Overview

 

The first half of this chapter examines types of government policiestoward the foreign exchange market and provides analysis of governmentintervention and exchange controls. The second half examines the actualpolicies that governments have adopted during the past 140 years.

 

Government policies toward the foreign exchange market exist for avariety of reasons, including to reduce variability in exchange rates, to keepthe exchange value of its currency either high or low, or to raise nationalpride in a steady or strong currency. The two major aspects of governmentpolicies toward the foreign exchange market are policies toward the exchangerate itself and policies that permit or restrict access to the foreign exchangemarket. Government-imposed restrictions on the use of the foreign exchangemarket are called exchange controls, which may be broad-based or may be appliedonly to some types of transactions (e.g., capital controls).

 

The basic choice that a government faces with its policy toward theexchange rate itself is between an exchange rate that is floating and one thatis set or fixed by the government. In the polar case of a clean float thegovernment permits private market demand and supply to set the exchange ratewith no direct involvement by government officials. In a managed float or dirtyfloat the government officials do intervene at times to try to influence theexchange rate, which otherwise is driven by private demand and supply.

 

If the government chooses to impose a fixed exchange rate, there arethree additional choices that the government faces. First, what to fix to?Answers could include gold (or some other commodity), the U.S. dollar or someother single currency, or a basket of currencies. (With the exception of thespecific examination of the gold standard, subsequent discussion assumes that afix is to one or several foreign currencies.) Second, when to change the fixedexchange rate? Never is a polar case, but it probably is not completelycredible (and we often then speak of a pegged exchange rate instead of a fixedexchange rate). If occasionally, we call the system an adjustable peg. Ifoften, we have a crawling peg. The choice of when to change the peg is closelyrelated to how wide is the band around the central or par value chosen for thefix. Third, how to defend the fixed rate? There are four basic ways—officialintervention in which the government buys and sells currencies; exchangecontrols, in which the government tries to suppress excess demand or supply;altering domestic interest rates to influence short-term international capitalflows; and adjusting the country's macroeconomic position to make it fit thefixed exchange rate. Of course, the government also has a fifth option—to alterthe fixed rate value or shift to a floating rate.

 

The first line of defense is often official intervention. If thecountry's currency is experiencing pressure toward depreciation, the country'smonetary authority can defend the fixed rate by entering the foreign exchangemarket to buy domestic currency and sell foreign currency. The intervention isfinancing the country's official settlements balance deficit and preventingthis excess private demand for foreign currency from driving the foreigncurrency's value above the top of the band. The monetary authority obtains theforeign currency that it sells into the market by using its holdings ofofficial reserves or by borrowing foreign currency. In addition, by buyingdomestic currency, the monetary authority is removing domestic money from theeconomy, which tends to lower the domestic money supply. (Chapter 23 takes upthe implications of this induced change in the domestic money supply.) Analysisof defending against appreciation of the country's currency follows similarlogic, with "the directions reversed."

 

If the imbalance in the country's official settlements balance istemporary, then official intervention that smoothes the time path of theexchange rate can enhance the country's economic well-being (althoughstabilizing private speculation could do the same thing without governmentintervention). If the disequilibrium is ongoing or fundamental rather thantemporary, then intervention alone is not likely to be able to sustain the fixedexchange rate. Instead, the government must shift to one of the other defensesor devalue. A key problem here is that it is not easy for officials to judgewhether a payments imbalance is temporary or fundamental.

 

Exchange controls are used by many countries, especially developingcountries. They cause economic inefficiency analogous to quantitative limits(quotas) on imports. They also incur substantial administrative costs. Effortsto evade them lead to bribery and parallel markets.

 

The second half of the chapter surveys exchange rate regimes usedduring the past 140 years. During the gold standard era (1870-1914), mostcountries pegged their currencies to gold, with each central bank willing tobuy and sell gold in exchange for its own currency. This implies that theexchange rates between currencies are also fixed (within a band resulting fromthe transactions costs of moving gold).Britainwas at the center of thesystem. The gold standard looked successful because it was not subject tosevere shocks (until it was suspended during World War I) and because successwas defined leniently, given that governments were not so concerned withstabilizing their macroeconomies.

 

The interwar period brought instability. In the years after theWorld War I Britain made the mistake of attempting to return to its prewar goldparity.Germanysuffered from hyperinflation, and other European countries also experiencedsubstantial inflation. The early 1930s brought turbulence that led to thegeneral abandonment of the gold standard. Compared with the gold standard era,exchange rates were quite variable. Experts at the time concluded that thisexperience showed the instability of flexible exchange rates, so that the worldshould return to fixed exchange rates. More recent analysis of this periodconcludes almost the opposite—that it shows the futility of trying to keepexchange rates fixed in the face of severe shocks and unstable domesticmonetary and fiscal policies.  Inaddition, recent research shows that the workings of the gold standardcontributed to the global spread and the severity of the Great Depression.

 

A compromise between the United States and Britain led to anagreement in 1944 that established the Bretton Woods System, a regime ofadjustable pegged exchange rates. While this system looked successful foralmost two decades, it also had two defects. One was that it set up one-wayspeculative gambles when currencies were in trouble  The second concerned the role of the U.S.dollar in the system. As the system developed, other countries pegged theircurrencies to the dollar, and theU. S.government was committed tobuy or sell gold for dollars with other central banks. ContinuingU.S.paymentsdeficits in the 1960s led some other countries to amass large holdings of U.S.dollar-denominated assets as official reserves. Confidence that theU.S.governmentcould continue to honor the official gold price dwindled. TheU.S.government was unwilling to contract theU.S.economy to reduce theU.S.paymentsdeficits. Instead, the private market for gold was freed in 1968.U.S.paymentsdeficits continued. In 1971 theU.S.government suspended convertibility of dollars into gold and imposed atemporary tariff on all imports until other countries agreed to revalue theircurrencies (so that the dollar would be devalued). The Smithsonian Agreement ofDecember 1971 attempted to reestablish the system (with many other currenciesbeing revalued), but the pegged rate system was abandoned by the majorcountries in 1973.

 

The box on “The International Monetary Fund,” another in the serieson Global Governance, presents the objectives of the IMF, the multilateralorganization created at Bretton Woods in 1944 to oversee the internationalmonetary system. This box also describes the IMF’s activities in pursuit oforderly foreign exchange arrangements and current account convertibility. (Asecond box on the IMF, in the next chapter, examines IMF lending practices.)

 

The current system is often described as a system of managedfloating exchange rates, and the trend is generally in this direction. Butthere is also much official resistance to market-driven exchange rates. Some ofthe resistance is seen in the active management of floating exchange rates.More dramatically, the countries of the European Union have attempted to createa zone of stability in Europe, first by usingthe snake within the tunnel, then through the Exchange Rate Mechanism of theEuropean Monetary System, and now with European Monetary Union and the euro. Agoodly number of countries maintain fixed or heavily managed exchange rates.However, the series of exchange rate crises during the 1990s and early 2000sshow how difficult it is for a government to defend a fixed or a heavilymanaged exchange rate in the face of wide swings in speculative internationalfinancial flows.

 

The actual current system is in many ways a nonsystem—countries canchoose almost any exchange rate policies that they want, and there is muchvariety. Two major blocs of currencies exist—one is the U.S. dollar and thecurrencies fixed to it, and the other is the countries adopting the euro andother currencies fixed to the euro. A growing number of countries have floatingexchange rates for their currencies, with a greater or lesser degree of “management.”Yet other countries use a fixed exchange rate to another currency, a fixedexchange rate to a basket of currencies, or a crawling pegged exchange rate. Afew countries are “dollarized”—each simply uses the currency of some othercountry as its own.