THE TRADITIONAL MACROECONOMICS of the period since World War II, as well as the more recent rational expectations and neo-Keynesian approaches, analyze one-commodity economies. Output, or real gross national product (GNP), is like the schmoo1 that lived in Dogpatch. It is a single good that can be consumed, invested, or exported, and it is produced by a homogeneous labor force and capital stock. The emphasis in these macro-economic models has typically been on the interaction between the real and financial sectors and on the role of aggregate demand policy. The international version of this model, in its simplified extreme, is the monetary model of the balance of payments or, more recently, of the exchange rate.


THE TRADITIONAL MACROECONOMICS of the period since World War II, as well as the more recent rational expectations and neo-Keynesian approaches, analyze one-commodity economies. Output, or real gross national product (GNP), is like the schmoo1 that lived in Dogpatch. It is a single good that can be consumed, invested, or exported, and it is produced by a homogeneous labor force and capital stock. The emphasis in these macro-economic models has typically been on the interaction between the real and financial sectors and on the role of aggregate demand policy. The international version of this model, in its simplified extreme, is the monetary model of the balance of payments or, more recently, of the exchange rate.

I. Introduction and Summary

THE TRADITIONAL MACROECONOMICS of the period since World War II, as well as the more recent rational expectations and neo-Keynesian approaches, analyze one-commodity economies. Output, or real gross national product (GNP), is like the schmoo1 that lived in Dogpatch. It is a single good that can be consumed, invested, or exported, and it is produced by a homogeneous labor force and capital stock. The emphasis in these macro-economic models has typically been on the interaction between the real and financial sectors and on the role of aggregate demand policy. The international version of this model, in its simplified extreme, is the monetary model of the balance of payments or, more recently, of the exchange rate.

During the 1970s emphasis shifted to the role of structure and the supply side. Most of the shocks to the industrial economies came from relative price changes, which cannot be analyzed clearly in a model with one commodity. The oil and raw materials price increases, exchange rate changes, and growth of manufacturing output in developing countries all appear as changes in relative prices in the economies of countries of the Organization for Economic Cooperation and Development (OECD). To analyze these events, structure must be specified.

Research in open economy macroeconomics has responded to the facts. Emphasis has shifted to the supply side and the role of structure in transmitting economic disturbances and effects of policy. Most recently the literature has begun to focus on questions of optimal structure. Examples are Flood and Marion (1982) and Marston (1982), who study optimal wage indexation and choice of exchange rate regimes.

This paper discusses some of the more significant results of the role of economic structure in determining how disturbances are transmitted. In general, the focus is on the exchange rate as an instrument for adjustment to external balance. Section II begins with an exposition of the monetary model of the balance of payments, which assumes virtually no structure. This provides a framework for the sections that follow and that introduce structural differences into the model, one at a time. In Section III the effects of trade structure on the results of changes in exchange rates are studied. The role of supply elasticities is emphasized. In Section IV the effects of wage rigidities and indexation are discussed. In Section V the effects of financial market structure on adjustment and the choice of exchange rate regime are studied.

The basic results can be summarized briefly. First, the effects of changes in exchange rates may be asymmetric between Europe and the United States. Movements in the exchange rate have their main effect on trade in the United States, by changing relative prices, which thus makes the exchange rate an efficient instrument for external adjustment in the United States. But in Europe changes in the exchange rate may have their main effect on domestic prices, making the exchange rate a poor instrument for external balance.

Second, demand policy in countries with real wage stickiness moves the price level in those countries, but influences output only in countries with nominal wage stickiness. Again, there may be a difference between Europe, with sticky real wages, and the United States with sticky nominal wages. Third, only countries with developed and open financial markets can expect a floating exchange rate to be stable. This may be the reason why the industrial countries tend to float, while the developing countries tend to peg their exchange rates.

II. The Monetary Model

In order to set the framework for discussion of the importance of various aspects of economic structure for international adjustment and interdependence, we begin with a simple version of the monetary model of the balance of payments that was a popular tool of analysis in the 1960s and early 1970s. The monetary model assigned virtually no role to economic structure. Much of the research since the early 1970s showing the role of structural aspects can be interpreted as modifying, or making more “realistic,” the assumptions of the monetary model. It thus provides a useful organizing concept and benchmark from which to begin the analysis.

The three aspects of economic structure that will be emphasized in the following sections of the paper are (a) structure of trade, (b) wage and price determination, and (c) structure of financial markets. So in setting out the monetary model, we will emphasize the assumptions made on each of these three points. We focus on the fixed exchange rate version of the model for a single country. The exposition here follows Johnson (1972). More sophisticated and complex versions can be found in International Monetary Fund (1977). Khan and Knight (1981) provide an estimated version with more detail in specification and empirical lags, estimated on pooled time-series, cross-section data for a number of developing countries.

The first strong assumption is (a) that goods are perfect substitutes. This means there is essentially one composite commodity produced by all countries in question. If the “law of one price” holds, the domestic currency price of the good P, and the foreign currency price P* are related by

P = eP*(1)

where e is the exchange rate in units of domestic currency. In a multicountry context, e would be an effective nominal exchange rate.

If the country being discussed is a small country, in the sense that it has no influence on world prices, P* is exogenous and independent of e in equation (1). A modification of the strong one-good assumption is to assume that each country is specialized in producing one (composite) commodity. Then equation (1) could be interpreted as translating the domestic currency price of the domestically produced export good into foreign exchange, and vice versa for imported goods. If the small-country assumption is maintained, so that many other countries are producing the same good as the home country, then all foreign exchange prices P* are exogenous. This specialization assumption provides the starting point of the analysis of the role of structure in goods markets in Section III below. As long as the small-country assumption is maintained, the basic results of the monetary model obtain under either the one-commodity or the specialization assumption.

The second important assumption of the monetary model is (b) flexible wages and prices. Flexible real wages are not sufficient; the system must be free of all nominal price rigidity or stickiness. In general, all relative prices must be free to move to clear the relevant markets, and the nominal price level must be free to adjust real demand to meet full-employment output. The assumption of wage and price flexibility sets domestic output y at its full-employment level ȳ

y = y¯(2)

So far we have exogenized P and y by assumptions (a) and (b). It remains to pin down the interest rate by assuming (c) that domestic and foreign interest-earning assets are perfect substitutes. In the fixed rate version of the monetary model this makes the domestic interest r equal to the exogenous world rate r*

r = r*(3)

The law of one price plus the assumption of perfect substitutes establishes the equality; the small-country assumption in asset markets makes r* exogenous.

Money demand in the monetary model is given by

MdP = m(r,y),(4)


Md = P·m(r,y)

It can be easily seen that assumptions (a)–(c) have exogenized all the determinants of money demand with fixed exchange rates. Substitution of (1) – (3) into (4) gives us

Md = eP*·m(r*,y¯)(5)

The demand for money is proportional to the exchange rate, given P*, r*, y. It is useful to note here that wealth is not included as a determinant of money demand in (4). Addition of wealth effects invalidates most of the clear propositions that come from the simple version of the monetary model, as shown, for example, in Branson and Buiter (1982).

The money supply Ms is determined by the central bank’s holdings of domestic debt D and foreign exchange reserves R in this simple stylized model

Ms = D + R(6)

The money multiplier is set equal to unity here; we could multiply (D + R) by a constant multiplier without influencing the results.

Equating money demand and supply gives us money market equlibrium

D + R = eP*·m(r*,y¯)(7)

With the determinants of money demand fixed, the money stock is demand determined. In most applications of the model, movements in D are set by requirements of financing the government budget deficit, G – T

D˙ = α(G,T)(8)

where α is the fraction of the deficit that is monetized, and a dot over a variable denotes its time rate of change—for example, Ḋ = dD/dt. With money demand fixed, equation (7) implies

R˙ = D˙(9)

We can now describe two thought experiments that show how the model works and outline the basic policy package it implies. These are “thought experiments” because they describe the reaction of the model to changes in policy beginning from a full equilibrium position. As the purpose of policy action is generally to eliminate disequilibrium, these experiments do not describe the likely results of actual policy moves. This we will do below. But these experiments do provide a way to describe how the model works. The simulations of Khan and Knight (1981) are exactly such thought experiments.

First, consider the effects of a given expansion of the domestic debt component of the money stock, generated by a temporary government deficit. Initially this increases the money supply by the increment to the domestic debt component ΔD With the exchange rate fixed, money demand on the right-hand side of equation (7) is unchanged. The expansion of the money supply by ΔD thus creates an excess supply of real balances, which leads to a rise in domestic absorption and a current account deficit. It also puts downward pressure on the domestic interest rate and leads to a capital outflow. Both effects reduce reserves, and the reserve loss continues until ΔR= –ΔD This restores real balances to their original value and re-establishes equilibrium. Thus, the increase in the money supply caused by the budget deficit is eliminated by an equal reserve loss.

Second, consider the effects of a devaluation. This is represented by an increase in e given in percentage terms by Δe/e. Here the difference between the one-commodity and the complete-specialization assumptions plays a role in the analysis. In either case the rise in e reduces real balances M/eP* by the same proportion. This reduces absorption and puts upward pressure on the interest rate, resulting in a current account surplus and a capital inflow. In addition, in the complete-specialization case there is a reduction in the price of home goods relative to foreign goods, which also stimulates a current account surplus. This is a trade elasticity effect.

The balance of payments surplus adds to reserves, and this increases the money supply until the latter has risen in proportion to the initial change in e—that is, until ΔM/M = Δe/e. At this point, the original value of real balances is restored, and the system is back in equilibrium. A devaluation generates a temporary balance of payments surplus. This adds to reserves and increases the money supply until the system is back in equilibrium. Thus, in the monetary model exchange rate policy is really policy to manipulate reserves not the current account balance.

We can now use these properties of the model to describe a policy package for a country in an initial state of disequilibrium. The monetary model, being an equilibrium model, cannot rigorously describe what happens out of equilibrium but it is frequently used to prescribe policy in such cases.

Consider a country with an existing budget deficit, which is being monetized by the central bank, causing the money supply to increase. This generates a rise in domestic spending and inflation. The excess of absorption over domestic output yields a current account deficit, and downward pressure on real interest rates may also produce a capital outflow. Thus, the existing budget deficit generates both inflation and a payments deficit. What is the policy prescription loosely implied by the monetary model?

One draconian possibility would be to unwind the entire process. If we could go back to some initial date when the economy was in equilibrium, this alternative would require reversing to a budget surplus that would diminish the money supply, would reduce prices, and would restore the initial reserve position. This would be a policy of deflation that re-established equilibrium solely through budget and monetary policy, with no change in the exchange rate.

This policy prescription may seem too strong. This is probably because the user of the monetary model to describe long-run equilibrium also has in mind a short-run model with some stickiness in wages and prices and adjustment costs in rearranging production. An actual deflation could mean a protracted spell of unemployment. The economy, or more precisely the existing government, may not reach the long-run equilibrium toward which the policy is aimed.

A less draconian alternative would be to end the budget deficit, halting the growth in the domestic debt component of the money supply, and to devalue in order to “validate” the past increase in M. If we can estimate the parameters of the money demand function m, then for given values of P*, r*, and y we can estimate the percentage devaluation that would reduce real balances M/eP* enough to restore equilibrium at the existing level of M. This would end excess absorption and validate the existing M as an equilibrium value.

This is the familiar policy package of balancing the budget to stop money growth and devaluing to end the loss in reserves. It avoids the need for actual deflation by validating the past money growth through devaluation. Preference for this policy over deflation already implies that the policymaker has some structural characteristic of the economy in mind that is not part of the monetary model.

A third alternative would provide a more gradual path to equilibrium. The budget deficit could be reduced to zero gradually. This would be accompanied by a jump devaluation to validate the existing money stock, and then further gradual devaluation at a decreasing rate to keep real balances in equilibrium as the budget deficit was reduced. An announced plan of this sort would be quite similar to the decelerating crawling peg attempts made by the “Southern Cone” countries of South America. These programs have run into a number of problems involving real appreciation of the currency, with devaluation ahead of inflation, as analyzed for example by Calvo (1981), Díaz-Alejandro (1981), Dornbusch (1980), and Krugman (1980). The explanation for the difficulty in all these cases involves specification of structure of the economy beyond the simple monetary model.

Both alternatives to simple monetary contraction imply that at least one of the three simplifying assumptions of the monetary model does not hold, and the alternative assumptions generally require some specification of the structure of the economy. We now turn to questions of the structure of trade.

III. Trade Structure and Devaluation

Under the strong assumption of perfect goods substitution, devaluation influences the current account only through real balance effects on expenditure. To study relative price effects of devaluation, we need to assume at least two separate goods (or commodity bundles), one produced by the home country and the other by the rest of the world aggregate. This adds a channel of effect for exchange rate changes, while preserving the real balance/absorption channel of the monetary model.

In this section we will analyze in a partial equilibrium framework the effect of a devaluation on the trade balance. The framework is the familiar elasticity approach. This can be used to illustrate the impact effect on the trade balance from the change in relative prices caused by the devaluation, which leads to general equilibrium adjustments. The graphs that will be used to illustrate various cases were introduced by Haberler (1949) and were used to analyze the Smithsonian realignments of 1971 by Branson (1972). The formal mathematics are presented in Appendix A of Branson and Katseli (1982).

We will characterize different “types” of trade structure in terms of special values for elasticities of demand or supply for exports, dx and sx, respectively, and imports, dm and sm. First we will begin with the traditional small country case, where dx and sm are infinite. The small country cannot influence world prices of its exports or imports. Then we will analyze the case of a “semismall” country, where sm is infinite but dx is not. The semismall country has “market power” on the export side; it cannot expand sales without reducing price. Most European countries may be in this category. A subcase of the semismall country is the “Keynesian small country,” where all supply elasticities are infinite. This is the model of the usual statement of the Marshall-Lerner condition that |dx+dm|>1 for a “successful” devaluation.

A third example is the “rigid” country, where sx and dm go to zero. This would be true for a developing country producing a supply inelastic agricultural export, using an intermediate import with fixed coefficients. A fourth case that combines aspects of the semismall and rigid countries would be the “pure manufacturing” economy that imports intermediate goods not produced at home and that exports manufactures. Here dm may approach zero. Japan may be an example of this.

In each case we wish to examine the effect of a devaluation on the trade balance and on the terms of trade. Negative results for either may be a reason for a country to reject devaluation as a way to eliminate a trade deficit, or in general to reject the use of the exchange rate as a tool for stabilizing the current account.

small country

We begin with the small country, where devaluation improves the trade balance and leaves the terms of trade unchanged. This case serves to introduce the basic diagrams in Figure 1, Panel A. On the vertical axes are the home currency prices of exports and imports, Px and Pm, relative to an overall index of domestic opportunity cost. Thus, the changes in exchange rates that are discussed below are changes in real exchange rates, as shown in Branson and Katseli (1982). Quantities are on the horizontal axes. The areas under the supply-demand intersections are the domestic currency values of exports and imports.

Figure 1.
Figure 1.

Effects of Devaluation

Citation: IMF Staff Papers 1983, 001; 10.5089/9781451956658.024.A003

In the small country, the infinitely elastic demand curve for exports and supply curve for imports are shifted up by the proportion of the devaluation. This raises both Px and Pm proportionately, leaving the terms of trade unchanged. This also increases export value but has an ambiguous effect on import value, depending on the elasticity of demand. It should be clear from the diagrams that the limiting case where the increase in import payments equals the increase in export receipts would be where the supply curve for exports and demand curve for imports are both vertical. This is the rigid country case, which we take up below.

In the small country, exchange rate changes stabilize the trade balance with no effect on the terms of trade. This is a clear example of structure that is consistent with the monetary model and with a policy that uses the exchange rate for external stabilization purposes.

semismall country

Next, consider the case of the country that is small on the import side, so that sm is infinite, but not on the export side. This case is consistent with traditional trade theory, in which each country concentrates on production of goods along its lines of comparative advantage and exports these few goods, but imports the whole range of consumption. Each country might then be “large” in its export markets, but “small” in its import markets. A system of such countries has been called the “world supermarket” by de Melo, Dervis, and Robinson (1977). Each producer is large in selling to the world supermarket, but small when appearing as a consumer. Indices of market power on the export and import sides were computed in Branson and Katseli (1980), and their differences were quite significant. Many medium-sized European countries and developing countries producing agricultural output or minerals and having significant shares of the world markets for these might fit into the semismall country category.

The effects of devaluation on a semismall country are shown in Figure 1, Panel B. The diagrams are the same as in Panel A except for the export demand curve. It is evident that the terms of trade Px/Pm deteriorate with a devaluation in this case. In general, fluctuations in the exchange rate will generate fluctuations in the terms of trade in the semismall country. The effect of this on real income and welfare was analyzed in Branson and Katseli (1980).

The same ambiguity in the effect of devaluation on import payments appears in Panels A and B, but the gain in export receipts is smaller in Panel B. In the semismall country case the full Marshall-Lerner conditions come into play. Insufficiently elastic demands can result in J-curve effects and lead to dynamic instability in the exchange markets.

A special subcase of the semismall country is the “Keynesian small country,” in which the supply elasticity of exports is also infinite. (Jeffrey Frankel reminded me of this terminology when the topic was discussed at the Institut Européen d’Administration des Affaires (Insead) in Fontainebleau in July 1982.) The justification for this assumption would be that the export sector of the home country is small relative to the total economy so that resources can be moved into the sector at a constant opportunity cost. In this case the Marshall-Lerner conditions simplify to the traditional |dx+dm|>1

In the semismall country, exchange rate fluctuations cause fluctuations in the terms of trade and may cause J-curve effects. The latter can raise problems of dynamic stability in the foreign exchange markets, as discussed in Branson (1977) and Artus (1982). Thus, even with this seemingly minor modification of the structure to conform with the basic ideas from trade theory, the use of exchange rate changes for external stabilization can be open to question.

rigid country

Most analysis using small or semismall country assumptions also implicitly assumes that the traded goods are final goods that substitute in consumption and that they are also substitutes in production for home goods. Consumption substitution yields demand elasticity and production substitution yields supply elasticity. Since the oil price increase in 1973, attention has turned to cases where imports are intermediate goods that may not be produced or consumed at home. The role of intermediate imports is explored extensively in Katseli (1980). In addition, there may be only a small domestic market for some exportables, such as raw materials and minerals, and the elasticity of total supply of some exports may be low.

An illustration (in the extreme) of the difficulties these structures cause might be a (probably developing) country that produces an agriculturally based raw material with an inelastic output supply in the short run. It also uses an imported intermediate input with fixed coefficients in the short run. This makes elasticities of export supply and import demand zero.

Devaluation in the rigid country is shown in Panel C of Figure 1. The terms of trade are not affected since Px and Pm rise by the same proportion as the devaluation, but for very different reasons than in the small country (compare Panels A and C). Import payments and export receipts both rise by the same proportion. The effect on the balance of trade depends on the initial balance. An initial deficit is magnified by the devaluation, a particularly perverse result. Most devaluations occur in an initial deficit position.

The perverse trade balance results also have macroeconomic implications. Devaluation raises internal prices, reducing real balances and demand for home goods. The increased trade deficit also siphons off income, reducing demand for home goods. This can result in a deflationary devaluation, in which the devaluation itself creates a demand slump and unemployment. This problem was noted by Cooper (1971) and was more recently analyzed by Krugman and Taylor (1978). A similar problem associated with J-curve effects generally was noted by Dornbusch and Krugman (1976).

In the rigid economy, exchange rate fluctuations can magnify trade imbalances if the usual prescription of devaluation to eliminate a deficit is followed. Exchange rate fluctuations can also generate demand fluctuations in unexpected directions. This is an instance where structure is crucial for the application of external balance policy.

pure manufacturing country

A final example, which is a variant on the rigid economy, is a country with imported intermediate inputs and manufacturing output. In this case export supply will have a positive slope, while import demand will be relatively inelastic. A case in point could be Japan, with 90 percent of its exports manufactured goods and 80 percent of its imports intermediate inputs.

Devaluation in this case can be analyzed with one or two modifications of Panel C in Figure 1. The effect of giving the export supply curve a positive slope is to reduce the increase in Px; the effect on export earnings depends on the elasticity of demand. If it is inelastic, export earnings fall relative to the rigid economy case, and the effect on the trade balance is even more perverse. Thus, devaluation in this case could worsen the trade balance and cause the terms of trade to deteriorate.

Even more bizarre would be the result if intermediate inputs were tied to final output by fixed coefficients. Then the import demand curve could be positively sloped. As exports rise, intermediate imports rise. This could add to the perversity of the trade balance results while reducing the terms of trade effects.

conclusion on trade structure

Traditional elasticity analyses of the effects of exchange rate changes on trade have generally implicitly assumed high supply elasticities and focused on small or semismall country cases, including the Keynesian small country. When I studied effects of the Smithsonian realignments in this framework (Branson, 1972), there was almost no literature on supply elasticities. Since the early 1970s, the problems introduced, especially by imported intermediate goods, have been recognized in the literature, and supply problems have come to the fore.

The literature on the monetary model is generally silent on elasticity conditions, which are usually presented as an alternative to the elasticity approach. The application of these conditions at the policy level, however, frequently assumes implicitly that the structure of trade meets the elasticity requirements. Their extension to the asset market approach to flexible exchange rates makes elasticity conditions important for the dynamic adjustment paths. Thus, empirical questions of trade structure have surfaced as important in the evaluation of exchange rate policy independently of the analytical approach or the degree of flexibility of the exchange rate under analysis.

IV. Wage Rigidity and Policy Interdependence

In this section the effects of sluggish adjustment, or stickiness, of wages and prices on policy interdependence are analyzed. The role of the exchange rate in the transmission of policy effects between countries will be especially focused on.

The monetary model of Section II assumes that flexible wages and prices set output equal to its full employment value. However, the idea that a nominal price or wage might be slow in adjusting to disturbances, policy or otherwise, has long been a part of the literature on output fluctuations. For example, the textbook “Keynesian” model focused on a sticky nominal wage. In the past decade there has been a resurgence of research on nominal wage stickiness as a source of real output fluctuations in the United States. Fischer (1977) and Taylor (1979) present models of multi-period nominal wage contracts in a framework of rational expectations; the literature is surveyed by Gordon (1981).

In Europe there has been a “neo-Keynesian” development that has studied adjustment of the domestic economy to a temporary equilibrium with rigid wages and prices. While this literature is highly technical, good expositions are provided by Malinvaud (1977) and Muellbauer and Portes (1979). These approaches all share the assumption that some nominal price is rigid, and this rigidity results in output fluctuations.

The role of stickiness of nominal or real wages in international adjustment has been studied by Sachs (1980, 1981) and Branson and Rotemberg (1980), among others. They observed that while sticky nominal wages might be an appropriate model for the United States, a more appropriate model for many European countries would be sticky real wages. Japan might be an intermediate case. The nature of the international transmission and adjustment processes then depends crucially on which countries have which rigidities and on where the disturbances originate.

All this is bound to have implications for the use of the exchange rate as an instrument for achieving external balance, depending on the location of rigidities and degrees of indexation. These implications have been worked out in recent papers by Flood and Marion (1982) and Marston (1982). The analysis below will use Marston’s graphic framework extensively.

Three aspects of recent research in this area provide excellent examples of the importance of the interaction of wage rigidity and economic structure for policy interdependence. The first is transmission with different kinds of wage rigidities. This can be seen most clearly in a one-commodity model. The second is the role of terms of trade effects in shifting aggregate supply; to study this we need at least two commodities. The third aspect is the pervasive importance of wage indexation, which can be seen by adding a nontraded good to the study. Each of these aspects will be analyzed in turn.

transmission with wage rigidities

Rather than proceed with an exhaustive taxonomy, let us make the point with a single case. The problem is analyzed in detail in Branson and Rotemberg (1980). Suppose we have two countries, notionally named the United States and Europe. Nominal wages are sticky in the United States and real wages are sticky in Europe, both above their equilibrium levels. In Malinvaud’s terms, unemployment in the United States is “Keynesian,” and in Europe it is “classical.” To make the particular point in the simplest way, let us assume both areas produce and trade the same composite commodity.

In this case, the aggregate supply curve in Europe is vertical at the level of output where the marginal product of labor equals the real wage, but in the United States it has a positive slope. These are shown in Figure 2, where P and y are, respectively, the U.S. gross domestic product (GDP) deflators and real U.S. GDP in dollars, and P*, y * are, respectively, the European GDP deflator and real European GDP in European currency units (ECUs). The aggregate demand curves have the usual downward slopes, and for convenience we index the $/ECU exchange rate at unity so that P0 = P0*

Figure 2.
Figure 2.

Demand Expansion in Europe

Citation: IMF Staff Papers 1983, 001; 10.5089/9781451956658.024.A003

The solid lines in Figure 2 (a) and (b) show an initial equilibrium, where supply equals demand, in both diagrams, so that both current accounts are balanced. The initial price level is given by P0(= P0*), and outputs are given by y0, y0*.

Consider now a policy-induced demand expansion in Europe with the exchange rate held constant. This shifts the European demand curve to the dashed line, and raises world demand. Prices rise to P1(= P1*), where the United States has a current account surplus, given by its excess of supply over demand, equal to Europe’s deficit. The outcome of this policy shift is a rise in prices in both areas, an increase in output and reduction in unemployment only in the United States, and a shift in the current account toward surplus in the United States and deficit in Europe.

The gain in output goes to the area with the sticky nominal wage, while the area with the sticky real wage gets inflation and a “deterioration” of the current account. It is, therefore, not surprising that the United States supported the “locomotive” approach in 1977 and Europe rejected it.

As a second policy experiment consider an appreciation of the U.S. dollar relative to the ECU. To keep the example clear we will assume this is achieved by tightening U.S. monetary policy and easing U.S. fiscal policy, which would have a neutral effect on U.S. demand in the absence of appreciation.

The results of appreciation are shown in Figure 3. Demand shifts from the United States to Europe, and prices in Europe rise relative to those in the United States. The final equilibrium shows a deficit in the United States (demand exceeds supply at Px) equal to the surplus in Europe at P*, where Pi = eP*at the new exchange rate.

Figure 3.
Figure 3.

Appreciation in United States

Citation: IMF Staff Papers 1983, 001; 10.5089/9781451956658.024.A003

In the one-commodity model, an appreciation of the U.S. dollar with a demand-neutral tightening of monetary policy raises prices in Europe relative to the United States, reduces output in the United States where the nominal wage is sticky, and shifts the current account toward deficit in the United States and surplus in Europe. Except for the constancy of European output at y0*, this is a fairly accurate description of recent economic developments in the two areas. Movement in European output can be explained by going to a two-commodity model with terms of trade effects.

terms of trade effects on supply

Consider a more realistic case in which the United States and Europe produce different composite commodities. Then a change in the exchange rate will alter the relative price of the two commodities. Here the difference between the price that is relevant for producer decisions and the price index that defines the real wage becomes important. This point is also discussed at length in Branson and Rotemberg (1980).

In each area the producers equate the marginal product of labor to the product wage W/Pi, where Pi is the price of the output of the area. On the other hand, in our example, workers in Europe are interested in the real wage W/I, where I is a consumer price index (CPI) defined across areas’ products

I = αP* + (1α)Pe(10)

Here α is the weight of European goods in the European CPI, and P/e is the European price of U.S. goods. We now are using P and P* to denote the domestic currency prices of the U.S. good and the European good, respectively.

An appreciation of the U.S. dollar relative to the ECU, by reducing e, raises the European CPI defined in equation (10). With a sticky real wage W/I, the nominal wage W rises along with I. This raises the product wage W/P* facing European employers, who react by reducing employment. The result of the dollar appreciation is a reduction in employment and output in Europe because of the terms of trade effect. This effect can be introduced into Figure 2(b), if we reinterpret P* as the price of European output. The negative terms of trade effect shifts the vertical European supply curve to the left. This reduces European output y * and further increases the price level P*. Thus, the result of the U.S. appreciation in this more realistic model is stagflation in Europe—output falls, and unemployment and prices (or the rate of inflation) rise.

A structure with nominal wage stickiness in the United States and real wage stickiness in Europe is consistent both with policy differences in the 1970s and the effects of the shift in the United States toward fiscal ease and monetary tightness in 1981–82. Tentative econometric evidence has been presented by Sachs (1981), Branson and Rotemberg (1980), and Grubb, Jackman, and Layard (1982) that supports this pattern of wage stickiness. On the other hand, the quick adjustment of the real wages in the Federal Republic of Germany to the 1979–80 oil price shock, summarized in my discussion of de Menil and Westphal (Branson, 1982), suggests that real wage resistance may be dissipating in the Federal Republic of Germany. The German model of Artus (1982) assumes nominal rather than real wage stickiness in the German economy.

The basic point that comes out in the examples is that the pattern of structural differences in wage behavior across countries is important for the transmission of policy effects.

wage indexation and nontraded goods

Wage indexation can provide a channel through which exchange rate changes pass quickly into prices of nontraded goods and thus escalate the entire domestic price level. In this case, changes in nominal exchange rates have no effects on real rates or relative prices, and we are back with the monetary model that relies solely on real balance effects. This is a generally well-known point, so a simple example should suffice to establish it.

Consider a small country that produces and consumes traded and nontraded goods. The nominal wage is indexed to the CPI, and the price of nontraded goods PN, assuming constant productivity equals the wage rate plus a markup. Then we have the following structure of wage and price movements.

The change in the home currency price of traded goods is the sum of movements in the exchange rate and the world price of traded goods

P^T = e^ + P^*(11)

Here P^T is the domestic currency price of traded goods, and P* is the world foreign currency price. A circumflex over a variable denotes percentage rate of change—for example, ê ≡ Δe/e.

The price of nontraded goods follows the wage rate

P^N = W^(12)

The movement in the consumer price index is given by a weighted average of home currency PT and PN

I^ = αP^T + (1α)P^N(13)

and wages are indexed to I

W^ = I^(14)

The combination of wage indexation in equation (14) and markup for prices of nontraded goods in equation (12) makes PN follow the index I

P^N = I^

If we substitute this into equation (13) for P^N, and equation (11) into (13) for P^T, we obtain

I^ = α(e^ + P^*) + (1α)I^

Solving I gives us the basic result

I^ = e^ + P^*

As P^N = Î, P^N also equals ê + P^*

The combination of wage indexation and markup pricing of the nontraded good passes exchange rate changes right through into wages, prices of nontraded goods, and the entire CPI. In this example of a fully indexed economy, exchange rate changes have no effects on relative prices. Thus, any effect on equilibrium output would have to come through real balance effects, which could be achieved direct through monetary policy. In a fully indexed economy, exchange rate fluctuations serve more to destabilize prices than to stabilize the trade balance.

conclusion on wage behavior

The structure of labor markets and wage behavior are important in determining the pattern of international transmission of the effects of policy shifts in any one country. In general, countries or areas with relatively sticky nominal wages will experience larger output responses and smaller price responses to demand disturbances than will areas with relatively sticky real wages. Terms of trade effects from an exchange rate change yield output effects even when real wages are sticky by shifting aggregate supply. However, in a fully indexed economy, all prices move with the exchange rate.

These results suggest a pattern of differences in adjustment to exchange rate changes between Europe and the United States. Suppose we think of the latter as having relatively sticky nominal wages and relatively less indexation than Europe. Then an exchange rate change will move relative prices and the balance on current account in the United States, and also influence output, all in the expected “stabilizing” direction. In Europe, however, the movement in the exchange rate will mainly move the overall price level, with minimal effects on the trade balance or output. So the exchange rate is reasonably viewed as an effective instrument for stabilizing the current account in the United States. In Europe, however, exchange rate fluctuations are equally reasonably viewed as essentially destabilizing the price level. The result is policy conflict based on different implicit assumptions about the underlying structure of labor markets and wage behavior.

V. Financial Markets and Exchange Rate Stability

In Section II, we presented the fixed exchange rate version of the monetary model as the initial framework for the analysis of effects of exchange rate changes in Sections III and IV. In this section we turn to the structure of financial markets and the stability of floating exchange rates.

The monetary model can be easily converted into a model of exchange rate determination. Let us retain the strong initial assumptions of the monetary model that (a) goods are perfect substitutes so P = P*, (b) wages and prices are flexible so y = y, and (c) assets are perfect substitutes so r= r*. The last assumption, combined with floating exchange rates, implies static expectations. The usual statement of perfect asset substitutability with a floating exchange rate is r = r* + ẽ, where is the expected percentage change in the exchange rate. One robust empirical finding from the 1970s is that spot exchange rates roughly follow random walks. Examples of these results can be found in Branson (1982) or Frenkel (1981). As a result, the best single predictor of the future spot rate is the present spot rate. This is shown, for example, in Bilson (1981). Thus, static expectations are a reasonable rule of thumb and we can retain the simplifying r = r* assumption.

The monetary model of Section II can be written as

M = eP*m(r*,y¯)(16)

If M is fixed as well as P*, r*, and y, this money market equilibrium condition determines a value for the exchange rate

e = M/[P*·m(r*,y¯)(17)

This is the equilibrium value of the exchange rate that clears the money market. With the assumption that assets are perfect substitutes, equation (17) is a monetary model of exchange rate determination. This serves as a useful starting point for the discussion in this section of the role of financial market structure.

The monetary model provides an interesting way to analyze the monetary policy problems of Section IV. Suppose we interpret the “home” country as Europe, so the asterisk variables are the United States. A tightening of U.S. monetary policy raises r*. This reduces the demand for real balances in Europe, m(r*, y). To keep this excess supply of money from raising e (i.e., depreciating the ECU against the dollar), European M would have to shrink proportionately. Holding the exchange rate constant in the face of tightening monetary policy in the United States would keep the demand curve from shifting upward in Figure 3(b).

The monetary model has strong implications for the relationship between price stability and monetary stability in an open economy. These are shown in the first subsection below. Then we explore the implications of imperfect asset substitutability for monetary and exchange rate policy. Finally, we end with a brief discussion of the effect financial market structure has on the choice between floating and pegging the currency.

monetary versus price stability

Consider the problem facing the monetary authority that wishes to stabilize the domestic price level in an open economy described by the monetary model. Since P =eP*, stabilizing P when P*, the world price level, is fluctuating requires offsetting fluctuations in e. As world prices rise, e must fall, that is, the domestic currency must appreciate, to prevent importation of the world inflation. As P* falls, the currency must depreciate.

How are these movements in the exchange rate to be achieved? From equation (17) we have

P = eP* = M/m(r*,y¯)(18)

Exogenous fluctuations in world interest rates (or full employment output) will move the demand for real balances m(r*, y). If fluctuations in the nominal domestic money supply meet these fluctuations in demand, the product eP* = P will be stabilized. In equation (17), the sole source of fluctuations in the excess demand for money will then be movements in P*, and these will cause offsetting changes in e, stabilizing P.

An immediate implication of the monetary model with a floating exchange rate is that to maintain domestic price stability the domestic money supply should adjust to meet fluctuations in demand for real balances as world interest rates fluctuate. This would be consistent with a constant money supply, or with a steady growth rate of the money supply equal to y, only if the international financial environment is stable.

asset substitutability and monetary policy

With r = r*(and static expectations) changes in the domestic money supply cause the exchange rate to change, as indicated in equation (17), regardless of how these changes are achieved. It makes no difference whether the central bank trades in assets denominated in domestic currency via open market operations, or assets denominated in foreign currency via foreign exchange market intervention; the two are perfect substitutes by assumption. The thing that matters is what happens to the money supply.

However, if home and foreign assets are not perfect substitutes, so that r ≠ r*, then it is important whether changes in the money supply are induced by open market operations or by intervention in the foreign exchange markets. Consider a given reduction in the money supply, ΔM. If this is achieved by selling domestic government debt, the interest rate will rise more, and the exchange rate will fall less, than it would if the same ΔM were achieved by selling foreign exchange reserves. This is shown formally in Branson (1977); Henderson (1982) and Obstfeld (1982) provide more up-to-date expositions, complete with rational expectations. The less substitutable the assets the more pronounced these differences will be, as is shown in Katseli and Marion (1982).

These differences could be important if the objective of the monetary restraint is to slow an existing inflation. As we saw in Section III, a reduction in e can have a direct influence on domestic prices, even with imperfect goods substitution and nontraded goods. Thus, a monetary tightening that has a maximum effect on the exchange rate will yield a direct effect on domestic prices. This could have an important influence on inflationary expectations.

The extent of imperfect asset substitution and the implied degree of freedom to conduct monetary policy are as yet unclear empirically. One line of research emphasizing calculation of optimal portfolios indicates a wide range of substitutability, and even complementarities. An example is de Macedo (1981). On the other hand, researchers looking for systematic variation of “risk premiums,” or interest rate differentials as asset supplies change, lean toward the perfect substitutes result. A good example is Frankel (1982). Thus, no general empirical result on asset substitutability is yet available. Given the rapid change in structure of international financial markets in the last decade, obtaining clear empirical results may remain difficult for some time.

financial stability and choice of exchange rate regime

In the short run, the value of a floating exchange rate is determined by equilibrium conditions in asset markets. In the monetary model, only the money market matters; in general, the exchange rate is part of the process of general achieving equilibrium in financial markets. Thus, we should expect a floating exchange rate to exhibit the fluctuations typical of stock prices rather than goods prices, as shown by Frenkel (1981). And the short-run stability of the exchange market depends on overall stability of the financial sector, as shown in Branson (1977). The Marshall-Lerner condition must be met if there is to be dynamic stability of the feedback process from the exchange rate to the current account, but in the short run it is financial stability that matters.

This implies that free floating is feasible only for countries with financial markets that are thick enough and sufficiently well-integrated into international financial markets to convince monetary authorities that private speculation will generally be stabilizing. The argument is given in detail in Branson and Katseli (1981). In this case a floating rate can be expected to be stable, and it is possible to leave exchange rate determination to the market.

If floating is not feasible, the central bank has to “make” the market in foreign exchange. This means it has to set a price, and the problem of exchange rate policy becomes one of how to determine the equilibrium price and adjustment toward it. One of the interesting developments of the 1970s was the alignment of countries into groups of “feasible floaters” with financial stability—mainly the industrial countries—and “peggers” with exchange rates fixed against one of the major currencies or an average of several of them.

Why might floating not be feasible for any single country? Stable floating requires the existence of a number of agents in the private sector who hold the home currency as part of a portfolio diversified across currencies and who will shift out of the currency when the exchange rate rises above its expected long-run level and into the currency when the exchange rate falls below that level. Agents may hold the currency either for transactions balances or for portfolio diversification. For many countries, the trade denominated in domestic currency is so limited that there is no external transactions demand for that currency. Some small countries, such as Singapore or Switzerland, have created portfolio demand for their currencies by giving them attractive stability or covariance properties. But portfolio diversification into many currencies is minimized, either by political risk that foreign claims on home country institutions denominated in home currency may not be honored, or by capital controls that make up part of a system of financial repression that rules out capital mobility and floating.

Thus, due to underdevelopment of the local financial market structure, floating may not be a feasible option for many central banks. This has led to the advent of more or less floating currencies and blocs such as the European Monetary System, at the center of the international financial system, while countries on the periphery are pegging in many instances.

conclusion on financial structure

The assumptions of free capital movement and perfect substitution are perhaps the most powerful and widely used combination in international finance. They permit the analyst to peg domestic interest rates to the world market level and to proceed with an analysis that essentially ignores the structure of financial markets. For some questions, this is the efficient way to proceed. For others—such as the choice of market for monetary policy intervention, or the decision whether to float or peg—consideration of aspects of structure in financial markets is essential. The choices that governments have made in these areas since the early 1970s attest to the governments’ views that even financial market structure is important for macroeconomic policy decisions.

The short-run determination of floating exchange rates by financial market equilibrium conditions has put financial structure in the center of analyses of policy interdependence and the choice of exchange rate regimes. Sir Arthur Lewis characterized the results in his Per Jacobssen lecture at the International Monetary Fund in 1977:

It is now the conventional wisdom that the currencies of the developed countries should float, but the currencies of the less developed countries (LDCs) should not; that is to say that each LDC should choose a more developed country (MDC) as a partner—or the SDR—and tie itself in a fixed relationship.2


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Bijan B. Aghevli

Branson provides us with a general survey of the rapidly growing literature to which he has himself made important contributions. The present paper contains a number of interesting ideas, particularly those relating to the nature of wage rigidities and policy interdependence between the United States and Europe. Following the organization of the paper, I will focus my comments on the structural aspects of the goods market, the labor market, and the financial market.

As pointed out by Branson, simple monetary models of the type described in the first section of his paper are not capable of analyzing the elasticity requirements for successful devaluation. In his section on trade structure, Branson presents a taxonomy of elasticity conditions and analyzes the effect of a devaluation under different circumstances. One certainly would not disagree with the familiar results of this analysis, but it seems to me that the essential policy issue, not discussed in Branson’s paper, is an empirical one: what are the numerical values of these elasticities over the relevant time horizon? In their recent survey of the empirical trade literature on this question, Goldstein and Khan1find that the estimated magnitudes of price elasticities are such that they would not be a barrier to a successful devaluation over the medium term (two-three years), although in the short run (up to six months) some perverse effects may occur. These results indicate the importance of distinguishing between short- and long-term elasticities. Moreover, the empirical estimates of supply and demand elasticities for exports and imports surveyed by Goldstein and Khan are based on a partial equilibrium specification that does not explicitly take account of the real balance effects of an exchange rate adjustment on absorption and income; it could, therefore, be quite misleading to rely on these results for policy purposes. Recent theoretical and empirical work has extended the simple monetary model to include both traded and nontraded goods, and I do not think it is any longer accurate to argue, as Branson does, that “the literature on the monetary model is generally silent on elasticity conditions.” A main issue in the more recent general equilibrium models is the speed at which output in the traded sector responds to relative price changes. Rigidities in real wages can neutralize the impact of an exchange rate adjustment on relative prices and, thereby, on output. In this context, the trade structure and the rigidities in the labor market are closely related.

This brings me to the second part of Branson’s paper, which deals with the implications of the “stylized fact” that in the United States nominal wages tend to be inflexible in the short run, whereas in a number of European countries it is real wages that appear to exhibit short-run rigidity. These labor market rigidities will obviously produce different patterns of output, current account, and price responses to exogenous shocks and policy changes in the two regions. In Branson’s framework, not only the real wages but also the relative price of traded and nontraded goods are assumed to be fixed in “Europe,” and, consequently, there is no room for output adjustment. A relaxation of the particular indexation formula used by Branson—which ties the price of nontraded goods to wages—would allow some real effects through the adjustment of relative prices, even if real wages were kept constant. In addition, a decomposition of traded goods into exports and imports would allow an analysis of the effect of an exchange rate adjustment on the external terms of trade; this phenomenon is particularly important if the country is a price taker in markets for some of its imports. (For instance, to the extent that oil prices are set in U.S. dollars in the short run, an appreciation of the currency in Europe against the dollar would shift the external terms of trade against Europe.)

Notwithstanding the restrictive assumptions made by Branson, however, it is reasonable to deduce, as does Branson, that if real wages are sticky in Europe the impact of a policy change in the United States will be more reflected in inflation in Europe than in the United States. Consequently, European countries would be reluctant to depreciate their currency to correct a current account deficit, as this would increase their domestic inflation. It should be noted, however, that the above argument does not hold in reverse, in the sense that European countries should not be reluctant to accept an appreciation of their currency to correct a current account surplus as this would lead to a reduction in their domestic inflation. I would also note the obvious implication of Branson’s analysis that Europe’s reluctance to accept a downward adjustment of its exchange rate should be based only on the implications for inflation and not on its ineffectiveness to correct an external imbalance. Presumably, the impact of an exchange rate adjustment on the current accounts of Europe and the United States should be of similar magnitude since the bulk of trade of the two is with each other.

I will briefly turn to the relation between financial stability and the choice of the exchange rate regime. The author’s proposition that “floating is feasible only for countries with financial markets that are thick enough and sufficiently well-integrated into international markets that the monetary authorities can trust private speculation to be stabilizing” is clearly valid. In practice, however, this seems to be a necessary but not a sufficient condition for stability of a floating rate. By this I mean that for countries that already have reasonably deep financial markets, more integration with other financial markets will not necessarily improve exchange rate stability; indeed, it could increase the fluctuations in the exchange rate in response to such factors as monetary shocks or shifts in expectations originating in other countries. This argument provides the basis for the recent upsurge of calls for capital controls to reduce unwarranted exchange rate movements. Whether or not such controls could be effectively implemented, however, is an issue that is open to question.

Recent monetary models have gone a long way in describing the behavior of exchange rates or, more accurately, in explaining why movements in exchange rates cannot be directly related to changes in what Dornbush calls the “fundamentals.” This literature is comprehensively analyzed in a recent paper by Frenkel and Mussa.2 While this literature is technical and does not make easy reading, its implications for policy are quite interesting and intuitively appealing. In Mussa’s analysis: “The response of the exchange rate depends not only on the current policy action of the government, but also on the effects of this action on expectations concerning the future behavior of exogenous real and monetary factors. Even a seemingly modest policy change can have a pronounced effect on the exchange rate if this change significantly alters expectations concerning the future path of government policy.” In the presence of wage price rigidities, the immediate response of prices to any policy change is likely to be much greater under a floating rate than under a fixed rate regime. Consequently, if changes in government policy were the major source of instability, a flexible rate system would lead to more instability because the exchange rate would immediately respond to a new information about the course of economic policy and, thus, affect prices. The impact of price fluctuations on output, however, would depend on the nature and extent of wage rigidities; this issue has been dealt with in a number of recent papers, notably those by Mussa3 and by Argy and Salop,4 but further theoretical and empirical work is required to incorporate structural factors into the monetary models of the balance of payments.

Ryutaro Komiya

The main message of Mr. Branson’s paper, as I understand it, is that in an economy in which various kinds of rigidities exist, such as rigid nominal or even real wages, wage indexation, low price elasticities, or poorly developed financial markets, it is more difficult to achieve full employment and price stability than in an economy in which there are fewer rigidities. I will make four comments of a more or less general nature, drawing upon recent Japanese experience where relevant.

First, I feel that recently governments of various countries have tended to complain too much about what other governments do in the area of macroeconomic policies. Some thirty years ago, Jan Tinbergen said in his Theory of Economic Policy that when there are a number of targets for economic policy, there must be at least an equal number of policy instruments in order to reach the given targets simultaneously. About fifteen years ago, Robert Mundell proposed a notion of the assignment problem. Mundell said that it was best to assign to each target a policy variable which exerted most direct influence on that target. Consider a very simplified model of an international economy, consisting of Europe, the United States, and Japan, and suppose that each of the three has two targets: the inflation rate and the unemployment rate.

Then there are altogether six policy targets, so that in order to achieve the six targets simultaneously there must be at least six policy variables. Each country should use its own fiscal, monetary, and/or incomes policies at their disposal to achieve their own policy objectives, and should assign each target a policy instrument that has the most direct influence on it.

Recently, European governments, and also to some extent the Japanese Government, have been complaining about high U.S. interest rates. But from around 1970 to 1973, and also in 1978, Europeans and Japanese complained about the lack of monetary discipline on the part of the United States. Now that the United States has firm discipline on money supply, they complain about high interest rates. I think that the U.S. money supply or the interest rate is not a policy variable that can be reasonably assigned to any target in Europe or Japan.

I am puzzled by Figures 2 and 3 of Branson’s paper (pages 54 and 55). If this is the correct picture of the European situation, not much can be done to reduce the unemployment level in Europe anyway. Apparently, the number of policy instruments is insufficient.

It might be said that the complaint is not about the U.S. monetary policy but about the large U.S. budget deficit that brings about high interest rates. The Japanese Government too is now being asked by foreign governments to expand the budget deficit further. But here again, any country’s budgetary policy belongs to the domain of its national sovereignty. The U.S. or the Japanese Government cannot be expected to change the size of its budget deficit to accommodate the needs of foreign macroeconomic targets. Unless there are a sufficient number of policy variables, we are bound to have a conflict of interest between countries. As far as Japan is concerned, in my view, there are a sufficient number of policy instruments and enough flexibility so that there is no need to complain about foreign countries’ macroeconomic policies.

In this connection I have a question about Branson’s statement on page 56. He says that a reduction in real wages due to the worsening of the terms of trade results in a rise in unemployment in Europe. When real wages decline, some workers may cease working because it is not worthwhile to continue to work at lower real wages and because they prefer leisure time or work at home. This is quite understandable: it may well be a rational and economic allocation of time by individuals. Why should one call this an increase in unemployment?

My second comment is on the time dimension of the notion of rigidities. Branson says on page 57 that the real wage resistance in the Federal Republic of Germany may be dissipating. I think that many of the rigidities are not absolute ones but relative to the length of time and that rigid relations can be made more flexible over time by appropriate policies. Even oil consumption, which is inelastic over the short run, is price elastic if one considers the long run. Compared with the level in 1973, Japan’s real gross national product (GNP) in 1981 was 40 percent higher, while oil consumption was over 20 percent less. It is encouraging that even in the United States workers in the automobile industry accepted lower wages in the face of major difficulties of the industry. So, various rigidities, such as wage indexation, should not be taken for granted if a country wants to attain high employment.

My third comment is concerned with fluctuations in exchange rates and swings in the balance of payments on the current account. Let me take up the current account balance first. The maximum swing in the current account balance of the United States or Japan has been in the range of 1–2 percent of their respective GNPs, at most. Major European countries have had larger swings, and for smaller countries the swing sometimes goes further, up to 8 and 10 percent. Nowadays, economies of developed countries are closely integrated with each other, by the reduction in tariff and nontariff barriers and in the cost of transportation and communications. In this highly integrated international economy, whatever is the exchange rate regime, the swing in current account balance of the size we have experienced should be taken for granted as a part of the normal macroeconomic adjustment process. Macroeconomic policymakers, and especially U.S. politicians and the general public, should not become excited about the size of Japan’s overall current account surplus or the U.S. overall trade deficit experienced from time to time in the past. These surpluses or deficits, which amount to 1 to 2 percent of GNP, cannot be made equal to zero every year, just as it is difficult to stabilize completely the amount of inventory investment or fixed investment in the business sector in any country.

Coming to fluctuations in exchange rates, certainly they have been much larger than most economists thought in years before floating. But if we take the real effective exchange rate, the degree of fluctuations have been generally within the range of 10–15 percent over a quarter, and within, say, 20–30 percent over a year, for most countries. As long as each major country pursues its own independent fiscal and monetary policies, we have to accept this degree of fluctuation in the exchange rate, as there is no better alternative.

Central bank intervention in the exchange market for the purpose of stabilizing exchange rates has not been successful, generally speaking, for two reasons. First, the amount of funds that the central bank can mobilize is too small compared with the private short-term capital flows. Second, nowadays market participants’ expectations are not influenced much by central bank intervention.

It seems to me that the mechanism of private speculation and short-term capital flows is not yet well understood. The largest source of speculation, at least in Japan, comes from the forward covering activity of exporters and importers. A predominant part of Japan’s exports and imports are denominated in U.S. dollars. Exporters and importers always have a large balance of already made export and import contracts amounting to, say, 4–6 or even 9 months’ exports and imports. Nowadays in normal times they cover by forward exchange only a small portion—say, 20 to 40 percent—of already made contracts. When exporters think that the yen has depreciated much from the trend line, they cover a much larger part of the balance by selling forward dollars. When importers think the yen has substantially appreciated, they cover a much larger part by buying forward dollars. Forward covering by exporters and importers initiates the flow of short-term capital through covered interest arbitrage. Exporters and importers can do the forward covering at any time between the time of signing the contract to the final payment, which may sometimes be half a year, nine months or even longer.

At present, the amount of Japan’s official reserves is approximately US$26 billion, which is among the largest in the world. Japan’s exports plus imports now amount to US$24–25 billion a month. This means that when the central bank intervenes strongly against the expectations of market participants, just one month’s leads or lags in forward covering will wipe out the official reserves or double them within a few weeks, depending on whether the intervention is selling or buying. I think that, for the same reason, the target zone approach or the band proposal cannot be workable whenever the exchange rate hits the ceiling or the bottom. Needless to say, there are many other sources of short-term capital flows in addition to the forward covering activity of traders, but even with this source alone, the short-term capital flows could be really large.

Private speculation of this kind does not completely stabilize fluctuations in exchange rates, but it ensures a certain degree of stability, at least in real effective exchange rates.

My final comment is on the feasibility of the floating system. I very much agree with Branson’s statement on page 62 that the floating system is feasible only for countries with well-developed financial markets. I still think the floating system is a luxury, in spite of some overshootings or large fluctuations in exchange rates. It enables the country to get rid of import restrictions, the artificial policy of promoting exports, or restrictions on capital flows. Only those countries that have well-developed and liberalized financial markets can have it.

On the other hand, I disagree with Branson on one of the reasons for the feasibility of floating. He says, for a country where the volume of trade denominated in its currency is small, the floating system is not feasible. But, as explained, when the country has liberalized forward covering activity, interest arbitrage, and short-term capital flows, there will be enough speculative activity. Potentially there will be a large amount of short-term capital flows resulting from leads and lags, and therefore even such a small country can have a floating system that will function reasonably well.


William H. Branson is Professor of Economics and International Affairs at Princeton University and Director of the Research Program in International Studies at the National Bureau of Economic Research (NBER). He is the author of Macroeconomic Theory and Policy and has served as a consultant at the World Bank. He is currently on leave as Visiting Professor at the Athens School of Economics and Business Sciences and concurrently at the Johns Hopkins University Bologna Center.


Character in U.S. cartoon by Al Capp.


“The Less Developed Countries and Stable Exchange Rates,” in The International Monetary System in Operation (Washington, 1977), p. 33.


M. Goldstein and M. Khan, “Income and Price Effects in Foreign Trade,” scheduled to be published in 1983 in W. Jones and P. Kenen, eds., Handbook of International Economics (Amsterdam).


J. Frenkel and M. Mussa, “Asset Markets, Exchange Rates and the Balance of Payments: The Reformulation of Doctrine,” scheduled to be published in 1983 in W. Jones and P. Kenen, eds., Handbook of International Economics (Amsterdam).


M. Mussa, “The Theory of Exchange Rate Determination,” scheduled to be published in Exchange Rates: Theory and Practice, eds. John Bilson and Richard Marston (University of Chicago).


V. Argy and J. Salop, “Price and Output Effect of Monetary and Fiscal Expansion in a Two-Country World Under Flexible Exchange Rates,” scheduled to be published in 1983 in Oxford Economic Papers.

IMF Staff papers: Volume 30 No. 1
Author: International Monetary Fund. Research Dept.