FROM TIME TO TIME, countries undertake a major reorientation of their exchange rate arrangements. Such a restructuring occurred after World War II with the advent of the Bretton Woods par value system; another change took place in the 1970s with the widespread adoption of flexible exchange rate arrangements by the major industrial countries.1 Each time a major change takes place, it is well understood that the change requires an expensive restructuring of institutions that may have to be altered yet again in the future, when the economic environment so necessitates.
The purpose of this paper is to study the economic environment relevant to recent exchange rate regime switches and to develop a simple model that enables an exchange rate regime switch to be viewed as a forecastable and optimal response by policymakers to the evolving state of the world. The examples we will develop involve switches between fixed and flexible regimes and vice-versa, but the methodology is broader. The framework may be used to analyze switches between other types of exchange rate arrangements; for example, the adoption or disbandment of multiple-tier or composite currency (basket) arrangements or between different general policies (such as interest rate versus monetary targets).
Issues related to the choice between fixed and flexible exchange rate regimes have generated a considerable literature over the past three decades. It is important, therefore, to indicate at the outset the manner in which the present analysis differs from previous work related to the choice of an optimal exchange rate regime. In particular, the focus of the recent literature on the optimal exchange rate regime is to derive the optimal degree of exchange market intervention as a function of the underlying parameters of the economy and of the variances of the existing monetary or real disturbances (see, for example, the papers collected in Bhandari (1985)). The principal result that emerges from these studies is that, for a small country, fixed rates are generally superior to flexible rates when monetary disturbances are dominant, whereas flexible rates are preferable when real shocks are dominant.2
The typical study of the choice of exchange rate regime, however, makes two assumptions that represent an unduly restrictive view of economic reality. First, it is usually assumed that the underlying economic structure (such as parameters and relevant variances) is time invariant, so that the optimal intervention stance (or exchange rate regime) is obtained as a once-and-for-all solution to a static optimization problem (see, however, Flood and Hodrick (1986)). Yet one of the prominent regularities in the financial and real sectors of real-world economies is that they undergo periodic turbulence and tranquility with the relative volatility of real and financial shocks, often exhibiting dramatic shifts. As the underlying economic structure changes over time, therefore, the nature of the optimal exchange rate regime can be expected to vary correspondingly, leading to an “evolution” of exchange rate regimes. Historically, countries have tended to switch back and forth between exchange rate regimes, as discussed in Section I below.
Second, the usual study of the choice of exchange rate regime takes for granted that prospective regime partners have agreed on similar inflation targets for their respective countries. In our view the temporary abandonment of low inflation targets seems to play a major role in the choice of exchange rate regimes and the timing of their adoption. To the extent that the inflation propensities of countries are predictable, the choice of exchange rate regime will also have predictable aspects.
The adoption or disbandment of various exchange rate arrangements over time may then be viewed as a predictable and optimal response to the inherently time-varying nature of the underlying state of the world. Previous analyses of exchange rate regimes have, as noted above, remained primarily concerned with computing the optimal degree of intervention for a fixed economic environment and, as such, cannot provide an explanation of predictably evolving exchange rate regimes. In this study we will begin to address concerns about these aspects of the regime choice problem by developing a theoretical framework that we believe is more in line with empirical regularities. In the model, the underlying stochastic structure of the economy evolves predictably over time, although it is subject to unpredictable shifts at any moment in time. The model is then extended to incorporate government expenditure as a policy goal. By allowing for time variation in desired government spending across exchange rate regimes, the inflation propensity of the country in question also develops predictably over time.3 The decision problem we focus on is at the level of the policymaker. It involves the choice by the policymaker of the exchange rate regime for the next period, together with the formulation of a plan concerning the path of the exchange rate regime over the indefinite future.
Although the following text contains a discussion of substantive results, the most interesting implication of the analysis is that, in the model and its extension, a policymaker can switch from one regime to another while planning to switch back at some point in the future. To our knowledge, this possibility has neither been discussed nor analyzed previously in the literature. This implication is suggestive insofar as changes in the exchange rate policy by some countries may be interpreted as a predictable and optimal response to a changing economic environment.
Section I presents a discussion of the historically observed shifts between exchange rate regimes and empirical observations of the time-varying movements of relative monetary and real variances in the major industrial countries over the past three decades. This section also presents empirical evidence relating to the dispersion of inflation rates in the same group of countries over the same period. Section II sets out the basic analytical framework, which involves a time-varying stochastic structure. Policy choices in the context of this model are studied in Section III. In Section IV, the basic model is extended to highlight the links between government expenditure, inflation rates, and the choice of the exchange rate regime. Section V offers conclusions, and two appendices provide details on estimation methods and data sources.
Abel, Andrew B., “Stock Prices Under Time-Varying Dividend Risk: An Exact Solution in an Infinite-Horizon General Equilibrium Model,” (unpublished; Philadelphia: The Wharton School, University of Pennsylvania, 1986).
Aizenman, Joshua, and Jacob A. Frenkel, “Optimal Wage Indexation, Foreign Exchange Intervention, and Monetary Policy,” American Economic Review, Vol. 75 (June 1985).
Bhandari, Jagdeep S., “Staggered Wage Setting and Exchange Rate Policy in an Economy with Capital Assets,” Journal of International Money and Finance, Vol. 1 (December 1982).
Bhandari, Jagdeep S., ed., “Informational Regimes, Economic Disturbances and Exchange Rate Management,” in Exchange Rate Management Under Uncertainty (Cambridge, Massachusetts: MIT Press, 1985).
Driskill, R., and S.A. McCafferty, “Exchange Market Intervention under Rational Expectations with Imperfect Capital Substitutability,” in Exchange Rate Management under Uncertainty, ed. by J.S. Bhandari (Cambridge, Massachusetts: MIT Press, 1985).
Engle, Robert F., “Autoregressive Conditional Heteroscedascity With Estimates of the Variance of United Kingdom Inflation,” Econometrica, Vol. 50 (July 1982).
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Flood, Robert P., and Nancy P. Marion, “The Transmission of Disturbances Under Alternative Exchange Rate Regimes with Optimal Indexing,” Quarterly Journal of Economics, Vol. 97 (February 1982).
Flood, Robert P., and Nancy P. Marion, and Robert Hodrick, “Real Aspects of Exchange Rate Regime Choice with Collapsing Fixed Rates,” Journal of International Economics, Vol. 21 (November 1986).
Hodrick, Robert J., “Risk, Uncertainty and Exchange Rates,” (unpublished; Evanston, Illinois: Kellogg Graduate School of Management, Northwestern University, 1987).
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Obstfeld, Maurice, “Floating Exchange Rates: Experience and Prospects,” Brookings Papers on Economic Activity: 2 (1985), The Brookings Institution (Washington).
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Mr. Flood is a Senior Economist in the Research Department. He obtained his Ph.D. from the University of Rochester.
Mr. Bhandari, an economist in the European Department, obtained his Ph.D. in economics at Southern Methodist University. He also holds a J.D. degree from Duquesne University.
Ms. Home is a Senior Economist in the Fiscal Affairs Department and obtained her Ph.D. in economics from the Graduate Institute of International Studies, University of Geneva.
At least two other major realignments can also be discerned: the adoption of the gold standard from approximately 1870 until World War I and the switch to floating rates during 1929–33. These realignments, along with the two mentioned above, were major in the sense of involving a substantial number of countries. There are, of course, numerous cases of single countries experimenting with alternative exchange rate arrangements in isolation.
These results have been shown by various authors to be robust in a wide variety of alternative model specifications, involving, for example, staggered wage setting (Bhandari (1982)), complex intervention rules (Turnovsky (1985)), and finite or perfect asset substitutability (Driskill and McCafferty (1985)). Note, however, that this proposition may not survive incorporation of differentiated or heterogeneous information sets (Bhandari (1985)).
An international gold standard exists when most major countries maintain convertibility between gold and their national monetary units at fixed ratios. Before the gold standard, a form of loose “bimetalism” existed (see Yeager (1976, pp. 295–97)).
During the period 1929–33, 35 countries abandoned the gold standard.
The breakdown of the Bretton Woods system can be dated from 1971, when its two main features—par values and U.S. dollar convertibility—were no longer operative (see de Vries (1986, chaps. 2 and 3)).
The classification of exchange rate regime is based on the Fund’s exchange rate arrangements classification (see International Monetary Fund (1987)). Important changes in this classification system occurred over the sample period, especially in 1973 and 1982. In particular, a new category, “exchange rate not maintained within relatively narrow margins,” was introduced in 1973; in 1982, this category was replaced by two new classes: “limited flexibility” and “more flexible” arrangements.
The original Articles of Agreement of the International Monetary Fund reflected the requirement of an agreed par value. Under temporary and specified circumstances, however, the Fund supported deviations from exchange rate arrangements, including fluctuating rates (for example, Canada during September 1950-May 1962; see de Vries (1986, pp. 49–56)). The classification of countries in the nonfixed category in the pre-1973 period is based on the criterion that either the country did not maintain a par value or adopted a freely fluctuating unitary effective rate.
Adjustable indicators were classified under a fixed-rate category before 1982. This change in classification affects four countries within the group.
A detailed description of the methodology used to estimate these shocks is given in Appendix I. For the United States, both money demand and money supply equations were estimated. Our emphasis is on the time-series behavior of the relative shocks—in contrast to Obstfeld (1985), who used cross-sectional data to show the relative dominance of real shocks in the early post-Bretton Woods period.
The sample period ends in 1987:4 for all countries except the Federal Republic of Germany, for which it ends in 1988:1.
When the 1980s are broken into the subperiod 1980–84, the standard deviation of monetary shocks rises to 1.42, reflecting the well-documented instability in U.S. money demand.
Interpreted in the above sense, a period such as the 1980s may be described as relatively tranquil, yet may still be characterized by large shocks in absolute terms.
The sharp rise in the variability of the ratio of real to monetary shocks in France in the 1960s reflects primarily a large real shock in 1968. For the United States, this statement is true for the decade average notwithstanding a large jump in the ratio of real to monetary shocks in the early 1960s.
In Flood and Marion (1982) p is treated as policy-varying, whereas in Flood and Hodrick (1986) p is time-varying and moves in accord with agents’ perceptions of an endogenously time-dependent stochastic structure.
Even if C = 0, the model predicts regime switches. C > 0 allows the possibility that switches will be delayed. We also assume symmetry in costs for the two regimes. It is possible that costs may differ from one regime to another or at different times for an individual country with respect to one regime. In the absence of any compelling rationale, however, it seems reasonable to retain the assumption of symmetry.
It is possible, of course, to allow for the immediate implementation of a current decision relating to the exchange rate regime. This leads, however, to algebraic complications without affecting any of the principal conclusions of the analysis.
The examples of a high-inflation country fixing its exchange rate to a low-inflation country seem to involve foreign exchange rationing on the part of at least one of the countries.
This does not make the subsequent analysis static. As will be seen below, time dependency in the present model is introduced through the government expenditure process.
A stabilization role for g could be built around a covariation of xt with wt or u t. However, we assume away such covariation.
Other settings for the rate of domestic money creation are possible. An attractive alternative would have θ(dt – dt-1) = π* +ut – ut-1 +wt – wt-1, which would accommodate shifts in domestic money demand. The policy setting here was chosen for simplicity.
This asymmetry occurs because a flexible rate is not a policy in the same sense as a fixed rate. Flexible rates simply set out what monetary policy is not and do not constitute a policy of fixing the exchange rate. See, however, Aizenman and Frenkel (1985).
This, of course, is the point of a flexible exchange rate policy: to “free up” government spending as a tool for, say, war management.
For example, a switch to fixed rates would require small coefficients on the ambiguous effects.
Linear homogeneity was imposed on the money demand function by setting a1= 1