DURING THE COURSE of the past decade, the use of objective indicators has been advocated increasingly as a means of introducing a new element of exchange rate flexibility into the par value system without undermining the purposes for which that system was designed. All advocates of objective indicators want prompter and therefore more frequent exchange rate adjustment than has, until recently, taken place. In virtually all cases this desire is motivated at least in part by the desire to avoid crises and speculative capital flows. This is true even for those who want to retain, in some sense, the criterion of fundamental disequilibrium. Many, probably most, advocates of objective indicators, however, have no faith in the discretionary assessment of fundamental disequilibrium and therefore believe that a gradual adaptation of the par value in response to such indicators is the best way of achieving fundamental equilibrium.

Abstract

DURING THE COURSE of the past decade, the use of objective indicators has been advocated increasingly as a means of introducing a new element of exchange rate flexibility into the par value system without undermining the purposes for which that system was designed. All advocates of objective indicators want prompter and therefore more frequent exchange rate adjustment than has, until recently, taken place. In virtually all cases this desire is motivated at least in part by the desire to avoid crises and speculative capital flows. This is true even for those who want to retain, in some sense, the criterion of fundamental disequilibrium. Many, probably most, advocates of objective indicators, however, have no faith in the discretionary assessment of fundamental disequilibrium and therefore believe that a gradual adaptation of the par value in response to such indicators is the best way of achieving fundamental equilibrium.

DURING THE COURSE of the past decade, the use of objective indicators has been advocated increasingly as a means of introducing a new element of exchange rate flexibility into the par value system without undermining the purposes for which that system was designed. All advocates of objective indicators want prompter and therefore more frequent exchange rate adjustment than has, until recently, taken place. In virtually all cases this desire is motivated at least in part by the desire to avoid crises and speculative capital flows. This is true even for those who want to retain, in some sense, the criterion of fundamental disequilibrium. Many, probably most, advocates of objective indicators, however, have no faith in the discretionary assessment of fundamental disequilibrium and therefore believe that a gradual adaptation of the par value in response to such indicators is the best way of achieving fundamental equilibrium.

The various proposals have been distinguished by (a) how mandatory, presumptive, or permissive the response is to be; (b) the size of the exchange rate changes advocated; and (c) whether or not interference with the existing right to change the exchange rate is advocated. But, perhaps more fundamentally, they reflect differing assessments of the extent to which the problem is merely one of inducing somewhat prompter adjustment, or one of finding new means to deal with the intrusion of increased capital mobility on the adjustment mechanism.

On the one hand, there are those who feel that greater flexibility might be achieved simply by providing a more clear-cut criterion of the need to adjust. They suggest a more explicit recognition that a country’s par value is of general concern, and they favor a more symmetrical treatment of surplus and deficit countries. To achieve this, they propose what amounts to reintroducing the mechanism advocated in the Keynes plan—the use of an objective criterion to trigger international consultation on a member’s parity—instead of leaving the initiative with individual countries as is presently required under Article IV, Section 5(b), of the Articles of Agreement of the International Monetary Fund (IMF).

On the other hand, there are those who see a basic conflict between the present degree of capital mobility—not envisaged at Bretton Woods—and a system based on large discrete changes in par values in circumstances where balance of payments considerations dictate recurring exchange rate adjustment. They question whether it is feasible to operate the present system with prompter and more frequent adjustment of par values while the individual adjustments are still of moderate size without a more adequate constraint on the speculative movement of funds. As a result, they see a choice between restricting capital mobility and abandoning the strict adherence to the criterion of fundamental disequilibrium for changes in par value. These writers have proposed two kinds of solution.

First, there have been proposals for more or less continuous adjustment of par values in very small steps to provide the additional element of flexibility. Proponents of this idea argue that by limiting the maximum rate of change of par values, and by making such changes responsive to evolving circumstances, it would be possible to offset any incentive for currency speculation with relatively small interest rate differentials and little, if any, additional constraint on monetary policy. Some proponents have advocated the use of an objective criterion to guide the week-to-week adjustment of parities in order to increase the inducement to adjust without encouraging the competitive manipulation of exchange rates.

Second, some proposals would retain the criterion of fundamental disequilibrium for initiating an adjustment (and, in addition, would preserve the predictability of exchange rates between fundamental adjustments) while combating the consequent inducement to currency speculation by effecting any adjustment decided upon at the predetermined maximum rate of crawl over a specified number of years. Such proposals call for a gradual parity rise (or fall) guaranteed for the medium term; one suggests that the desired rates of crawl might correspond to the disparities in national rates of price inflation.

I. The Main Proposals

Proposals to encourage prompter adjustment of par values

The Keynes plan

A major difference between the compromise reached at Bretton Woods and the Keynes plan was the omission in the former of Keynes’s elaborate mechanism for ensuring adequate adjustment of par values. On this, there is evidence of a substantial divergence of opinion between the representatives of the United Kingdom and those of the United States on the role of parity changes in the adjustment mechanism.1

Keynes was emphatic on the need for an equilibrating mechanism that did not jeopardize a country’s ability to preserve full employment, and he envisaged a major role for par value changes in achieving this. He not only proposed the use of an objective criterion as a trigger in the adjustment process but also provided the Governing Board of the Clearing Union with powers to induce desired changes.

The Keynes plan stipulated that a member state having a debit balance reaching half of its quota should deposit suitable collateral against its debit balance, and that the Governing Board might require:

  • (i) a stated reduction in the value of the member’s currency, if it deems that to be the suitable remedy;

  • (ii) the control of outward capital transactions if not already in force; and

  • (iii) the outright surrender of a suitable proportion of any separate gold or other liquid reserve in reduction of its debit balance.2

Moreover, a surplus country with a credit balance exceeding half of its quota would be required to discuss measures to restore the equilibrium of its international balances, including:

  • (a) Measures for the expansion of domestic credit and domestic demand.

  • (b) The appreciation of its local currency in terms of bancor, or, alternatively, the encouragement of an increase in money rates of earnings.

  • (c) The reduction of tariffs and other discouragements against imports.

  • (d) International development loans.3

A country would, in addition, pay interest on the amount of its average balance in bancor (whether it was a credit or a debit balance) that was in excess of one fourth of its quota.

The White plan, on the other hand, was more concerned with discouraging than encouraging the adjustment of exchange rates. It proposed that

changes in the exchange value of the currency of a member country shall be considered only when essential to the correction of fundamental disequilibrium in its balance of payments, and shall be made only with approval of three-fourths of the member votes including the representative of the country concerned 4

and this was the opinion that largely prevailed in the Joint Statement5 and in the Articles of Agreement.6

Professor Triffin’s “fork” proposal

Professor Robert Triffin revived the idea of a reserve trigger at the Claremont International Monetary Conference in March 1969, although he related it to a member’s total reserves rather than holdings of bancor. Recognizing the need for more exchange rate flexibility—particularly on the part of surplus countries—but cautious of it being automatic, he proposed the following:

To deal with this problem, I would suggest, not a band system, but what I would call a “fork” or “prong” system. Under the prong system, each country would undertake to keep its exchange rate stable within limits determined by its reserve accumulations or its reserve losses. Thus a country would intervene in the market to keep its rate stable so long as its reserve losses—or its reserve accumulations—did not exceed a certain percentage, say 30 per cent, of its normal reserves. Beyond this percentage, a country which was losing reserves would be required to consult with the Fund. But a surplus country would be exposed to the same kind of discipline. If it increased its reserves beyond the agreed percentage, it would have to discuss the situation with the Fund, and if no agreement could be reached on what should be done, the country would be enjoined from continuing to support its exchange rate by buying foreign exchange from the market. At that point, its rate would go up; that is, flexibility would be imposed on the surplus country, just as flexibility would be imposed on the deficit country when it lost the agreed percentage of reserves.7

In describing his proposal, Triffin draws a parallel with the European Payments Union agreement rather than with the Keynes plan:

This approach is not entirely new. In the European Payments Union Agreement, to which we might look for other constructive suggestions, you will remember that when a creditor country had accumulated surpluses in excess of its quota, it had no right automatically to get gold, dollars, or anything else from the deficit countries; the nature of future settlements had to be discussed and agreed upon by the entire EPU membership. In any case, the prong system that I have outlined would introduce flexibility of exchange rates where needed, and a country could jump rather than crawl if a jump were more appropriate. I think that this system would be the best way to introduce greater exchange-rate flexibility, without pretending to make it automatic or to apply it to problems which cannot be cured by that method.8

Proposals for a facility for week-to-week adjustment of parvalues9

The idea for a facility for a more continuous adjustment of par values, with a strict limit on the maximum rate of change in any one year, appears to have originated in an article by Mr. Maurice Scott [17] in 1959 on the sterling area. He suggested a maximum rate of change of about 3 per cent per annum but did not link the changes in par value to a specific objective indicator. Rather, he suggested that the authorities

would need to have at least a medium-term policy about the rate, that is, they should decide how much the rate should be changed up or down, or whether it should be left the same over the next year or two. Their decisions would, of course, need to be continually revised in the light of changing circumstances.…10

It was Mr. John Black, in an unsigned article in The Economist in 1961, who provided the first link with an objective indicator.11

Mr. Black’s proposal

Mr. Black proposed that

the registered par rate of any currency against gold … be made equal to the daily average of market rates over some past period, such as a year. (Italics supplied.)12

He advocated this in recognition of the dilemma embodied in the system

between maintaining exchange rates that have become inappropriate to changed circumstances, and of provoking speculation by allowing the belief to arise that any currency may suddenly be devalued by a large amount.13

On the question of discipline he recognized that this would not eliminate the need to avoid major inflationary or deflationary movements, but argued that the scheme would

provide a useful measure of long-run flexibility combined with short-run stability for countries whose problems are less extreme, but none the less real and persistent.14

He suggested (in 1961!) that

the deutschmark troubles of the past few years, for which a 5 or 10 per cent appreciation were suggested, could have been coped with more smoothly by a movement spread over three to five years than by the actual method of a jump of 5 per cent, the size and timing of which had attracted wholesale speculation for half a decade.15

Furthermore, Black recognized the deficiency of a simple widening of margins in this respect. He suggested margins on either side of parity of 1 per cent, and he correctly related a maximum rate of parity change of 2 per cent per annum to a market average based on a past period of one year. He also argued that the possible effects on speculation of the prospect of a maximum rate of appreciation or depreciation of 2 per cent per annum should be controlled easily by relatively small interest rate differentials.

Regarding this facility as an adjunct to the existing system, he suggested that there should be nothing to prevent major once-for-all shifts in parities any more than at present. He also maintained that it had an advantage over more drastic reforms in that its introduction need involve no violent upsets, so that it could be subjected to rational discussion in public before being adopted. To the extent that exchange rates were initially misaligned, this would mean merely a somewhat more severe interest rate constraint during the first year or two while the parity crawled up or down, but this would be no worse than under existing arrangements.

Professor Meade’s proposal

At about the same time, Professor J. E. Meade [12] suggested an alternative to Mr. Black’s scheme linking par value changes to the level of the exchange rate. Building on Scott’s proposal, he suggested a more explicit link between parity changes and movements in reserves. In a comment appended to a paper presented before a subcommittee of the U.S. Joint Economic Committee in 1962, he proposed the following change in the rules of the IMF:

  • (1) Each member would as at present fix a gold parity for its national currency.

  • (2) Each member would be allowed in any year to raise (or lower) this par rate by 2 percent above (or below) the parity fixed in the preceding year.

  • (3) Each member would undertake never to raise the price of gold in terms of its own currency by the permitted 2 percent unless it was at the time incurring a substantial loss of monetary reserves.

  • (4) Each member would undertake never to lower the price of gold in terms of its own currency by the permitted 2 percent unless it was at the time incurring a substantial accumulation of monetary reserves.16

He proposed this to meet what he saw to be a need for

extremely moderate changes in rates which would, moreover, occur only in response to basic structural needs.17

He also recognized the possibility of offsetting the incentives for speculative movements of funds by establishing interest rate differentials.

Meade [13] and [14] developed this idea further in two articles in 1964 and 1966, introducing what might be interpreted to be a new measure of automaticity into his proposal. He suggested that

the authorities in each country, instead of maintaining a fixed gold parity for the national currency, would undertake not to change the parity by more than, say ⅙ per cent in any one month. Further, within this narrow limit they would undertake to depreciate their currencies if, but only if, they were faced with what appeared to be a continuing balance-of-payments deficit…18

and vice versa. He also suggested that it would be possible to provide unlimited financing of any imbalances that occurred as long as there was a concomitant undertaking to adjust.

Professor Cooper’s proposal

However, it was not until 1969, when proposals for small parity changes linked to objective indicators were under general review, that a more specific proposal for the use of reserve changes as an objective indicator emerged. This was Professor Richard Cooper’s proposal for a gliding parity facility.

Cooper suggested the following:

A country would be expected to change its exchange parity weekly whenever its payments position warranted a change. The weekly change in parity would be fixed at 0.05 per cent, cumulating to about 2.6 per cent a year if changes were made in the same direction every week. A change in parity would be triggered by a movement in the country’s international reserve position. If reserves rose more than a stipulated amount during a given week, the country would announce, at the end of the week, an upvaluation in its parity for the following week, and vice versa for a decline in reserves. The movement in reserves would determine whether the parity changed or not, but not the amount of the change in parity, which would be fixed at 0.05 per cent. Market exchange rates need not change by the full amount of the parity, however, for the country’s central bank might adopt a strategy of supporting the market rates temporarily even after a change in parity.19

Furthermore, he proposed that

changes in parity would be presumptive rather than mandatory. Where special circumstances influenced reserve movements, a country might ignore the presumption that the parity should be changed. But a country that failed to alter its parity when an alteration was indicated would be required to explain and justify its decisions before other trading nations, which would meet on a regular basis several times each year to review international monetary developments. Any country that systematically ignored the presumptive rules and offered unacceptable justification would be open to sanctions: for a country in deficit, no credit from the IMF and other international sources of balance-of-payments support; for a country in surplus, discriminatory “exchange equalization” duties against its products.20

Cooper saw this facility as providing relatively smooth accommodation to certain kinds of disturbance to balance of payments equilibrium; in particular

  • (1) gradual shifts in the patterns of demand, as incomes grow and tastes change, toward or away from the products of individual countries;

  • (2) gradual changes in international competitiveness or other supply conditions, such as might arise from exhaustion of natural resources or from small differential rates of change in labor costs due in turn to different national choices regarding tolerable increases in money wages;

  • (3) modest influences on trade positions due to alterations in national policies, for example, rates of indirect taxation and corresponding border-tax adjustments.21

He recognized that it would not be suited for coping with large disturbances to international payments, and that, for this reason, large discrete changes in exchange parities, as called for under the Bretton Woods System, could not be ruled out.

Proposals for a gradual parity change guaranteed for the medium term

In 1965 Mr. John Williamson suggested an alternative possibility involving the use of gradual adjustment of par values. Seeing little opportunity for a more radical departure, he suggested that parity adjustments should continue to be determined according to existing criteria—essentially, the recognition, by the country concerned, of a situation of fundamental disequilibrium—but that, once determined, they should be effected at a predetermined maximum rate of crawl. This, he felt, would preserve what the authorities judged to be an important characteristic of the par value system: the predictability of the rate of exchange at any particular moment in time.22

The German Council of Experts’ proposal

Williamson purposely avoided bringing an objective criterion into the arrangements that he proposed, but a subsequent proposal by the German Council of Experts at least hinted at such a criterion by suggesting that relative price indices might provide some measure of the evolving disequilibrium and might be a guide to the required rate of crawl:

In order to insulate domestic stabilization policy against an annual rise in the international price level of 2 to 3 per cent, the agencies responsible for monetary policy would make a binding statement to the effect that during a specified period in the future the rates at which the Bundesbank would be required to intervene in the spot exchange market would not remain constant, but would be moved up very gradually from week to week, so that in the course of a month there would be a parity rise, for example, of 0.2 per cent. Instead of the constant parity of today, there would be a rising parity, and instead of a normal swap rate of 0 per cent, one of about 2.5 per cent a year. The specified period of commitment would have to be moved forward in time, so that it would not shrink. The fixing of the normal swap rate precludes analogy with a flexible exchange rate regime, so that the objections against that system would not apply. But neither would it have the advantages of a system of greater exchange rate flexibility, apart from enabling the government to guarantee monetary stability in spite of (1) the international interconnection of prices and (2) its powerlessness to induce other countries to pursue a policy of greater price stability.23

II. Analytic Review

Objective criteria as a trigger for international consultation24

An important objection to any attempt to make the criterion for parity change more objective or even more rational, and hence make the change more predictable, is that as long as the size of the adjustment remains greater than a percentage point or so, this will provide at the same time an additional inducement to currency speculation. Moreover, the attractiveness of currency speculation is likely to increase as the frequency of par value changes increases (in spite of a reduction in their size) until a point is reached where the potential profit is no longer sufficient to offset the transactions cost and the remaining risk that the change will not occur.

There are, however, a number of ways in which the effects of increased predictability of parity adjustments on speculative capital flows might be mitigated. First, such flows might be more rigorously controlled. Second, the risk of speculating might be increased by the use of wider exchange rate margins. And, third, provision could be made for alternative measures to be used in place of par value changes when this seems desirable.

In contrast to Triffin’s proposal, the Keynes plan did provide such protection. It envisaged a substantial measure of control over capital movements and also set out explicit alternatives to par value changes. In their absence, Triffin’s proposal would be likely to lead de facto to greater exchange rate flexibility and its merits would be those of the ensuing regime—either floating or crawling, with a reserve constraint on official intervention.25

The use of foreign exchange market indicators in guiding exchange rate adjustment26

With the possible exception of the proposal by the German Council of Experts—which might be interpreted to involve a fairly direct link between the week-to-week parity adjustment and the movement of the index of relative prices—all the indicators suggested in the literature for guiding a gradual adjustment of par values depend on the manifestation of balance of payments developments in the foreign exchange markets during the current period or in the recent past. As such, they are imperfect, lagged indicators of the underlying movement toward fundamental or structural disequilibrium. But, above all, their use is underpinned by the presumption that adjustment of par values in response to current and recent movements in the balance of payments will, on average, lead to less fundamental disequilibrium in the payments system and to less need for large, discrete changes than under the present regime.

Two types of indicator are involved: price indicators, as in Black’s proposal, which relate to levels or changes in spot (and forward) exchange rates; and quantity indicators, as in Cooper’s proposal, which depend on the level or change in various measures of international reserves or the balance of payments.27

The extent to which any balance of payments development will be reflected in spot and forward exchange rates will depend on the extent to which it is absorbed by reserve movements and forward intervention, and vice versa. Consequently, the relative performance of these indicators will be intrinsically dependent on what assumptions are made about, or what constraints are imposed upon, intervention by national authorities in spot and forward markets. In particular, whereas the absorption by exchange rate movements is limited strictly by the intervention points, there is much greater scope for cushioning by use of the reserves, especially in a surplus situation. As a result, it may be more important to prescribe intervention rules with an exchange rate indicator than with a reserve indicator.

On the other hand, the possibility of countries intervening so as to influence the exchange rate indicator, and thus the par value change suggested by it, provides an opportunity for discretion over parity changes by the country concerned. This would permit a more discretionary system, and on these grounds an exchange rate indicator might be preferred. Moreover, persistent manipulation of the exchange rate would be evidenced by reserve accumulation or decumulation, and this could be the subject of international review under the protection of the limit on the rate of crawl.28

Thus, the choice between such indicators, based on performance and scope for discretion, will depend not on whether current and recent balance of payments developments are able to provide adequate guidance on the emergence of fundamental disequilibria but on the nature of the foreign exchange intervention to be expected, on the possibilities for controlling it, and on the acceptability of any such constraints. Other factors may be simplicity and comprehensibility to the layman.

However, the use in general of any indicator based on the manifestation of payments developments in the foreign exchange markets may be criticized on a number of grounds. A brief discussion of these criticisms, which apply with more or less equal force to all such indicators, follows.

Seasonality

One criticism is that seasonal variations in the balance of payments would lead to unnecessary annual oscillations in par values and, consequently, in the intervention points. But it is doubtful whether this would be serious. In the first instance, seasonal variations in the balance on current account are likely to be financed to a substantial degree by market anticipation, and other variations could be offset by appropriate official intervention. Moreover, the extent of such oscillations would be severely constrained by the limit on the rate of crawl. Alternatively, seasonally adjusted indicators—or, more simply, if this were appropriate in other respects, an arithmetic or geometric annual average of the exchange rate or reserve movements—could be used.

Cyclical demand variation

Similarly, cyclical factors might lead to adjustments in par values when adjustments are not appropriate to the underlying position. On the other hand, such a response of a country’s exchange rate to its own domestic imbalance might help to inhibit its transmission to other countries as well as to reinforce the need to pursue appropriate domestic policies. Otherwise, similar remarks as for seasonal fluctuations would apply. The effect on the par value could be cushioned by appropriate intervention: by the movement of the exchange rate within the margins for a reserve indicator, or by use of the reserves for an exchange rate indicator. The possibilities for cyclical undulation would be limited, as for seasonal variations, by the maximum rate of crawl, although this would also constrain the extent to which the par value could respond to fundamental imbalance.

Lagged response to underlying developments

It is also argued that the use of foreign exchange market indicators would mean too little adjustment, too late—a criticism that would apply with greater force the larger the time period used in determining the parity response. But, against this, it could be argued that some prior adjustment would be achieved. The lags involved under such a regime are likely to be considerably less than those experienced by waiting for unambiguous and generally accepted evidence of a fundamental disequilibrium. It is unlikely, for example, that price developments, which might be expected ultimately to lead to a payments disequilibrium, would be taken alone as sufficient evidence for a major adjustment.

Disequilibrating capital movements

However, perhaps the main objection to the use of foreign exchange market indicators is that these would expose the exchange rate to short-term disequilibrating capital movements and thus introduce an unnecessary measure of exchange rate uncertainty. Such movements relate to the situation when net capital movements are not dominated by the market’s forecast of the underlying equilibrium position of exchange rates. Such a situation may occur either when the market’s view is not strongly held or when other factors are influencing relative yields, for example, the possibility of speculating on a large once-for-all parity change in a particular currency, large swings in national stock markets, or divergent cyclical interest rate developments.

Of these, the most troublesome flows—those motivated by the prospect of once-for-all parity changes—should be substantially reduced with the provision for additional scope for par value adjustment. So, too, should the severity of the interest rate constraint, once something near equilibrium is established (see The interest rate constraint). But the need for some control over disruptive capital movements would remain. This would apply especially for a reserve indicator, if the exchange rate margins were not sufficiently wide to cushion the major part of such flows.

Wrong directions and false starts

The use of indicators is also criticized on the grounds that, because of the weight attached to historical criteria, the parity will on occasion be moving in a direction not appropriate in the light of subsequent developments. And a similar situation might result from any of the other factors discussed above—seasonal and cyclical variations, or temporary capital flows. Yet, this need not preclude the possibility that an adjustment mechanism based on such an indicator may, in the situations for which it is designed, perform better than existing arrangements. The presumption is that occasional movements in the wrong direction do not matter. What is required of the indicator is that, on average, it will be moving in the right direction. It may be better for the parity, constrained as it is, to register too many disturbances rather than to miss the underlying developments, including those on capital account.

A particular example of a situation where it is suggested that a system of self-adjusting parities would have led to perverse movements is the case of the deutsche mark during the winter of 1968-69. At that time it was technically weak, despite Germany’s huge current account surplus and the eventual need for a revaluation. However, as Professor Cooper has argued, the reason for this weakness is to be found in the attempts of the German authorities to offset the surplus by stimulating capital outflows.29 This involved a degree of monetary ease that the German authorities themselves regarded as alarmingly expansionist from the domestic point of view, and which they later reversed. Cooper suggests that sliding parities would have helped to prevent this situation from occurring, but it is nevertheless likely that this event had a major impact in cooling official enthusiasm for a system based on self-adjusting par values.

Moreover, it has been argued that the existence of a certain amount of random movement in the par value might have a beneficial effect in defusing the political impact of parity changes and in dampening one-way speculative expectations and thus reducing the likelihood of large short-term capital movements.30 But this factor has to be measured against the influence of false starts on the effective maximum rate at which the parity will respond in the equilibrating direction, and against the exchange rate uncertainty so generated. To achieve the same degree of exchange rate flexibility, a larger parity increment per period must be permitted, and this will introduce more exchange rate uncertainty in the form of the possibility of a somewhat more precipitate rate of change.

It is doubtful, therefore, whether this argument can justify the use of an averaging period as short as one week for reserve changes, as suggested by Cooper. After all, it is not the uncertainty about the direction of the weekly change in par values that deters the speculator, but the uncertainty about where the parity will be six months or a year hence. The problem with a period as short as a week (particularly for reserve changes) is that for such a period the level of “noise,” or random disturbance, may be high in relation to the underlying movement. With fixed incremental changes in the par value, this will tend to make the parity rather sensitive to the noise and rather less sensitive to the trend.

Other objective indicators of exchange rate adjustment

The alternative to using foreign exchange market indicators, either to trigger international consultations or to guide week-by-week adjustment of parities, is to use some forward indicator of the balance of payments. The intimation of the German Council of Experts of a role for indices of relative prices in conjunction with exchange rate changes guaranteed for the medium term is one such example. Another might be the use of a specific and more elaborate model of the balance of payments. Such indicators rely more on being good forecasters of impending disequilibrium in the balance of payments than on the property, possessed by exchange market indicators, that, almost by definition, sooner or later they will respond to a payments imbalance.

The use of a relative price index, in particular, depends on its role as a determinant of the current balance, or, more strictly, the trade balance. Thus, objections to its use in guiding parity adjustments fall into two categories: those directed, in general, at the use of the trade balance as a proxy for underlying balance of payments developments; and those directed at the performance of a price index, alone, in forecasting the balance of trade.

The trouble with linking parity adjustment to the trade balance is that this ignores any structural developments on capital account. And the deficiencies of price indices in trade forecasting are well known. Nor can one rely to any great extent on their performance over the longer term. Trade flows can be crucially dependent, in addition, on changes in tastes, technology, and resource availability; differences in income elasticities of demand for different products; and changes in the fiscal and commercial environment.

The other possibility is to develop a composite index on these lines that perform somewhat better; or, ultimately, to use a more complete model of the balance of payments. Since this would likely depend on parameters available at best on a quarterly basis, it is doubtful whether this could form a workable basis for continuous adjustment of parities. On the other hand, the refinement of specific criteria indicating the desirability of changes in par value might be useful in the context of a regime of smaller and more frequent adjustment with an increased measure of IMF supervision.

The interest rate constraint

One further aspect deserves brief mention, although it is not specifically confined to proposals incorporating objective indicators. It is the question of the interest rate constraint under the alternative regimes, respectively, (1) prompter, although still substantial and discrete, par value changes; (2) very small and essentially automatic changes in par values; and (3) a system of parity adjustment guaranteed for the medium term.

The first of these essentially retains the characteristics of the present regime. In particular, the interest rate of a country whose currency is under pressure is constrained from diverging from the interest rates of other countries in a direction that would enhance that pressure. If it did, the speculator or arbitrageur would be offered both a higher interest rate and an effectively “one-sided” option.

In comparison, with a facility for automatic adjustment, there may be a presumption that such situations of sustained currency weakness or strength would not occur, or, if they did, that they would be much less frequent. The parity adjustment should go at least part of the way toward removing the disequilibrium. If this were so, the exchange rate would be less frequently up against the margin and the direction of its future movement less certain, and this would tend to weaken the interest rate constraint.

Only when the parity was crawling unambiguously from an initial imbalance would its future level be predictable. Even then, compared with the situation where it was unable to crawl, the position of the exchange rate within the margin would be increasingly open to doubt.31 Consequently, even though initially a larger nominal interest rate differential might be required, the degree of constraint would not be as great.

Contrasted with this, proposals for parity changes guaranteed for the medium term imply a much more marked interest rate constraint, perhaps even more so than with large, discrete adjustments, since there would be an almost riskless option. The interest differential would need to correspond to the rate of crawl, tempered only by the exchange rate uncertainty afforded by the exchange rate margin.

Moreover, the interest rate constraint is not the only objection to a predetermined crawl where the crawl is initiated by a once-for-all announcement. Because of the implication for security prices, the expectation of an announcement of a crawl would transfer a good deal of the speculation from the foreign exchange markets into the securities markets. And although this would involve less movement of funds across the exchanges—since the domestic holders of securities would now play a predominant equilibrating role—it may be equally objectionable to the authorities.

BIBLIOGRAPHY

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*

Mr. Underwood, a graduate of Clare College, Cambridge, and the London School of Economics and Political Science, was an economist in the Special Studies Division of the Research Department when this paper was prepared.

1

See, for example, the discussion by Professor Halm [6], pp. 3-5. Numbers in square brackets refer to items listed in the Bibliography, pp. 116-17.

2

Keynes [10], p. 23.

3

Ibid., p. 24.

4

White [18], p. 89.

5

Horsefield [8], Vol. III, p. 128.

6

Article IV, Section 5(a), provides that “a member shall not propose a change in the par value of its currency except to correct a fundamental disequilibrium,” and Section 5(b) that “a change in the par value of a member’s currency may be made only on the proposal of the member and only after consultation with the Fund.”

7

Hinshaw [7], p. 21. We are primarily concerned here with that aspect of the proposal in which the reserve trigger is used to induce prompter adjustment within the workings of the par value mechanism rather than with the substitute flexible exchange rate regime. For a discussion of proposals for using an objective criterion to constrain official intervention in the foreign exchange market in the context of greater exchange rate flexibility, see Marsh [11] and Willett [20] and [21].

8

Hinshaw [7], pp. 21-22.

9

An earlier paper covered much of the same ground in describing proposals to smooth out adjustments in par values over time. See Michael Kuczynski, “Proposals for Small and Perhaps Frequent Changes in Par Values” (unpublished, International Monetary Fund, February 3, 1969).

10

Scott [17], pp. 245-46.

11

These contributions were reported in 1962 in an article by Mr. Douglas Jay, M.P. [9], p. 727. Meade [14], p. 22, also mentions the idea put forward by Mr. Black. Professor Carter Murphy [15] made an almost identical proposal in 1965, and Mr. Plumptre [16] discussed a similar proposal before an IMF seminar in November 1968.

12

Black [1], p. 486.

13

Ibid.

14

Ibid.

15

Ibid.

16

Meade [12], pp. 242-43.

17

Ibid., p. 242.

18

Meade [13], p. 14.

19

Cooper [3], p. 251.

20

Ibid.

21

Ibid., p. 252.

23

German Council of Experts [4], p. 152, para. 268 (in German).

24

This relates to the proposals in the section, Proposals to encourage prompter adjustment of par values.

25

The same remarks would apply to Mr. Hirsch’s proposal for using a more elaborate model of the balance of payments in guiding a system of periodic multilateral surveillance of exchange rates, and similar protection against speculative capital flows would be required. See Fred Hirsch, “The Exchange Rate Regime: An Analysis and a Possible Scheme,” Staff Papers, Vol. XIX (1972), pp. 259-85.

26

This relates to the proposals in the section, Proposals for a facility for week-to-week adjustment of par values.

27

For a discussion of some of the variants, see Kuczynski, op. cit.

28

This element of discretion is, of course, additional to that resulting either from the optionality of the crawling peg facility, or from any arrangement whereby a country may ignore the indicated adjustment (perhaps subject to international surveillance as suggested by Cooper), or from the continuing ability to make discrete parity changes.

29

Cooper [3], pp. 254-55.

30

Willett [21], PP. 9-11.

31

For a discussion of the interest rate constraint, see Willett [19].

IMF Staff papers: Volume 20 No. 1
Author: International Monetary Fund. Research Dept.