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Federal Reserve Bank of Cleveland

ISSN 0428-1276

September 24, 1984

Should We
Return to Fixed
Exchange Rates?
by Nicholas V Karamouzis
There has been growing dissatisfaction with the current system of
managed floating exchange rates,
leading a small but increasing number of economists, policymakers,
and journalists to call for a return
to a system of limited exchange-rate
flexibility. One group advocates a
return to the gold standard. At the
1984 Republican National Convention, for example, several members
of the platform committee favored
a return to the gold standard as a
vehicle to sustain domestic price
stability and to restore international
monetary soundness. Others have
harbored the view of returning to
a system of more stable exchange
rates similar to the Bretton Woods
system, with an important role
ascribed to the dollar'!
Critics of floating exchange rates
blame exchange-rate variability for
many economic problems. These
charges are largely unsubstantiated,

••

The author is an assistant professor, Case Western
Reserve University, and visiting scholar, Federal
Reserve Bank of Cleveland. The author would like
to thank Owen Humpage, Gerry Anderson, and
Amy Kerkafor their helpful comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

however, and the introduction of a
system of limited exchange-rate
flexibility would not mitigate the
economic problems. The events that
contributed to the collapse of the
Bretton Woods system in the early
1970s should be expected to present
similar problems in the 1980s, if a
system of limited exchange-rate
flexibility were introduced.
The Volume of International
Transactions
A common argument against exchange-rate flexibility is that it is
accompanied by excessive exchangerate volatility, which generates uncertainties. Over time, these uncertainties tend to reduce the volume of
international trade and discourage
international investment. In such
cases, the welfare of nations is considerably reduced. Although such an
outcome theoretically could be possible under certain conditions, empirical studies have failed to establish
any strong relationship between
nominal exchange-rate volatility and
the volume of international trade.'
Furthermore, evidence shows no
reduction, but instead an actual
increase, in each country's trade
transactions as a percent of its own
GNP since the end of the Bretton
Woods regime (see table 1).Although
we should be cautious in generalizing or drawing definite conclusions
from these empirical findings, the

••

1. Francois Mitterand, for example, stated "the
time has come to think of a new Bretton Woods. . . .
outside this proposition, there will be no salvation" (New York Times, May io, 1983). A Wall
Street Journal editorial (Iune 22, 1982) stated
"given the success of Bretton Woods and the failure of what followed, it can certainly serve as
a model for the direction we ought to head:'

Table 1 Imports plus Exports
as a Percent of Nominal GNP
Nation

United States
Japan
West Germany
United Kingdom

Average
over
1960-70

Average
over
1973-83

7.3
16.7
30.3
29.3

14.6
21.7
43.1
41.3

SOURCE: International Monetary Fund,International
Financial Statistics, Yearbook 1984, vol.XXXVII, Washington, DC.

••

2. See Farrell, DeRosa, and McCowan (1983)
and IMF (1984b).

relationship between the volume
of international transactions and
exchange-rate volatility appears to
be weak, which is not surprising.
Facilities for hedging against foreignexchange risk have been adequate,
and the cost of hedging constitutes
a small fraction of the value of
transactions in foreign currencies.
Even if the adverse effects of
exchange-rate variability on international trade were well-established,
the introduction of a system of limited exchange-rate flexibility would
not ensure a reduction of exchangerate uncertainty. Under such a system, if policymakers fail to submit
their policies to the requirements
of a system of fixed parities, the
current continuous variability of
exchange rates will be replaced by
abrupt, discrete, and large realignments of exchange-rate parities.
Although the lack of a common
measure of uncertainty in the two
systems makes comparison difficult, a system of limited exchangerate flexibility should not mitigate
the problems associated with exchange-rate uncertainty unless
policymakers pursue suitable
macroeconomic policies. In fact,
a system of limited exchange-rate
flexibility might increase uncertainty during those times when the
market believes that the officially
maintained exchange rate is inconsistent with market fundamentals. It can be argued that stabilizing domestic macroeconomic policies
would be more effective in reducing exchange-rate variability than
changing the exchange-rate regime.
Inflation
Another criticism of exchange-rate
variability is the claim that such
a system is inherently more inflationary. Critics argue that exchangerate flexibility tends to exacerbate
and perpetuate the price effects of

real and monetary disturbances
and policy shocks. Moreover, they
maintain that the current system
of floating exchange rates has
removed the discipline that a par
value system (such as Bretton
Woods) or the gold standard imposes on monetary authorities. Policymakers thus were more prone
toward inflation in the 1970s.
Two theories relate exchangerate flexibility to a magnification of
the inflation problem-the
vicious
circle hypothesis and the ratchet
effect. A vicious circle is a cumulative process of price inflation and
exchange-rate depreciation. Depreciation of a currency is rapidly
translated into higher domestic
prices and costs, which in turn lead
to further depreciation of the currency. This dynamic instability is
presumed to perpetuate and reinforce a spiral of exchange-rate
depreciation, followed by more
inflation. Note that such a spiral
could allegedly be set in motion by
exogenous real or monetary shocks,
initial exchange-rate overshooting,
or changes in the public's expectations about future fiscal and monetary policies. The ratchet effect
hypothesis posits that in a world of
downward price inflexibility, prices
in the appreciating economy do not
fall as fast or as much as prices
rise in the depreciating economy.
The net effect is an increase in the
world's inflation rate.'
Even though these views are
particularly popular among policymakers, empirical and theoretical
studies have shown that, unless
monetary policy is accommodative, the dynamic spiral described
above cannot be sustained+ Undoubtedly, exchange-rate movements tend to reinforce the price
effects of monetary policy and even
shorten the time lag between changes
in the money stock and changes
in the domestic price level. This is
not to say that exchange-rate move-

••

3. Because there are no significant empirical findings to substantiate this view, the discussion
focuses on the vicious circle hypothesis.
4. See Bilson (1979) and Wallich and Gray (1979).

ments cause inflation or that they
constitute an independent systematic source of inflationary pressure.
It is generally accepted today that,
over the longer run, exchange-rate
depreciation, accompanied by rising inflation and interest rates, is
symptomatic of domestic money
supply that grows faster than
the transaction needs of the economy. Furthermore, the sound monetary policy pursued by the Federal
Reserve has been a necessary condition for the dollar appreciation in
the last three years. Of course, the
appreciation of the dollar exerts a
beneficial effect on domestic prices.
But again, credible monetary policy
is the driving force behind exchangerate appreciation and low inflation.
The second argument why a system of floating exchange rates is
more inflationary compared with
limited exchange-rate flexibility
stems from the presumption that
the latter imposes discipline on
monetary authorities not to inflate.
It is undoubtedly true that, under
the current system, monetary
authorities in each country have
regained control over their own
money supply, and thus can exercise more policy discretion. In a
system such as Bretton Woods or
the gold standard, inflationary policies would result in the loss of foreign reserves or gold, respectively,
which eventually would pose some
restraint on monetary authorities
from pursuing inflationary policies.
Our experience with the Bretton
Woods system showed that such
discipline applies only to the nonreserve-currency countries and not
to a reserve-currency country such
as the United States. During much
of the Bretton Woods period, the
United States maintained a balanceof-payments deficit because foreigners were willing to hold U.S.
dollars instead of converting them
into gold. Rapid U.S. money-stock

growth consequently was not constrained by a reduction in U.S.
international reserves. In the early
1970s, as inflation in the United
States accelerated, foreigners became
more reluctant to hold dollars in
the face of continuing U.S. balanceof-payments problems and rising
U.S. inflation. The situation placed
excessive strain on foreign-exchange
markets and the value of the dollar.
On August 15, 1971, crisis erupted,
convertibility was suspended, and
the system was abandoned. Subsequent attempts to re-establish
more realistic exchange-rate parities
(and the Smithsonian Agreement)
were short-lived because countries
were unwilling to submit their policies to the requirements of a system of limited exchange-rate flexibility. The unsuccessful experience with the British pound and
the gold standard in the early 1930s
was repeated.
Undoubtedly, inflation rates
across countries will probably be
less divergent under a system of
limited exchange-rate flexibility. However, the reserve-currency
country would be able to export its
own inflation to the rest of the
world. This asymmetry in the system is disadvantageous for smaller
countries. Exchange-rate flexibility
provides considerable policy discretion to monetary authorities and
ensures to a certain extent that a
nation bears most of the costs and
benefits of its own policy choices.
The remedy for inflation and exchange-rate instability rests not
on the choice of the exchange-rate
regime but on the ability and willingness of policymakers to pursue sound and stable macroeconomic policies.

External Adjustments
A third argument against exchangerate flexibility is that exchangerate movements have not facilitated the working of the international adjustment process, i.e., the
reduction of the gap between the
actual payments balance and
the equilibrium payments balance.
There are two views on this issue.
The first one, which is conceptually and analytically incorrect,
posits that exchange-rate movements have failed to reduce current
account imbalances. The flaw in
this argument is that the role of
net private capital flows is ignored.
It is a generally accepted premise
that current account imbalances
per se do not constitute a state
of external disequilibrium as long
as net private capital flows move in
the opposite direction, i.e., financing the current account imbalances? Note that a country with a low
saving ratio but relatively attractive domestic investment opportunities (such as the United States,
recently) would run a current
account deficit that is financed
by foreign saving. In a purely allocative sense, such imbalances
might not manifest disequilibrium
but an efficient allocation of international resources as capital moves
into countries with the highest
rates of return. For instance, the
U.S. current account deficits of
$9.2 billion and $41.6 billion in
1982 and 1983, respectively, were
financed by net private capital
inflows (including errors and omissions) of $16.9 billion and $42.4 billion, respectively.
The second view, both conceptually and analytically preferable,
examines the sum of the current
account and the private capital
flows as an appropriate indicator

••

5. The existence of government deficits and trade
and capital restrictions makes it difficult to define the equilibrium balance of payments, particularly because it entails consideration of sustainability and optimality of the public sector's
tax and spending structure.

••

3. Because there are no significant empirical findings to substantiate this view, the discussion
focuses on the vicious circle hypothesis.
4. See Bilson (1979) and Wallich and Gray (1979).

••

· .. stabilizing domestic macroeconomic policies would be more
effective in reducing exchangerate variability than changing
the exchange-rate regime.

of the extent of external disequilibrium, although difficult to measure. Note that the closer to zero
that this sum is, the more satisfactory the external adjustment. A
recent study by the International
Monetary Fund (1984a) concludes
that external adjustments have not
been slower under the current system of floating rates. For the large
industrial countries, particularly
West Germany and Japan, adjustments have been substantially better and faster. For instance, the
average of current account imbalances plus private net capital flows
as a percentage of GNP for large
industrial countries has fallen from
0.51 in the 1965-72 period to 0.22
in the 1973-81 period.
When the net normal private capital flows were insufficient to support current account imbalances,
movements in exchange rates produced only slow results in changing the current accounts. Such outcomes should not be attributed to a
failure of exchange rates to adjust
completely. It mainly reflects the
influence of three factors: (1) trade
flows adjusted to exchange-rate
changes only after a lag; (2) supporting demand-management policies often were lacking; and (3) important changes took place in the
structure of international trade,
particularly the two oil shocks and
the emergence of Far Eastern countries as major exporters.
The question arises as to whether
a system of limited exchange-rate
flexibility would have produced
better results in terms of reducing
external imbalances. It is undoubtedly true that to maintain the
existing exchange-rate parities and
reduce these foreign-sector imbalances, countries would have to pursue suitable macroeconomic policies. If such an option were not
feasible or were politically impractical, systematic intervention in

the foreign-exchange market and/
or severe trade and capital-flow
restrictions would become necessary. Considering that the effectiveness of these measures is questionable in the longer run, large
abrupt changes in exchange rates
would have been more likely. The
history of events in the early 1970s,
when the failure of the United
States to deal with the disequilibrium in its balance of payments
resulted in several discrete devaluations of the dollar, confirms this
scenario. There is no reason to
believe that such discrete and sudden changes and the "crisis" conditions that attend them are preferred or superior to a system of
exchange-rate flexibility.
The Overvalued Dollar
The most recent criticism of
exchange-rate flexibility stems
from the argument that the dollar
is currently overvalued and that
such overvaluation has two significant effects: it adversely influences
the level of domestic production
and employment, and it exacerbates
the problems associated with international debt. While no one disputes that such effects do indeed
exist, it is fair to point out that the
dollar appreciation is exerting some
beneficial effects as well-first, on
domestic prices, and, second, on
foreign production via stimulation
of foreign exports.
The controversial issue is not to
assess the effects of dollar appreciation on economic activity at home
and abroad, but to examine whether
the dollar is indeed overvalued and
what policy makers can or cannot
do about it. The term overvalued
implies that the actual path of the
exchange rate deviates from the
equilibrium path or the socially

optimal path. There is no consensus today on the equilibrium path
of the exchange rate. For instance,
there are several competing hypotheses to explain the recent behavior
of the dollar. Some argue that the
dollar is overvalued because it is
not depreciating to eliminate the
huge U.S. current account balance.
Others argue that the dollar is not
overvalued but is being supported by
foreign capital flows attracted by
high returns on dollar-denominated
assets. Some mention irrational
speculation or bubbles that sooner
or later will burst.
Granting that anyone or a combination of these hypotheses is
correct, the question arises as to
whether policymakers can obtain a
better outcome through policy rules
than the market does. An affirmative answer to the question presumes that countries will be able
to do the following: (1) identify
and arrange the right structure
of exchange rates better than the
market does; (2) institute rules
or formulas-which
are generally
accepted-to govern adjustments
of exchange rates to changes in fundamentals; and (3) intervene systematically (and do so effectively)
to preserve a set of announced
parities-believed
to be the correct
ones-even when the market's perception is quite different. To what
extent these conditions can be fulfilled is questionable. The evolution
of international monetary relations
has shown that negotiations among
nations about the correct structure
of exchange rates has been cumbersome, slow-moving, and characterized by inflexibility when exogenous shocks and structural changes
dictate a realignment of parities.
Because political factors are implicitly interjected into negotiations,
the negotiating process does not
converge to a solution fast enough,

or it converges to a solution that
the market considers inconsistent
with the changes in fundamentals. In these instances, the use
of foreign-exchange intervention
to preserve the established parities is costly, and its effectiveness
is questionablef
Controllability of
the Money Stock
A fifth argument against exchangerate flexibility is related to the
issue of international currency
substitution. Specifically, it is
assumed that domestic and foreign
currencies are substitutes in the
asset portfolios of corporations and
international investors with an
allegedly high elasticity of substitution. It is argued that the high
substitutability among currencies
results in large swings in the exchange rates; furthermore, it makes
the controllability of home money
stock extremely difficult. For instance, if the public anticipates a
dollar appreciation, private agents
will massively convert foreigncurrency holdings into dollars,
leading to an immediate appreciation of the dollar and faster growth
in the domestic money stock. If
expectations are reversed, the opposite phenomenon occurs. Critics
of exchange-rate flexibility argue
that, in an era of shifting monetary
policy, such swings in the exchange
rates and the demand for different
currencies are possible, and they
can be quite destabilizing. The
suggested solution is a return to a
system of fixed parities, accompanied by coordinated foreign-exchange
intervention, to maintain a stable
growth in the world's money stock.

6. See Jurgensen

(1983).

However, empirical evidence,
mostly based on quarterly data,
does not support the assumption
of high elasticity of substitution
among currencies; nor does evidence support the hypothesis that
controllability of domestic money
stock is hindered by international
currency substitution? In the case
of the dollar, the results are even
more disappointing for critics of
floating exchange rates. It is certainly possible that significant currency substitution occurs in shorter
time intervals or that the empirical
methodology used was not powerful enough to capture the effects.
Nevertheless, based on what we
know, there is no serious justification to return to a system of fixed
parities because of destabilizing
international currency substitution.
The Collapse of the
Bretton Woods System
The lesson from the breakdown of
the Bretton Woods system should
be clear. A return to a workable
system of limited exchange-rate
flexibility requires first that economic policies be coordinated and
second that monetary authorities
give up their independence and
submit their policy actions to
the disci pline of fixed exchange
rates. This is particularly true for
reserve-currency countries because
of their ability to inflate the world
economy and destabilize the system. Many have serious doubts
that this is a feasible option. Economic cooperation is faced with
serious problems, because countries differ in their institutional
structure, policy objectives, and
socioeconomic constraints. Time
after time, policymakers have
been unwilling to correct chronic
balance-of-payments problems by

7. See Spinelli (1983).

an adjustment of macroeconomic
policies. However, such behavior is
not surprising. Because policymakers in each country are traditionally evaluated on the performance
of their economy, they would be
less than eager to introduce policy
changes on balance-of-payments
grounds when such changes are
perceived to be in conflict with the
achievement of domestic objectives.
Those who doubt that national
goals and policies can be harmonized believe a viable international
monetary system requires sufficient flexibility of exchange rates
to reflect the relevant disparities
across nations. In addition, political
constraints make a fixed-rate system unworkable. The recent experience of the European Monetary
System shows the difficulties associated with a system of limited
exchange-rate flexibility. Although
it may be an acceptable scapegoat
in the domestic policies, calling for
a return to a system similar to
Bretton Woods and treatment of
such change as a panacea to solve
domestic economic problems should
be viewed with skepticism.
Federal Reserve Bank of Cleveland
Research Department
P.O.Box 6387
Cleveland, OH 44101

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References
Bilson, john F.O. The "Vicious
Circle" Hypothesis. International
Monetary Fund Staff Papers,
vol. 26, no. 1 (March 1979),
pp. 1-37.
Farrell, Victoria S., with Dean A.
DeRosa and T. Ashby McCowan.
"Effects of Exchange Rate Variability on International Trade
and Other Economic Variables: A
Review of the Literature:' Staff
Study No. 130, Board of Governors of the Federal Reserve System, December 1983.
International Monetary Fund. The
Exchange Rate System: Lessons of
the Past and Options for the Future.
Occasional Papers Series, No. 30,
july 1984a.
International Monetary Fund. Exchange Rate Volatility and World
Trade. Occasional Papers Series,
No. 28, july 1984b.
Iurgensen, Phillippe, Chairman.
Report of the Working Group on
Exchange Market Intervention.
Washington, DC, March 1983.

Spinelli, Franco. Currency Substitution, Flexible Exchange Rates, and
the Casefor International Monetary Cooperation: Discussion of a
Recent Proposal, International
Monetary Fund Staff Papers,
vol. 30, no. 4 (December 1983),
pp.755-83.
U.S. General Accounting Office.
Floating Exchange Rates in an Interdependent World: No Simple
Solutions to the Problems. Report
to U.S. Senate and U.S. House
of Representatives, April 20, 1984.
U.S. General Accounting Office.
Symposium on Floating Exchange
Rates in an Interdependent World.
Held February 18,1983; published
April 20, 1984.
Wallich, C. Henry, and ]o Anna Gray.
Stabilization Policy and Vicious
and Virtuous Circles. International Finance Discussion Paper
No. 152, Board of Governors of
the Federal Reserve System, 1979.