the international constraint on monetary policy

8/3/2019 The International Constraint on Monetary Policy

1/21

Polytechnic University of the Philippines

College of Economics, Finance, and Politics

Department of Banking and Finance

Sta. Mesa, Manila

THE INTERNATIONAL

CONSTRAINT ONMONETARY POLICY

Submitted by:

Araa, Dyan E.

Anyayahan, Sherry Mae M.

Dioquino, Harold Jim B.

Mercado, Monica Lucille Anne M.

Onte, Pamela M.

Valdez, Janine Luz A.

BBF 4-10N

Submitted to:

Mr. Rolando Fernandez


2/21

THE BALANCE OF INTERNATIONAL PAYMENTS AND MACROECONOMIC

EQUILIBRIUM

The theory of monetary policy assumed that the central bank had complete freedom to

manipulate the money supply. Such freedom implies no significant constraints on the level of

interest rates other than those imposed in the market by the behavior of asset holders. This isnot always the case in practice.

For example, in discussing the theory of central bank control of the supply of money we

referred briefly to the period during and immediately after World War II, when the Federal

Reserve stabilized government bond yields at low levels. The Federal Reserve guaranteed

holders of government bonds that the price of those securities would not change significantly.

Under postwar inflationary conditions, the policy of pegging interest rates was inconsistent with

the vigorous use of monetary policy to restrain aggregate demand. The Federal Reserve was

virtually powerless to use open-market operations to restrain those inflationary pressures.

In the contemporary context, there are other powerful external constraints onindependent monetary action by the central bank that have arisen from the rapid increase in

trade between countries, persistent balance of payment disequilibria, and the increasing mobility

of capital flows across national boundaries in a world that has adhered to fixed exchange rates.

FOREIGN EXCHANGE RATE

The foreign exchange rate is simply a price the dollar price of one unit of foreign

currency. Of course, there are many foreign currencies and in this sense many foreign

exchange rates.

Although it is simply a price, in most respects just like the price of any other financial instrument

determined in the market place by the interaction of supply and demand forces, foreign

exchange rates have one rather than unusual and, for our purposes, crucial characteristic. They

have been the central concern of negotiation, agreements, and tensions for several decades. In

1944, an international treaty, the Articles of Agreement of the International Monetary Fund

(commonly called the Bretton Woods Agreement) was signed. It was supposed to resolve all

financial problems between countries by creating a constitution for a stable international

monetary system. The key concept was that of stable exchange rates, adjusted from time to

time in an orderly, mutually agreed upon function. Nations were not to resort to competitive

devaluations of their currency in order to achieve a balance-of-payments surplus or to correct

temporary balance of payments disequilibria. An international monetary fund was created to

overcome the monetary system and to make loans of foreign exchange reserves from time to

time to assist in maintaining the fixed exchange rates. The emphasis of the Agreement was onpromoting the exchange of goods and services freer trade. Little was mentioned about

freedom of capital movements. In fact, controls on international capital flows by individual

countries were permitted. Gradually, barriers to international capital flows were relaxed by many

of the industrialized nations.

The basic obligation assumed by the governments under the Bretton Woods

international monetary constitution was to declare an official par rate of exchange and to


3/21

ensure that the foreign exchange rate at which transactions were consummated in the spot

foreign exchange markets did not depart from a narrow band around that official par rate.

The United States obligation was to maintain convertibility between dollars and gold.

The value of the dollar was fixed in terms of gold; other national currencies were also fixed in

terms of gold. Those nations, however, maintained convertibility of their currencies into dollars

(or, in a few cases, pounds sterling) rather than gold.

The Bretton Woods rules were not inviolable. Naturally, most national governments were

unwilling to surrender control of their monetary sovereignty and become unquestioning

adherents to these rules. Domestic policy considerations, often at odds with fixed exchange

rates, necessitated unilateral action. Most countries made major or minor violations from time to

time. From World War II to mid-1971, only 2 countries the United States and Japan out of 21

developed, industrialized countries did not change the official par value of their currency.

Despite the frequent violations of the Bretton Woods Agreement, this international

monetary system served its members and world trade well until the mid-1960s. Since that time

monetary crises were more frequent, which suggests that the Bretton Woods rules had been

abandoned for all practical purposes and the major industrialized nations were seeking a new

international monetary constitution. Gold had been partially demonetized, and its price

fluctuated widely in free international markets. Many major countries had flexible exchange

rates while international conferences were convened to seek a new, more suitable set of rules;

new monetary agreements are not written quickly. Such activity takes time, cooperative and

creative effort, and a great deal of compromise.

Let us examine how the Bretton Woods system of fixed exchange rates constrained

monetary policy, for although there were frequent and often serious violations of the Bretton

Woods rules, that in it should not be taken as evidence that those rules were irrelevant. Rather,the violations are evidence that rigid application of such rules gave rise from time to time to

serious stresses and strains within the international financial system.

From our point of view, the underlying problem was that the Bretton Woods rules

imposed severe constraints on domestic stabilization policies for many countries. Indeed, the

policies required by the international rules of the game occasionally stood in stark conflict with

those required to achieve important domestic objectives. Our task in this and the following

chapter is to examine the economics of monetary and fiscal policies in the context of an

international financial system operating according to the Bretton Woods rules. Only then will we

be able to understand the nature of the problems give rise to urgent proposals for reform of the

international financial system.

What were the most important rules of the game under Bretton Woods?

Under Bretton Woods rules, each government was obliged to ensure that the forces of

supply and demand in the foreign exchange market did not drive its foreign exchange rate

beyond the narrow band around the official par rate of exchange. A flexible exchange rate that,

in response to demand and supply pressures fluctuated over a wider range that the official hand


4/21

on either side of par a clear violation of the letter and spirit of monetary constitution. Member

countries could impose narrower bands and intervene when foreign exchange rated exceeded

these self-imposed limits. The United States had a slightly different obligation under Bretton

Woods. It guaranteed to maintain the dollar convertible into gold at a fixed price. It was willing to

buy and sell gold at prices within a similar narrow band around the official price of $35 per

ounce. The American central bank was not obligated to intervene in spot foreign currency interms of the dollar; that was the responsibility of the foreign central banks. Its commitment was

to maintain the price of the dollar in terms of gold. Since 1961, however, the Federal Reserve

has intervened in both the spot and forward exchange markets from time to time to maintain

exchange rates. The United States should be viewed as a country that normally did not

intervene.

Adjustable Peg. Adjustments in the official par rate of exchange were not ruled out,

although such changes were not to be infrequent, subject to international consultation and

approval, and only in response to exceptional and intractable balance of payment pressures. No

criteria were made explicit by which official par exchange rate disequilibria could be judged as

either temporary or fundamental. This hampered the timely adjustment of official exchange ratesand permitted pressure on domestic economies and exchange rates to accumulate.

As we shall see, the requirement of a pegged exchange rate of monetary controls to

help achieve domestic price level or employment objectives may be rendered impossible.

Avoidance of Direct Controls

There is frequently an easy way out of the dilemma posed by a conflict between the

domestic and external objectives of monetary policy through the use of direct foreign exchange

controls. Thus, for example, when the problems is excess demand for foreign exchange at the

maximum permitted foreign exchange rate, it is possible to maintain stability of the foreignexchange rate by official rationing of the restricted supply of foreign exchange in place of

rationing by the price mechanism. By giving itself the power to approve or disapprove

applications for foreign exchange, the government adds another weapon to its policy armory,

making it possible to keep the foreign exchange market in a continuous state of disequilibrium in

the foreign exchange market, monetary policy is freed from the international constraint, at least

in the short run.

Several countries have resorted to direct exchange controls from time to time. In order to

control foreign currencies the government usually must license firms exporting and importing

goods. The government must control the purchase of foreign assets by its residents,

investments made abroad by the country. Direct controls involve arbitrary interference with theallocation of resources in the economy. In general, they impair microeconomic efficiency. In any

case, aside from exceptional circumstances, direct foreign exchange controls with regard to

trade of goods and services were to be avoided under the Bretton Woods rules.

In the event of excessive demand or supply pressures in the foreign exchange market,

the government has two courses of action open to it if it is to maintain the stability of the foreign


5/21

exchange rate without resort to direct foreign exchange controls. We can call these direct

intervention and indirect intervention.

Direct Intervention

The government can intervene directly in the foreign exchange market, buying foreign

exchange when there is an excess supply at the minimum permitted exchange rate and selling itwhen there is excess demand at the maximum permitted foreign exchange rate. For this

purpose the government institutes a stock of foreign exchange that can be augment or drawn

upon as necessary to permit direct intervention in the market.

Indirect Intervention

Alternatively, the government can attempt to regulate the underlying private demands for

or supplies of foreign exchange. Thus, for example, if the problem is excess demand for foreign

exchange, the government can attempt to reduce private demands for foreign exchange or to

increase the flow of foreign exchange from private sources onto the foreign exchange market.

Part of our problem is to show how the government can do this, and particularly how monetarypolicy can be used to regulate the demand and supply of foreign exchange. The main concern

of this chapter is the analysis of these two modes of governmental intervention in the foreign

exchange market. However, before turning to this analysis it is useful to have before on a brief

sketch of the foreign exchange market.

THE FOREIGN EXCHANGE MARKET

The term foreign exchange market is used in a broad sense to encompass all

transactions involving the exchange of foreign currencies against dollars, and in a narrow sense

to refer to a highly organized component of the broad market, the interbank market in foreign

exchange. In what follows w use the term in the broader sense, which encompasses alltransactions in which foreign exchange is exchanged in against dollars, whether those

transactions occur in the United States or abroad. It should also be noted that the definition

encompasses both spot and forward exchange transactions. However, throughout most of the

discussion we will not distinguish between the spot and forward exchange rates.

The foreign exchange market in the United States is not an organized exchange with a

specific physical location but is similar to the market for money market instruments. Its

participants are linked by telephone and teller communication to each other here in the United

States and to institutions performing similar function in financial centers around the world.

Several New York banks handle the bulk of trading in the United States, although some trading

occurs in other cities. If these New York banks are to satisfy the requirements of their customersimmediately and without question, they must hold an inventory of foreign exchange. To this end,

they hold some foreign currency in their vaults and maintain deposit balances with foreign

banks. These are the banks working balances. The banks buy and sell foreign exchange to

meet the needs of their customers, be they businesses, households, governments, or other

domestic banks. Foreign exchange purchased is added to these working balances; foreign

exchange sold is drawn out.


6/21

However, both profit maximization and the ever present foreign exchange risk dictate

that working balances should be no larger than necessary for efficiency in foreign exchange

operations. This means that the bank must have an efficient mechanism for the quick disposal

of excess foreign exchange and for the quick acquisition of foreign exchange to replenish

working balances should they be inadequate. Such a mechanism is provided by the interbank

market.

The Interbank Market

The interbank market is made in New York among those dealing in foreign exchange

dealers and brokers in foreign exchange, agents of foreign banks, some securities firms, and

the Federal Reserve Bank of New York acting on behalf of the Federal Reserve System and

the Treasury. Secondary, the market for foreign exchange exist kike San Francisco, Boston,

Chicago, Philadelphia, and Detroit, but most participants have representatives in the New York

interbank market as well.

International Arbitrage.The foreign exchange rate determined in the interbank market in

New York is influenced by interbank foreign exchange markets in other financial centers

throughout the world. In these other markets dollars as well as other currencies are bought and

sold. If the rate in one market is out of line with that in another, an arbitrager will place an order

for immediate execution to buy in one market and resell in the other. While the margin of profit

in arbitraging is small (from which transactions cost must be deducted), on a larger volume of

funds this could be an attractive proposition. Arbitrager may involve more than two foreign

exchange markets and it may be conducted by professional arbitragers, who are alert to

disorderly cross rates of exchange, or by the normal participants in the market. Perhaps most

important as a continuing force the market are the banks buying the foreign exchanges they

require in the cheapest market and selling their excess foreign exchange in the dearest market.

The banks are well organized to do this, being in instantaneous contact with their agencies inother major international financial centers.

An International Market.The important point is that arbitrage will occur as long as the

rates in other markets are out of line with each other, and this arbitrage will have the effect of

bringing the rates into line. In this way, arbitrage ties the foreign exchange markets in all

countries together into a single international foreign exchange market.

THE BALANCE OF PAYMENTS

The balance of payments is a statistical summary of the actual flow of economic

transactions between Philippine residents and residents of the rest of the world during a given

period.

The Accounts

For the purposes of balance of payments accounting, international transactions are

divided into three major categories: the balance of international payments on current account,

the balance of international payments on capital account, and the movement of gold coins and

bullion is sometimes shown separately in the third section.


7/21

Balance of International Payments on Current Account:

The balance of payment, as we know, is built up in terms of credit and debit entries. On

the side of credit account, the amount which a country has to receive from the other country is

shown, while on the debt side of the account, the payment which has to be made to other

countries is entered. In the balance of payment on current account, only those items are entered

which do not create a new item or cancel a previously existing capital claim.

Main Credit Items in the Balance on Current Account are as Follow:

(i) Value of merchandize exports.

(ii) Payments received from foreigners for rendering banking insurance and shipping services.

(iii) Travel expenditure of the foreign tourists in the country.

(iv) Expenditure of foreign students.

(v) Remittances of money by the nationals of the country living in other countries.

(vi) Income on investment (interest and dividend, etc.), from abroad.

(vii) Charity contributions made to the institutions by the foreigners.

(viii) Miscellaneous government transactions such as sale as of diplomatic representatives,

repatriation, military and payments, etc., etc.

Main Debit Items in the Balance of Payments on the Current Account are as Follows:

(i) Value on merchandise imports.

(ii) Payments made to the foreigners for rendering banking and insurance and shipping services

for the country.

(iii) Travel expenditure of country's tourists in other countries.

(iv) Payments made to country's students studying abroad.

(v) Remittance by immigrants to their home countries.

(vi) Interest and dividend payments by the foreigners to their countries.

(vii) Donations sent to other countries.

(viii) Miscellaneous government transactions such as salaries of diplomatic representatives,

repatriation; military aid payments, etc., etc. to other countries.


8/21

Balance of International Payments on Capital Account:

The balance of international payments on capital account is split up into two parts, (i) the

balance of payment on long term capital account and (ii) the balance of payment on short term

capital account.

In the balance of international payment on long term capital account, we include the netprivate and government long term loans and net long term foreign investment. The short term

capital account is composed of (i) private or government short term loans and (ii) net investment

in short term debts.

The movement of capital from one country to another takes place due to three reasons:

Firstly, when country has to make investment abroad. Secondly, when it has to advance loans

to another country. Thirdly, when the capital has to he shifted due to safety reasons.

The movement of capital from one country to another has a serious repercussion on the

international payments on current account. When the capital is shifted to another country, a

payment is to be made. Therefore, it is a debit entry and when we borrow from abroad, wereceive payment, therefore it is credit entry. If we have a favorable balance on current account,

it may be offset by a debit account balance on capital account.

Gold Movements:

Gold is sometimes an important balancing item. If the deficit on international account

exists, it is covered by shipping gold from one country to another. U.S.A. received large quantity

of gold from other countries in the 1930's.

MACROECONOMIC EQUILIBRIUM

Macroeconomic equilibrium for an economy in the short run is established when

aggregate demand intersects with short run aggregate supply. This is shown in the diagram

below:

At the price level Pe, the aggregatedemand for goods and services is equal tothe aggregate supply of output. Theoutput and the general price level in theeconomy will tend to adjust towards thisequilibrium position.

If the price level is too high, therewill be an excess supply of output. If theprice level is below equilibrium, there willbe excess demand in the short run. In bothsituations there should be a process takingthe economy towards the equilibrium levelof output.


9/21

Consider for example a situation where aggregate supply is greater than currentdemand. This will lead to a build up in stocks (inventories) and this sends a signal to producerseither to cut prices (to stimulate an increase in demand) or to reduce output so as to reduce thebuild up of excess stocks. Either way - there is a tendency for output to move closer to thecurrent level of demand.

There may be occasions when in the short run; the economy cannot meet an increase indemand. This is more likely to occur when an economy reaches full-employment of factorresources. In this situation, the aggregate supply curve in the short run becomes increasinglyinelastic.

This diagram tracks the effect ofthis. We see aggregate demand risingbut the economy finds it difficult to raise(expand) production. There is a smallincrease in real national output, but themain effect is to put upward pressure onthe general price level. Shortages of

resources will lead to a general rise incosts and prices

Impact of a change in aggregate supply

Suppose that increased efficiencyand productivity together with lower input costs (e.g.of essential raw materials) causes the short run aggregate supply curve to shift outwards. (I.e.an increase in supply - assume no shift in aggregate demand).

This diagram shows what is likely tohappen. AS shifts outwards and a newmacroeconomic equilibrium will be established.The price level has fallen and real national output(in equilibrium) has increased to Y2.

Aggregate supply would shift inwards ifthere is a rise in the unit costs of productionin theeconomy. For example there might be a rise inunit wage costsperhaps caused by higher wagesnot compensated for by higher labourproductivity.

External economic shocksmight also cause the aggregate supply curve to shift inwards.

For example a sharp rise in global commodity prices. If AS shifts to the left, assuming nochange in the aggregate demand curve, we expect to see a higher price level (this is known ascost-push inflation) and a lower level of real national output.


10/21

Impact of a shift in aggregate demand

In this diagram we see the effects on aninward shift in aggregate demand in theeconomy. This might be caused forexample by a decline in business

confidence (reducing planned investmentdemand) or a fall in United Kingdomexports following a global downturn. Itmight also be caused by a cut ingovernment spending or a rise in interestrates which leads to cutbacks in consumerspending.

The result of the inward shift of AD is a contraction along the short run aggregate supplycurve and a fall in the real level of national output. This causes downward pressure on thegeneral price level.

If aggregate demand shifts outwards (perhaps due to increased business confidence, aneconomic upturn in another country, or higher levels of government spending), we expect to seeboth a rise in the price level and higher national output.

National Income Equilibrium when Aggregate Supply is Perfectly Elastic

When short run aggregate supply isperfectly elastic, any change in aggregatedemand will feed straight through to a changein the equilibrium level of real national output.For example, when AD shifts out from AD1 toAD2 (shown in the diagram below) theeconomy is able to meet this increaseddemand by expanding output. The newequilibrium level of national income is Y2.Conversely when there is a fall in totaldemand for goods and services (AD1 shiftsinwards to AD3) we see a fall in real output.

Long Run Economic Growth

We have considered short-term changes in both aggregate demand and aggregatesupply. For an economy to experience sustained economic growth over the longer run it must

shift out the long run aggregate supply curve by either increasing the supply of factors ofproduction available (e.g. an increase in the labor supply, more land and more capital inputs);increasing the productivity of those factors or the economy might increase LRAS by achievingan improvement in the state of technology.


11/21

An outward shift in the LRAS issimilar to an outward shift in the productionpossibility frontier.

The effects are shown in thisdiagram. If LRAS shifts out the economy

can operate at a higher level of aggregatedemand and can achieve an increase inreal national output without running intoproblems with inflation.

One of the main long-term economic objectives of the current labor government is toraise the economy's productive potential and therefore provide a platform for faster economicgrowth in future years. For this to happen, the economy needs to achieve a higher level ofinvestment in new capital and new technology. And the quantity and productivity of the laborforce also needs to increase over time.

PRICE LEVELS, EXCHANGE RATES. AND INTERNATIONAL LIQUIDITY PROBLEM

THE PRICE LEVEL AND THE BALANCE OF PAYMENTS

One of the basic propositions of elementary economic theory is that a change in relative

prices will induce substitution effects among the goods in question. Exactly the same thing will

happen if the prices of American goods and services change relative to those of goods and

services produced in the rest of the world. A rise in the American price level will induce

international substitution effects.

These effects will show up in various ways. Domestic consumers will be induced topurchase more important goods in substitution for the relatively more expensive goods

produced in the United States. Domestic producers of very close substitutes for imported goods

will find that they cannot raise prices without losing many costumersbut with rising costs they

will find it much less profitable these goods for sale at the given world prices. Their output will

fall as imports take over a larger share of the market. Similarly, domestic producers of goods for

export, faced with higher labor costs, will find it less profitable to produce for sale in world

markets at a given world prices. Their exports will fall. Indeed, even exporters who are not price

takers will find that higher prices their sale will be reduced.

The extent of the impact on the flow of the international trade will depend on the magnitude of

the change in prices and the relevant elasticities of demand and supply. However, the generaleffect of a rise in American costs and prices relative to world prices will be some decline in

exports and some rise in imports, reducing a surplus or increasing a deficit in the current

account of the balance of payments. A decline in American prices relative to world prices would

have the opposite effects. That is, it would to increase exports and reduce imports, increasing a

surplus or reducing a deficit in the current account of the balance of payments.


12/21

This effect of changes in the price level on international trade introduces an important new

consideration into our analysis of the relationship between domestic monetary and fiscal policies

and the balance of international payments.

The Price Level, Domestic Policy Objectives, and the Balance-of-Payments Constraints.

Earlier we explored the relationship between domestic monetary and fiscal policies and the

balance of international payments on the assumptions that the domestic objective of policy was

very simple: the achievement of the unique level of the aggregate demand that would provide

full employment without inflation. If, instead of a unique full employment level of income, the

authorities are faced with a trade of function, a negative association between the level of

unemployment and the rate of change of the price level;, the objective of domestic policy is

necessarily more complicated. The choice of an objective involves an important subjective

consideration. The government must balance the undesirable consequences of higher rates of

inflation against the undesirable consequences of the higher levels of unemployment in order to

find what they consider to be the socially least undesirable combination of unemployment and

inflation. The objective of domestic policy, then, is the point on the trade-off functions that the

government considers most preferable. It is not necessarily a point of full employment, nor is itnecessarily a point of price stability. Let us briefly reconsider the problems of reconciling the

domestic and external objectives of monetary and fiscal policies in this context.

The Trade-Off Function and Policy Conflicts.In our previous analysis we considered the

domestic and external objectives of policy to have been achieved simultaneously if the balance

of payments was in equilibrium at full employment. When we introduce the trade-off function,

the comparable condition might seem to be that the balance of payments be in equilibrium at

the point on the trade-off function selected by the government, that is, at the combination of

inflation and unemployment preferred on domestic social and political grounds.

Unfortunately, the equilibrium of the balance of payments may be fleeting. The rate ofprice level change selected by the government may have continuing effects on the balance of

payments that will eventually disrupt the equilibrium.

For example, suppose that the rate of inflation chosen by the government for domestic

reasons is higher than that prevailing in the rest of the world. Even though the balance of

payments is initially in equilibrium, if prices here rise more rapidly than prices in the rest of the

world, international substitution effects will gradually worsen the current account balance, and a

deficit will emerge in the balance of payments. Under pegged exchange rates the exchange rate

will be driven to the ceiling, and exchange reserves will begin to fall. What appeared initially to

be a condition of harmony between the domestic and external objectives of policy will be turned

into a condition of conflict.

Something has to give. There are only two possibilities (unless the government resorts

to direct controls): the exchange rate or the domestic policy objective. If the exchange rate is to

remain pegged at its original par, the balance of payments must be brought into equilibrium, and

that means domestic policy will have to be modified in order to accept a lower rate of inflation

and a higher level of unemployment than the government would otherwise find most desirable

on social grounds. In effect, domestic policy formation is faced with a price level constraint. If


13/21

the balance of payments is to be kept in equilibrium, he country will have to move toward the

same rate of inflation as that prevailing in the rest of the world.

The problems that arise because of balance of payments deficits are always dramatic.

However, as we have already seen, continuous balance-of-payments surpluses can also be

troublesome to a nation determined to maintain a pegged exchange rate.

With this in mind, consider what happens if the government chooses a rate of inflation

lower than that prevailing in the rest of the world. In this case, international substitution effects

will tend to produce an improvement in the current account, and although the balance of

payments is initially in equilibrium, a balance of payments surplus will eventually emerge. The

exchange rate will fall, and the government will be forced to accumulate foreign exchange

reserves to maintain the pegged rate.

Again, something will have to give. The government cannot go on accumulating foreign

exchange reserves indefinitely. Even if the financial problems associated with the accumulation

of reserves do not directly produce inflationary pressures, the government will eventually have

to modify its domestic objectives and accept the higher world rate of inflation if it is going to

maintain the pegged exchange rate.

Conclusion: The Price Level Constraint. The conclusion of this analysis is important.

While there is always some room for maneuver inherent in the imperfect operations of markets

and in time lags in the adjustment of production, consumption, and trade, with a pegged

exchange rate a government cannot choose any rate of inflation it desires, even though that rate

of inflation may initially be consistent with balance of payments equilibrium. These are a price

level constraint on domestic policy. Although this constraint is not instantaneous, that

government will be forced eventually to modify its ;policies to the world rate of inflation

accepting the implications of the trade-off function for the domestic level of unemployment.Attempts to achieve any other combination of inflation and unemployment will mean a chronic

balance-of-payments problem.

But all this presumes that the exchange rate is pegged. What happens if we make the

ultimate relaxation of our assumptions and allow the exchange rate to vary? Can the world

economy and the world financial system function with flexible exchange rates?

THE ECONOMICS OF FLEXIBLE EXCHANGE RATES

A change in American prices relative to prices in the rest of the world can have a

powerful impact on the U.S. balance of international payments. However, it is not necessary to

change the price level to produce these effects. They could be achieved in theory equally wellby changing the foreign exchange rate.

Changes in the Exchange Rate vs. Changes in Price Levels

A rise in the price of foreign exchange raises the delivered price of foreign goods to

American buyers just as effectively as a rise in the foreign price level itself. Thus, it will tend to

restrict American imports. Similarly, the rise in the foreign exchange rate lowers the delivered


14/21

price of American goods to foreign markets just as effectively as a decline in the U.S. price

level. It will tend to increase American exports. Taking the two affects together, a rise in the

foreign exchange rate will improve the current account balance and hence will tend to increase

a balance-of-payments surplus or reduce a balance-of-payments deficit. In terms of its impact

on the balance of payments, a rise in the foreign exchange rate is substitute for a fall in the

American price level or for a rise in the world price level.

The opposite arguments hold for a fall in the foreign exchange rate(a rise in the external

value of the dollar). By making American goods more expensive for foreign buyers, it would tend

to restrict exports. By making foreign goods less expensive by comparison for American buyers,

it would tend to increase imports. Thus, a fall in the foreign exchange rate will tend to worsen

the balance on current account and hence will tend to reduce a balance-of-payments surplus or

increase a balance-of-payments deficit even more. In terms of its impact on the balance of

payments, a fall in the foreign exchange rate is a substitute for a rise in the American price level

or a fall in the world price level.

The Exchange Rate and Contradiction Among Policy Objectives. It follows that changesin the exchange rate could be used to resolve balance-of-payments problems that would

otherwise force a drastic change in domestic monetary and fiscal policies if they were permitted

under a new international monetary constitution. A balance-of-payments deficit (whatever its

cause), we have seen, can be removed by an appropriate drop in the foreign exchange rate.

However, these are one-time changes. If domestic policy involves a rate of price level

change that is different from the rate prevailing in the rest of the world, balance-of-payments

equilibrium will require continual adjustment of the exchange rate. A more rapid rate of inflation

than the rest of the world is experiencing is consistent with balance of payments equilibrium only

if the exchange rate continuously rises. A slower rate of inflation than in the rest of the world

would call for continuous fall in the exchange rate. In other worlds the independence ofdomestic policy from external constraints is possible only if the exchange rate can be continually

adjusted to changing pressures in the foreign exchange market.

Flexible Exchange Rates. As we noted earlier, the foreign exchange rate is simply a

pricethe price of foreign moneyand as much is determined by the interaction of supply and

demand in the foreign exchange market. However, under the pegged exchange rate system,

that price is allowed to vary only within very narrow limits around the official par rate (unless, of

course, a decision is taken to alter the par rate). With a flexible exchange rate, there is no such

constraint on movement of the exchange rate. A flexible exchange rate is free to adjust

continually to changing pressures of supply and demand in the foreign exchange market.

Flexible Exchange Rates and Monetary Policy

Flexibility of the exchange rate crates a fundamentally different environment for

monetary and fiscal policy from that provided by the Bretton Woods international monetary

constitution. We examined the implications of the Bretton Woods rules for domestic stabilization

policy in the previous chapter.


15/21

The Exchange Rate and Balance of Payments Equilibrium. The crucial difference

between the fixed and the--flexibleexchange rate systems is the mechanism for establishing

equilibrium in the balance international payments.

With a fixed exchange rate, the maintenance of equilibrium in the balance of payments

must be the responsibility of the government policy, particularly monetary policy. Unless there is

considerable flexibility in the levels of wages and prices, there is no automatic mechanism to

ensure the equilibration of demand and supply forces in the foreign exchange market in the

short run. With a flexible exchange rate, by contrast, the foreign exchange rate can be expected

to adjust automatically to maintain equilibrium in the balance of payments.

Consider the case in which the balance of payments is in deficit, perhaps because the

deficit on current account is greater than the surplus as capital account. There will be excess

demand for foreign exchange at the existing exchange rate. It is this pressure of excess

demand that will tend to increase the foreign exchange rate, and in the absence of an official

constraint on the rate it will rise.

The Current Account. As noted previously, a rise in the foreign exchange rate is

equivalent to a rise in the world price level relative to prices and wage rates in the United States.

As a result, these should be substitution effects in the current accounts of balance of payments.

Exports, which are now relatively cheaper to the rest of the world, should increase, and imports,

which are now relatively more expensive to American should fall. The current account should

adjust so as to eliminate the excess demand for foreign exchange.

The Capital Account.The behavior of the capital account is more problematic. The level

of the foreign exchange rate per se should relevant to international portfolio investment

decision. As long as the investor expects to bring his funds back at the same exchange rate at

which he takes them out of the country, the level of the foreign exchange rate will not be a factorin his calculations. If the investor expects the exchange rate to be the same when he brings his

funds home as when he sends them out, the exchange rate applicable to the two foreign

exchange transactions simply cancel each other out. All that is relevant to the calculation of the

expected net return is the difference in interest rates (although the risk of change in the

exchange rate will be relevant to the investment decision, of course).

It is different if the investor has reasons to expect a change in the foreign exchange rate.

Any increase in the foreign exchange rate will give an added premium to American investments

in securities denominated in foreign, currencies and will impose a penalty on nonresidents

investments in American securities.

To know what will happen in the capital account as the exchange rate rises, then, we

must know what happens to investors expectations about the future course of the exchange

rates, there will be an incentive for more American investment abroad and less foreign

investment in the United States. Capital outflows should be increased or capital inflows reduced.

However, if investors feel that the rise is temporary and that the rate will eventually subside,

there will be an incentive for less American investment abroad and more foreign investment in

the United States. Capital inflows should be increased or capital outflows curtailed. If, by


16/21

contrast, they expect the exchange rate to be unchanged at any particular level established at

any particular time, then capital inflows and outflows will be unaffected by the change in the

exchange rate. In other words, if the net capital inflow does not increase or decrease it will stay

the same.

The crucial consideration is that of investors expectation of future changes in the

exchange rate, not the present level of the exchange rate. Unfortunately, we know very little

about the determinants of these expectations. With this in mind, perhaps it is best to first

consider the case in which we can ignore expectations. That is, we will assume that investors

take the existing exchange rate to be the best to first consider the case in which we can ignore

expectations. That is, we will assume that investors take the existing exchange rate to be the

best estimate of what future exchange rates will be, regardless of the present level or the past

history of the exchange rate. In this case, the entire adjustment in the balance of payments

occurs in the current account. The net capital inflow will be unaffected by the rise in the

exchange rate. Imports must fall and exports rise until the current account deficit is tailored to

the net capital inflow. Exactly the opposite arguments would apply if we had chosen a case of

balance-of-payments surplus.

The Balance-of-Payments Constraint on Monetary Policy. The first important point is that

the BK curve (the focus of combination of interest rate and the income levels that are consistent

with the equilibrium in the balance of payments) is no longer a useful concept. Balance-of-

payments equilibrium will be maintained through continual adjustments in the foreign exchange

rate.

We started with the net capital flow function, reflecting the sensitivity of international

capital flows to international differences in interest rates. If we can ignore expectations of future

changes in the exchange rate, this function will be unchanged under a regime of flexible

exchange rates.

The second component of the BK curve was the current account balance function, which

we build up on the assumption that exports were given and imports depended on the levels of

investment and consumption expenditures. However, with a flexible exchange rate, both imports

and exports depend directly on the level of the foreign exchange rate. Moreover, since the

foreign exchange rate will always rise when there is an excess demand for foreign exchange

(e.g. the current account deficit exceeds the capital account surplus) and fall when there is an

excess supply of foreign exchange (e.g. the current account deficit is less than the capital

account surplus), the exchange rate will always adjust until he current account balance is equal

in size and opposite in direction to the capital account balance.

It should be emphasized that this could require wide fluctuations in the exchange rate

from time to time, depending on the sensitivity of import and export demands to change in the

exchange rate.

With a flexible exchange rate, the current account balance is a residual, determined by

the capital account balance. The current account balance function is the mirror image of the net


17/21

capital flow function. The sole determinant of the aggregate current account balance will be the

level of interest rates in the United States relative to world interest rates.

The current account balance is based on the assumption that the flexible exchange rate

will adjust until the current account balance is just equal in the size and opposite in direction to

the capital account balance. At high levels of interest rates in the United States, there will be a

net capital inflow. However, as a result of the automatic adjustment of the exchange rate, the

surplus in the capital account will be exactly offset by an equal deficit in the current account. At

low levels of interest rates in the United States, there will be a net capital outflow. However, as a

result of the automatic adjustment of the exchange rate, the deficit in the capital account will be

exactly offset by an equal surplus in the current account. The net balance-of-payments surplus

or deficit (lower section) will always be zero, regardless of the level of interest rates (and hence,

by implications, regardless of the level of income and output). A flexible exchange rate will

ensure that the balance of payments is always in equilibrium.

If the government is willing and able to ignore wide fluctuations in the foreign exchange

rate, a flexible exchange rate frees domestic monetary policy from the balance-of-paymentsconstraint.

This is not the only implication of flexibility in the foreign exchange rate, however. A

flexible exchange rate, coupled with highly interest elastic international capital flows, will

reinforce the impact of monetary policy on domestic income and output.

Effectiveness of Monetary Policy. The implications of flexible exchange rates for the

domestic impact of monetary policy should be obvious if you keep in mind that both exports and

imports are factors determining the level of aggregate demand.

We have seen that restrictive monetary policy, which raises American interest rates

relative to interest rates in the rest of the world, will induce capital inflows and thus, by creating

an excess supply of foreign exchange, depress the foreign exchange rate. The exchange rate

will have to fall until the combination of increased imports and reduced exports produces a

current account deficit large enough to offset the capital inflows. But remember, both the

increase in imports and the reduction in exports depress aggregate demand. These exchange

rate induced effects on aggregate demand are in addition to any effects that might result from

the direct impact of tight money on investment expenditures. In other words, the flexibility of the

exchange rate, coupled with the sensitivity of international capital flows to interest rates, has

strengthened the restrictive impact of a tight money policy.

You should be able to trace a similar analysis for the case of an expansionary monetary

policy under a regime of flexible exchange rates. The conclusion is the same: Flexibility of

exchange rates reinforces the impact of an expansionary monetary policy.

A Classical Case. The elasticity of the IS function in the flexible exchange rate case

depend directly on the elasticity of the net capital flow function. In the extreme, we might

conceive of the net capital flow function that is perfectly elastic with respect to American interest

rates. That is, any deviation of American interest rates from some given level (world interest


18/21

rates, or world interest rates plus a risk premium) would induce massive movement of capital

either into or out of the country. In such a situation, the level of interest rate here would be

rigidly tied to the world level of interest rates, and the IS curve would also be perfectly interest

elastic at this level of interest rates.

In this case, the level of income depends simply on the demand for and the supply of

money. Monetary policy would be all powerful, while fiscal policy would have absolutely no

impact. An increase in government expenditures, for example, would tend to increase income.

But with a given money supply this would imply higher interest rates. The resulting flood of

capital flowing into the country would present interest rates from rising, but it would induce a

drop in the foreign exchange rate. The result would be an offsetting deficit in the current account

of the balance of payments. There could be no net change in the level of income and output

unless there was a sympathetic increase in the money supply. With a perfectly elastic net

capital flow function and flexible exchange rates, we are back in the world envisioned by the

classical quantity theorists.

Exchange Rate Expectations. In this analysis of the economics of flexible exchangerates we have ignored what we said earlier was a crucial consideration in international capital

flowsinvestors expectations of future changes in the exchange rate.

Let us consider the case in which an expansionary monetary policy initiates a rise in the

flexible exchange rate. Aside from the assumption about exchange rate expectations, these are

two possibilities. Either the rate is expected to continue to rise, or it is expected to fall back

toward a more normal level.

Expectations of future rises in the exchange rate will induce speculative capital

movements. Capital outflows will increase and capital inflows will be retarded. The impact of the

expansionary monetary policy that initiated the whole process will be accentuated.

If rises in the exchange rate induce expectations of further rises, the whole process

could become cumulative. It should be clear, however, that if a rise in the exchange rate

induces strong expectorations of a continuing rise in the future, there is a serious danger of

severe instability in the foreign exchange market.

Expectations of a continuing rise in the exchange rate will reinforce the impact of

monetary policy in a regime of flexible exchange rates. The opposite is true if the rate is

expected to fall back to normal in the near future.

If a rise in the exchange rate induces expectations of a return to a lower, more normal

level, the effects will be the opposite of those discussed earlier. The rise of the exchange ratewill be damped, and the overall effectiveness of the expansionary monetary policy will be

reduced.

The Controversy Over Flexible Exchange Rate

Considered from the point of view of the effectiveness of domestic monetary policy,

flexible exchange rates appear to have a major advantage over pegged exchange rates. Yet


19/21

flexible exchange rates are anathema to most central bankers (who are charged with the

implementation of monetary policy) and to many economists who specialize in international

financial economics. As a result, proposals for the adoption of a system of flexible exchange

rates are surrounded by sharp controversy. Two main charges are commonly directed against

flexible exchange rates.

Instability and Uncertainty.It is argued that flexible exchange rates are inherently highly

unstable. This amounts to an assumption that the dominant pattern of expectations ; that a

change in the exchange rate will generate expectations of future changes in the same direction.

Flexibility of the exchange rate, it is argued, provides excessive scope of speculators, and their

activities may generate wide and purposeless fluctuations in exchange rates. The experience of

the 1920s and 1930s is commonly cited as evidence that this is a real and serious problem.

Promotion of Nationalist Economic Policies. The second argument is the primary

argument in favor of flexible exchange rates, converted into an argument against flexibility.

Again, the experience of the 1920s and 1930s is invoked in support of an argument that

flexible exchange rates promote nationalist economic policies rather than internationalist

policies. Manipulation of a flexible exchange rate can be used instead of tariffs to protect

domestic industries and, more particularly, to promote production in period of recession. Thus, a

country may use the flexible exchange rate to export its own unemployment problems.

We have seen that a pegged exchange rate can impose severe constraints on domestic

monetary policy as long as the government is determined to maintain the par rate. The choice of

a price level objective is particularly circumscribed. It is increasingly argued that in the

contemporary context worldwide inflation is a serious threat, and that pegged exchange rates

are an essential source of financial discipline on inflation prone national governments. Flexible

exchange rates would remove the discipline. Thus, it is argued, the adoption of flexibleexchange rates would result in an accentuation of inflationary pressure throughout the world. In

effect, this is an argument that national governments cannot be trusted with responsibility for the

formulation of monetary and fiscal policies in the international and, indeed, the national

interest.

The Case for Flexibility. The case for the flexibility is largely an assertion of national

sovereignty in the formulation and implementation of monetary and fiscal policies including the

right to make disastrous mistakes- and the denial of the relevance or validity of each of the

preceding points. Far from disrupting the international economy, it is argued, flexible exchange

rates would further international development by providing an automatic solution to the

international liquidity crises that have periodically beset, at times with devastating effect, thepegged exchange rate system.

First, the relevance of evidence drawn from the experiences of several countries with

flexible exchange rates in the 1920s and 1930s is disputed, largely on grounds of the peculiar

economic and political environment of that time. Indeed, most of the evils commonly ascribed to

flexible exchange rates are asserted to have been a result of attempts to maintain or establish

inappropriate par rates of exchange, or of the social, political, and economic turmoil of the time.


20/21

They could hardly be blamed on the flexibility of exchange rates. The Canadian experience from

1950 to 1962 is commonly cited as evidence that, in an otherwise stable environment,

expectations may tend to stabilize the exchange rate rather than inducing pointless fluctuations

(thus somewhat reducing the effectiveness of a flexible exchange rate as a tool of nationalistic

economic policies). During this period, the Canadians exchange rate was not a harbinger of

inflation and, while flexible, was remarkably stable. Furthermore, there is no evidence tosuggest that by floating its currency Canada restricted its trade.

Indeed, it is argued that proponents of the former international monetary constitution with

fixed exchange rates have the economics of speculation backwards. We have already seen that

the adjustable peg system not only is peculiarly vulnerable to speculation but also tends to incite

speculation. Speculation is turned into a one-way gamble, and as a result the official limits to

exchange rate fluctuations become dams behind which tremendous speculative pressures can

build up. With a flexible exchange rate, by contrast, speculators are faced with greater risks, and

adjustments of the exchange rate in response to small amounts of speculative activity will

quickly remove he basis for continued speculation. Speculation could actually be less intense

than it was under the Bretton Woods system, and such speculation as did occur would performthe desirable economic function of speeding adjustment to new, more appropriate levels of the

exchange rate. Thus, it is argued, speculation is a problem in attempting to maintain stability

under an adjustable peg system, not under a flexible exchange rate system.

The associated proposition that flexible exchange rates increase he uncertainty

surrounding all international investment decisions has also been disputed by proponents of

flexibility. With respect to decision n longer term projects, there can be no certainty regarding

the level of the exchange rate, even under the Bretton Woods type of system. Major

realignments of par rates of exchange occur under that system. A flexible rate system would

simply make the transition to new levels easier. With respect to short-term uncertainty, the

forward exchange mechanism is capable of providing fully adequate hedges against therelevant risks.

Furthermore, it is argued, the pegged exchange rate system was not successful in

preventing countries from pursuing inflationary financial policies if they so chose. All it did was to

associate such policies with periodic financial crises or with direct controls. More fundamentally,

attempts to impose financial discipline from outside are a significant infringement on national

sovereignty. It is a denial of the right of a national government to choose its own policy

objectives.

Thus, proponents of flexible exchange rates argue that a pegged exchange rate system

is the worst of all possible worlds. It does not provide the certainty and the pressure for theinternational integration of economic and financial policies that would follow from immutable

exchange rates, nor does it provide the freedom in domestic policy formation that is associated

with flexible exchange rates. Indeed, it is calculated to maximize policy conflicts and

purposeless speculation.

Conclusions. The economics of flexible exchange rates is a broad topic requiring

historical as well as theoretical and statistical analysis. We have barely scratched the surface.


21/21

However, the important point has been made; Flexible exchanged rates provide a type of

flexibility in domestic policy formation that is absent with a pegged exchange rate system. There

is good reason to believe that flexible exchange rates are variable, but there is strong opinion to

the contrary. In any case, there is little likelihood that a completely flexible exchange rate

system will be adopted. Participating countries are sharply divided at present between returning

to an adjustable pegged exchange rate system and institutionalizing the interim system offlexible exchange rates.

References:

Helen B. O'Bannon, David E. Bond, Ronald A. Shearer, Money and banking: theory, policy, and

institutions, Harper & Row, New York, 1975

http://www.economicsconcepts.com/presentation_of_international_balance_of_payments.htm

http://www.tutor2u.net/economics/content/topics/ad_as/ad-as_equilibrium.htm
http://www.economicsconcepts.com/presentation_of_international_balance_of_payments.htmhttp://www.tutor2u.net/economics/content/topics/ad_as/ad-as_equilibrium.htmhttp://www.tutor2u.net/economics/content/topics/ad_as/ad-as_equilibrium.htmhttp://www.economicsconcepts.com/presentation_of_international_balance_of_payments.htm

the international constraint on monetary policy

Documents