International Monetary Relations — 1: Exchange Rate Regimes

Summary

There are two main factors determining whether the balance of payments adjustments of some geographic area would be more easily handled as a region within a common currency area or as an independent country with a separate currency and a potentially variable exchange rate. The first of these is size. The smaller the size of the region, the easier it is for it to adjust within a common currency area and the greater the difficulty of making an independent command over monetary and exchange-rate policies effective. Larger countries may enjoy certain economies of scale (for example in government itself) and the existence of large currency areas does eliminate the need for continuous currency exchanges within the area. On the other hand, a region which cannot adjust its exchange rate in response to external shocks will have to bear additional adjustment costs in terms of disturbances to labour markets (e.g., migration and unemployment) and large shifts in incomes and wealth. If the prime goal is internal stability, it would seem that the greater the number of separate currencies the better. However, simple observation shows that single currency areas range from huge countries down to very small states. This diversity suggests that the costs of diverging from the optimally-sized currency area are not sufficient to outweigh other more powerful forces shaping political boundaries.

Indeed the second, and more important, factor determining the optimal extent of currency areas is the existence of social and political unity between the regions of the area. If this exists, fiscal transfers (and migration) will ease, and possibly resolve, regional disparities, and allow the burden of adjustment to disturbances to be amicably shared. It is, however, possible to find counter-examples of countries linked together in a single currency area without the support of a (partially) centralised fiscal authority. One such example was provided by the earlier fixed relationship between the Irish and UK currencies before Ireland joined the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) while the UK did not (1979). Another more famous example is provided by the Gold Standard.

The maintenance of permanently-fixed exchange rates virtually implies the abandonment of autonomous control over domestic monetary policy. Otherwise the more inflationary country, within a fixed exchange-rate system, would not only obtain command over additional goods and services, but would also pass on unwanted inflation to its partners. No such system can, therefore, persist without some discipline over the monetary policies of the countries involved. But, in the modern world, powerful, independent nations are not likely to submit themselves to the external constraints of automatic rules. The discipline and decisions necessary to run a fixed exchange-rate system will nowadays have to depend on political harmony.

The political scene today gives few grounds for optimism on the prospects for establishing a permanently-fixed exchange-rate system over the Atlantic community. The world system will continue to contain a number of countries (currency areas) with separate currencies whose value in exchange can, and will, vary. The question, addressed in Section 2, is how such adjustments are best carried out; in particular we examine whether the exchange rate should be allowed to float entirely freely or whether its movements should be managed by the authorities; and if the decision is to manage the exchange rate, whether this should be by maintaining (temporarily) fixed but adjustable parities or by intervening to moderate the rate of change of the exchange rate.

I doubt whether it would be desirable to leave the exchange rate entirely at the mercy of market forces. In the short run devaluations often seem to worsen the trade account, probably because of lags in adjustment to price changes (the J-curve syndrome), while speculation is also usually on too short run a basis to provide a stabilising influence. So a regime of freely floating rates may lead to considerable ‘overshooting’ and unnecessary instability. Moreover, when external balance is disturbed, not by an external shock, but by some impulse from domestic conditions, reliance on flexible exchange rates to restore external balance will tend to exaggerate the initial divergence from internal balance. Supporters of flexible exchange rates have a liberal optimism in the perfectability of domestic policy making.

On the other hand, once an exchange rate is pegged it ceases to insulate the economy from external shocks. If the authorities are not driven from their internal objectives and the whole idea is to prevent that happening — an external imbalance will develop over time. The existence and direction of this imbalance will generally become obvious, opening up one-way options to speculators. If the authorities try to peg the rate for any length of time, the change in the rate ultimately necessary to restore equilibrium will become larger. Large, abrupt, occasional changes in market conditions tend to impose greater adjustment costs than small, continuous changes. Furthermore, the longer a rate is forcibly held at some disequilibrium level the harder it may be to see what the appropriate level at which to re-fix might be.

For all these reasons my own conclusion has been that the authorities should intervene in exchange markets, but that their concern should not be to pick and to defend any particular level of rates, but to control the rate of change of parities, managing this rate of change to see that it never becomes too large (e.g., under the influence of low short-run elasticities and destabilising market speculation) to become a disruptive force.