serious today than in earlier times but rather that the intractability of the problem is exaggerated. The viability of the EMS, despite its short tenure, may provide some support for this view. Specifically, if there are sufficient political commitment, generous support facilities for riding out balance of payments difficulties, active exchange market intervention policies, a presumptive indicator for adjustment, and the acceptance of the need for occasional, and sometimes occasionally large, realignments of central rates, then such a system can function, even with relatively narrow margins.

Issue No. 4

Is a solution to excessive exchange rate variability to be found in new taxes or restrictions on international capital flows?

Commentary. This is again a familiar issue but one that has gained new relevance in the debate of how to cope with overshooting of floating rates. The case against throwing “sand in the wheels” of the international capital market includes the following arguments: (1) no strong presumption exists that the resource allocation costs from impeding the international flow of capital would be less serious than those emanating from restrictions on goods; (2) there is no reliable (ex ante) method of separating “productive” from “nonproductive” capital flows by reference to such factors as maturity (short term versus long term) or ownership (portfolio versus direct investment); (3) any tax on capital flows would make it more difficult for a country to finance a current account imbalance because it would have to raise interest rates enough not only to create a favorable interest rate differential but also to offset the cost of the tax; (4) even aggressive control programs, such as those of the early 1970s, often failed to stem private capital flows, and the subsequent development of offshore banking markets makes their efficacy today less likely; and (5) unless uniform restrictions or taxes could be negotiated and accepted by all parties, there would be a constant danger of escalation and retaliation, with damaging spillovers for other international transactions. The case for such impediments to capital flows does not deny these costs; instead, it argues only that they will be smaller than the macroeconomic costs associated with larger exchange rate fluctuations under free mobility of capital.

Issue No. 5

Should greater stability of floating exchange rates be sought primarily in greater stability of macroeconomic policies at the national level and in greater coordination of these and of other policies (e.g., exchange market intervention) across countries?

Commentary. As emphasized earlier, it is by now widely accepted that floating exchange rates would show less volatility if a firmer anchor could be established for medium-term and long-term private sector expectations about exchange rates. The case for stressing the implementation of stable, credible, and balanced policies is simply that, quite apart from their favorable impact on domestic economic objectives, these policies are the single most important ingredient in generating such a stable anchor for exchange rate expectations. For, if market participants cannot gauge the medium-term course of basic policies and if they cannot be confident that basic economic objectives can be reconciled across countries without either dramatic shifts in policy mixes and/or in exchange rates, they will have little basis from which to “form a view” about future exchange rates. In such circumstances, speculative “bubbles” and “bandwagon” effects become more prevalent because there are no natural bounds for the expectations of speculators. Conversely, where countries have a history of stable policy behavior and where, therefore, forecasts of policy intentions have credibility, neither minor shocks nor short-term deviations of policies from targets are likely to be translated into large exchange rate movements because longer-term expectations about rates will not be much affected. The relative stability of the floating Canadian dollar over the 1950–61 period is often cited as an example of such a stabilizing anchor at work (i.e., the belief that a dollar should be worth approximately a dollar). Because better conduct is widely recognized as improving the functioning of any exchange rate regime, no case can be made against better macroeconomic policies. But there are doubts and questions about if and how such improved policy conduct can be brought about within the present system.

In thinking about this issue, it may also be useful to consider the following questions:

(1) What characteristics of policy behavior in the major currency countries could have been responsible for observed exchange rate behavior over the past two to three years?

(2) Have the external adjustment problems of the past decade been primarily due to a lack of agreement on appropriate policies across countries or rather to the absence of political will to implement such appropriate policies?

(3) What role should exchange market intervention play in communicating policy intentions to the market and in otherwise trying to establish an anchor for exchange rate expectations?

(4) What can be done in labor and product markets to increase the flexibility of wages and prices so that financial market prices do not have to carry so much of the burden of responding to disturbances?

Issue No. 6

Would official forecasts or target zones for exchange rates help both to reduce the variability of exchange rates and to increase the incentives for external adjustment?

Commentary. The case for official forecasts or target zones rests on two arguments. First, in the absence of such official forecasts, it is too difficult for market participants to form a view about future exchange rates. Even where policies are relatively stable, there are just too many factors operating on exchange rates to make a firm judgment about the value of the exchange rate 6 or 18 months ahead. Official forecasts of the exchange rate, provided that they are credible, are thus deemed to be necessary for generating an anchor for exchange rate expectations. Second, because the authorities would be under some pressure either to keep actual exchange rates within the target or forecast zone or to explain departures from the zone, it is claimed that the speed of external adjustment would be increased. It is argued that without such official forecasts, authorities have insufficient incentives for adjustment since they can always equate the “right” rate with the market rate.

The idea of official forecasts or target zones differs from the traditional adjustable peg system in three principal respects. First, a country’s intervention and monetary policy obligations are considerably looser under the former than under the latter. Specifically, the country does not have to intervene in the exchange market to keep its forecast rate within the prescribed zone (so-called soft margins) and it similarly does not have to make exchange rate considerations paramount in setting its monetary policy. Instead, it should not use intervention to push the actual rate away from the forecast rate when the former is outside the zone,109 and it pledges to give exchange rate considerations more attention than under the present system in formulating monetary policy.110 A second difference is that the forecast or target zones are usually contemplated as being much wider than under the adjustable peg system; those wide zones are to reflect the large margin of error associated with attempting to forecast the equilibrium exchange rate and are to provide some buffer against large and sudden capital flows. Third, the forecast rate and the zone are expected to be examined, and if necessary, altered at frequent intervals to reflect changes in countries’ comparative advantage or relative competitive positions. Because of this feature, it is possible that in some situations departures of actual exchange rates from target zones would be accommodated by changes in the target zone rather than by policy measures designed to move actual rates back into the zone.

To some observers, the practice of announcing official forecasts or targets for the growth rates of monetary aggregates in a domestic context provides a useful analogy. Such forecasts or targets provide a presumption that the authorities will conduct policies so that the growth rates of aggregates would evolve within ranges specified. In the event that the targeted aggregate should move outside its expected range, it is presumed that the authorities will act to offset this movement or will explain why the earlier target is no longer appropriate. Moreover, in many countries more than one aggregate is targeted and when, as is often the case, the different aggregates behave differently, again it is presumed that the authorities will explain their emphasis on one aggregate or another in current circumstances. Even when the explicit quantitative targets are not always attained, it is argued that they provide an anchor for expectations and a relatively straightforward context for explaining the authorities’ actions.

The case against official forecasts of exchange rates is that: (1) in a world of stable underlying macroeconomic policies, no additional anchor is needed for exchange rate expectations; (2) knowledge of the determinants of exchange rate movements, or of the equilibrium exchange rate, is so rudimentary that the target zones would have to be too wide to have value as an anchor for expectations; (3) negotiation of forecast rates, zones, and changes in them would be subject to all the centralized management delays of the Bretton Woods era, thereby robbing the scheme of its flexibility; (4) the best guide for domestic monetary policy is still that of achieving price stability; in contrast, the exchange rate can often give false signals; and (5) forecast rates or zones would only have credibility if they were backed by broad coordination of macroeconomic policies—and if such coordination could be achieved—no change in the present system would be necessary.

Statistical Tables

Table 6.

Exchange Rate Arrangements, June 30, 19831

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Source: IMF, Annual Report of the Executive Board for the Financial Year Ended April 30, 1983, p. 20.

No current information is available relating to Democratic Kampuchea. All members whose currencies are pegged to a single currency do so at present within zero fluctation margins. Members whose currencies are pegged to the SDR or “Other composite” maintain their exchange rates within zero or very narrow margins, seldom exceeding ±1 percent about the peg. Within the “Flexibility Limited” category, the “Single currency” subcategory lists those members that are observed to maintain an exchange arrangement such that their exchange rate fluctuates with a variability equivalent to 2¼ percent margins with respect to another member’s currency. The subclassification, “Cooperative arrangements,” lists the countries participating in the European Monetary System (EMS). With the exception of Italy, which maintains margins of 6 percent, these countries maintain 2¼ percent margins with respect to their cross rates based on the central rates expressed in terms of the European currency unit (ECU). Members with exchange arrangements listed under the “More Flexible” category are divided on the basis of the extent to which the authorities intervene in the setting of exchange rates. In some instances the exchange rate is allowed to move continuously over time; if the authorities intervene at all they do so only to influence, but not to neutralize, the speed of exchange rate movement. That exchange arrangement is classified as “Independently floating.” Alternatively, the exchange rate may be set for a short interval, usually one day to one week, and the authorities stand ready to buy and sell foreign exchange at the specified rate (the “managed floating” group).

All exchange rates have shown limited flexibility vis-à-vis the U.S. dollar.

Member maintains dual exchange markets involving multiple exchange arrangements. The arrangement shown is that maintained in the major market.

Exchange rates are determined on the basis of a fixed relationship to the SDR, within margins of up to ±7.25 percent. However, because of the maintenance of a relatively stable relationship with the U.S. dollar, these margins are not always observed.

Changes in the exchange rate vis-à-vis the pound sterling generally occur when the effective exchange rate, as calculated on the basis of the weighted currency basket, deviates by more than ± 1 percent from the pegged level.

Margins of ±6 percent are maintained with respect to the currencies of other countries participating in the exchange rate mechanism of the European Monetary System.

The exchange rate is maintained within margins of 5 percent on either side of a weighted composite of the currencies of the main trading partners.

The fluctuation band of the Bank of Finland’s currency index is currently about 4.5 percent (equivalent to margins of ±2 ½ percent).

The exchange rate is maintained within margins of ± 2.25 percent.

The exchange rate is maintained within margins of ± 2.5 percent in terms of the fixed relationship between the kwacha and the SDR.

Table 7.

Estimates of Import and Export Price Changes in Response to a Devaluation of 10 Percent

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Table 8.

Estimates of the Elasticity of Domestic Prices with Respect to Changes in Import Prices

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Table 9.

Equations Relating Growth of World Output and World Trade1

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Source: IMF, Exchange Rate Volatility and World Trade, Occasional Paper No. 28 (July 1984).

Standard errors in parentheses.

Seven-country trade-weighted average of quarterly variability in real effective exchange rates (based on gross domestic product).

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