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FRBSF
WEEKLY LETTER
September 22, 1989
Monetary Policies and Exchange Rates
In theory, floating exchange rates can insulate an
economy from the effects of foreign monetary .
policies. For example, under a floating~exchange
rate system, inflationary monetary policies
pursued abroad should cause the nominal
exchange value of the home currency to appreciate, thereby maintaining its purchasing power.
Thus, the real value of the home currency-that
is, its nominal exchange rate adjusted for differences in the general level of prices at home
and abroad-would not change, insulating the
domestic economy from the effects of inflation
abroad.
Experience with floating exchange rates since
the breakdown of the Bretton Woods system in
1973, however, shows that floating rates have not
stabilized real exchange rates, so that economies
still have been subject to monetary (as well as
nonmonetary) disturbances emanating from
abroad. The main reason for this experience is
that wages and prices adjust relatively slowly to
changes in monetary policies, and as a result,
real interest rates, output, and employment can
be affected by such changes in the medium
term. Differences in real interest rates across
national economies, in turn, produce shifts in international capital flows, with consequent effects
on real exchange rates and the balance of trade.
This Letter suggests that through their effect on
real interest rate differentials, divergent national
monetary policies have contributed to fluctuations in the real value of the dollar during the
period of floating exchange rates. The preceding
Letter (September 15, 1989) suggested that divergent national fiscal policies also have had a
significant influence on the real value of the dollar, but not primarily through their effect on real
interest rate differentials. Taken together, monetary and fiscal policies explain most of the
fluctuations in the dollar's value in the floatingrate period.
Inflation cycles
real interest rates during the 1970s and 1980s. A
common view of these fluctuations is that they
resulted from erratic monetary growth. However,
as will be explained below, fluctuations in real
interest rates and inflation also can be dynamic
responses to sustained increases or decreases in
the rate of monetary growth.
Chart 1 shows the basic features of such a dynamic inflation cycle, produced by simulating a
structural. model of the U.S. economy developed
at the Federal Reserve Bank of San Francisco. In
the simulation, a sustained increase in the rate of
monetary expansion first puts downward pressure on both nominal and real interest rates
because wages, prices, and expectations of future
inflation adjust relatively slowly. (The assumption
that expectations of inflation are formed adaptively--'-that is, based on past inflation-is
common to macroeconomic models that follow
neo-Keynesian theory.)
CHARYl
Monetary Inflation Cycle
Percent
Percent
30
12
Inflation Rate
10
10
-
Real Bond Rate
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
YEARS
The decline in real interest rates then produces
an expansion in the demand for real output, a reduction in the unemployment rate, and therefore
a rise in the inflation rate. Thus, in the first phase
of the cycle, real interest rates are falling and the
inflation rate subsequently is rising, with declines in real interest rates preceding increases in
the rate of inflation by one to two years.
.
The United States and its major trading partners
experienced major fluctuations in inflation and
In the second phase of the cycle, the rising inflation rate eventually begins to exceed the rate of
FRBSF
monetary growth, thereby putting upward pressure on nominal and real interest rates. As real
interest rates rise,output slows, unemployment.
rises, and the rate of inflation begins to decline,
even though the rate of monetary expansion remains unchanged. The increases in real interest
rates again precede the declines in inflation by a
year or two. The cycle in real interestrates and
inflation then tends to repeat itself, damping out
only gradually.
U.S. and foreign inflation cycles
Chart 2 shows the actual cycles in inflation and
real bond rates experienced by the United States
and its major trading partners during the period
of floating exchange rates. Compared with earlier years, this period has been characterized by
a higher trend rate of monetary growth in both
the United States and abroad. The behavior of inflation and real interest rates~both.at home and
abroad~conforms quite strikingly to the simulated inflation cycles produced byap~rmanent
increase in monet;:lry growth. Troughs {peaks} in
real interestratesleadpeaks(troughs} in inflation, and the periodicity ;:Indamplitud~s of the
cycles in reaL interest rates and inflation are.similar to those in the simulation. The biggest
differences between simulated and actual inflation occurs in 1974 and 1979-80, due to surges
in oil prices.
CHART 2
Percent
Percent
Inflation and Bond Rates
18
16
14
12
10
8
6
35
30
25
20
U.S. Real Bond
o
-2
-4
·6
Moreover, as shown in Chart 2, until the mid
1980s, U.S. and foreign cycles in real interest
rates and inflation showed a relatively high degree of conformity under floating exchange rates.
From 1973 to 1977, real interest rates at home
and abroad were declining, and subsequently inflation accelerated in both cases, reaching peak
values in 1980. Similarly, real interest rates began
to rise in the late 1970s both at home and
abroad, peaking in the
in 1985. Decelerations in inflation followed these rising real
interest rates in both cases. After 1984, however,
U.S. and foreign real interest rates became "uncoupled:' with the
real bond rate declining
sharply and the foreign real bond rate continuing
to rise.
u.s.
u.s.
Exchange rate implications
The conformity between foreign and domestic
real-interest and inflation rates prior to 1985 is
consistent with an apparent tendency for central
banks to conduct monetary policies with consideration given to stabilizing the real value of the
dollar. Specifically, prior to 1985, central banks
apparently tended to minimize changes in the
differential between
and foreign real bond
rates, thereby reducing changes in capital flows
that affect exchange rates.
u.s.
15
4
2
·8
without having any corresponding impact on inflation. Overall, then, the evidence suggests that
the recent cycles in real interest rates and inflation in the U.S. and abroad predominantly have
been lengthy dynamic responses to a higher
trend rate of monetary expansion, and were not
primarily the result of erratic short-run monetary
movements.
........
------
R~ate:-- _ _
--- -------------
------F'o;;,ign R~I Bond Rate
-l--.---.---.---.-:--.-:-,-,-.--.--.---.---.---.---.--r-+1973
19751977
1979
19B1
1983
1985
-5
1987
Some have pointed out that money grew erratically around the higher growth trends during the
floati ng-exchange-rate. period,· and. have suggestedthat this may account for the observed
cycles in inflation. However, becaljse of the relatively long lags between money and prices, these
short-term movements in money had relatively
little impact on the path of inflation. Moreover,
financial deregulation since about1980 contributed to erratic movements in measured money,
Alternatively, if the U.S. had pursued a course for
monetary policy in the 1970sthatwas substantially different from that of its trading partners,
fluctuations in the real value of the dollar would
have increased. For example, if U.S. monetary
policy had been significantly tighter than that of
its trading partners, interest rates would have
risen relative to those abroad, attracting inflows
of capital and appreciating the real value of the
dollar significantly. The stronger dollar, in turn,
tradeable goods
would have depressed the
sector.
u.s.
Simulation of the structural model suggests that
changes in the real bond rate differential accounted for swings of no more than 20 percent in
the dollar's value prior to 1984. In contrast, between the beginning of 1985 and the end of 1987,
the real bond rate differential dropped about 3Y2
percentage points, contributing an estimated 50
percentage points to the dollar's depreciation in
the later period (Chart 3).
1973.100
CHART 3
Real Bond Rate Differential and the Exchange Rate
1973 ~ 100
125
120
115
110
110
100
90
1~
00
1M
ro
~
00
00
00
~
~
00
W
75
ro
65
60
~
10
+-.--.--..--..--.,-.,-.---.---,--,--.---,-,-.--r-+ 0
1973
1975
1977
1979
1981
1983
1985
1987
These results suggest that the less-than-perfect
coordination of u.s. and foreign monetary policies from 1975 through 1984 contributed to the
dollar's depreciation in the late 1970s and appreciation in the early 1980s. As discussed in the
preceding Letter, divergent U.s. and foreign fiscal
policies during these two periods also contributed to the dollar's movements. Specifically, the
tightening of u.s. fiscal policy and the easing of
foreign fiscal policies between 1975 and 1980
contributed to the moderate depreciation in the
dollar observed in that period, while the easing
of u.s. fiscal policy and the tightening of foreign
fiscal policies from 1980 to 1984 contributed to
the subsequent sharp appreciation of the dollar.
After 1984, when u.s. and foreign cycles in real
interest rates became significantly less synchronized, the large decline in the dollar appears
to have been predominantly the result of changes
in monetary policy at home and abroad. Consistent with this view, the decline in real interest
rates in the United States relative to foreign rates
was associated, after a lag, with an acceleration
of inflation in the u.s. compared to inflation
abroad. In contrast, changes in fiscal policy in
this period were too small to explain the sharp
change that occurred in the dollar.
Policy coordination
As we have seen, ad hoc coordination among
central banks contributed relative stability to the
real value of the dollar in the 1970s and early
1980s. Beginning with the Plaza Agreement
among the G-5 countries in 1985, the international coordination of monetary policy became
more formalized. But from 1985 to 1987, the goal
of coordination changed, with the G-5 expressing a desire to bring the real value of the dollar
down, rather than to stabilize it. As shown
above, the real bond rate differential and the real
value of the dollar declined sharply, consistent
with that desire.
Two factors appear to explain this change in goal
and the resultant "uncoupling" of u.s. from foreign real interest rates after 1985. First, fiscal
shifts both in the u.s. and abroad between 1980
and 1985 produced a sharp worsening in the
u.s. trade balance, which tended to generate
protectionist pressures in the United States. A
decline in the real value of the dollar was considered desirable in order to correct this problem.
Second, concern about inflation generally was
greater abroad than in the U.S., so an easing of
u.s. real interest rates relative to foreign rates
seems consistent with this divergence of concerns.
Adrian Throop
Research Officer
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board 1)f Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author...• Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.
r
Research Department
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120
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