Jared Friedman December 13, 2004
Exchange Rate Systems S ystems in Two Two eriods o! "a#ita$ "a# ita$ %obi$ity
"hoosing an exchange rate system is &n'&estionab$y among a co&ntry(s more im#ortant #o$icy decisions) The choice o! exchange rate system system has direct direct e!!ects e!!ects on exchange rates, interest rates, and in!$ation) in!$ation) *&t the choice is a$so o!ten o!ten di!!ic&$t, di!!ic&$t, as each c&rrency o#tion has distinct costs and bene!its which can be di!!ic&$t di!!ic&$t to weigh) +n exce$$ent conce#t&a$ !ramewor !or &nderstanding com#eting o#tions !or an exchange rate system is #ro-ided by the %&nde$$.F$eming mode$, which states that the three genera$$y desirab$e '&a$ities o! ca#ita$ mobi$ity, !ixed exchange rates, and an inde#endent monetary #o$icy can ne-er a$$ be had sim&$taneo&s$y sim&$taneo&s$y)) The genera$ #re-a$ence o! the !irst !irst o! these conditions, ca#ita$ mobi$ity, has changed great$y o-er the #ast two cent&ries) *e!ore the mid. to $ate nineteenth cent&ry, ca#ita$ mobi$ity was $ow, as $arge internationa$ !inancia$ marets had not yet yet de-e$o#ed) /n the $ate nineteenth and ear$y twentieth twentieth cent&ries, internationa$ !inance and the g$oba$ economy ca&sed signi!icant ca#ita$ mobi$ity !or the !irst !irst time) /n the years between 114 and 13, ca#ita$ mobi$ity mobi$ity #$&nged wor$dwide, destroyed by the wor$d wars and the reat De#ression, and then restricted by the ca#ita$ contro$s o! the *retton *retton oods oods !ixed.exchange rate system) system) +!ter the demise o! the *retton oods go$d.do$$ar system, the rise in the sie and im#ortance o! !inancia$ marets has made restricting ca#ita$ mobi$ity di!!ic&$t, and !ree ca#ita$ exchange has been the r&$e 5ob-io&s$y with some some exce#tions6) There are th&s two #eriods #eriods o! high ca#ita$ mobi$ity, mobi$ity, where the choice o! exchange ex change rate system has been $arge$y between !ixed exchange rates and an inde#endent monetary #o$icy 7 the decades be!ore 114, and the decades a!ter 13) This #a#er examines the moti-ations moti-ations !or exchange rate system system choices in these time #eriods)
First, it is he$#!&$ to consider in the abstract what maes each %&nde$$.F$eming condition desirab$e and the e!!ect o! incor#orating it into an exchange rate system) "a#ita$ mobi$ity is !a-ored ob-io&s$y by !inanciers and anyone in-o$-ed in ca#ita$
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trans!ers, b&t a$so by go-ernments who want to r&n $arge $arge de!icits) Fixed exchange rates genera$$y increase internationa$ trade and #artic&$ar$y internationa$ in-estment by red&cing the ris o! c&rrency !$&ct&ation !$&ct&ation in those transactions) transactions) Fixed exchange rates a$so o!ten red&ce the ris o! in!$ation and genera$$y increase the stabi$ity o! the money s&##$y) +n inde#endent monetary #o$icy #o $icy a$$ows co&nter.cyc$ica$ management o! the economy, and wi$$ a$so a$$ow some contro$ o! exchange exchan ge rates i! &sed in a system witho&t !ixed rates) These basic e!!ects were e'&a$$y tr&e in both time #eriods) 8owe-er, as we sha$$ see, the e!!ects a co&ntry saw as most im#ortant, and th&s which c&rrency o#tion it chose to ado#t, changed considerab$y across the two time #eriods)
/n the decades be!ore 114, there were essentia$$y three choices !or exchange rate systems9 the go$d standard, a !ree.!$oating c&rrency, c&rrency, or a si$-er.baced c&rrency) c&rrency) The #attern !or which co&ntries chose which was c$ear9 the ind&stria$ co&ntries were in-ariab$y on the go$d standard, and $ess ind&stria$ied, #rimary #rod&ct ex#orting co&ntries were either !ree.!$oating or si$-er.baced)1 /t might might initia$$y seem that both go$d and si$-er baced c&rrencies re#resent a choice o! !ixed exchange rates, and !ree !$oating c&rrencies re#resent a choice o! monetary inde#endence) This is tr&e tr&e to some degree, b&t si$-er.baced c&rrencies are #robab$y better c$assi!ied as a choice o! inde#endent monetary #o$icy o-er !ixed exchange rates) :ne reason !or this is is that si$-er. si$-er. baced c&rrencies were '&ite sma$$ in tota$ monetary -a$&e -ers&s go$d.baced c&rrencies, maing the gains o! the !ixed exchange rate sma$$er) + more im#ortant reason, in terms o! its historica$ signi!icance, was that si$-er had a history o! consistent$y dec$ining in -a$&e com#ared to go$d, and as we sha$$ see, the monetary #o$icy co&ntries on si$-er wished to #&rs&e was one o! com#etiti-e de-a$&ation, o! an &nder-a$&ed c&rrency) +nd &n$ie with the go$d standard, i! si$-er si$-er !ai$ed to dec$ine as ex#ected, a de-a$&ation o! the exchange rate was m&ch more #ermissib$e with a si$-er.baced c&rrency than with the internationa$ go$d.standard, where s&ch a de-a$&ation wo&$d ha-e com#$ete$y destroyed credibi$ity) credibi$ity)
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The section on this time #eriod draws most$y !rom Frieden, The Modern World Economy 1896-200. cha#) ;, ##)11.1)
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Th&s, the ind&stria$ co&ntries were essentia$$y choosing !ixed exchange rates o-er an inde#endent monetary #o$icy, #o $icy, and the de-e$o#ing co&ntries were choosing the abi$ity to de-a$&e their c&rrencies o-er !ixed !ixed exchange rates) The reasons !or this this s#$it ha-e to do with the re$ati-e bene!its !or di!!erent co&ntries o! being ab$e to &se com#etiti-e de-a$&ation to increase their ex#orts -ers&s ha-ing the #ri-i$eged access to wor$d !inancia$ marets that came with with adherence to the go$d standard) /t is not hard to see that wea$thy ind&stria$ co&ntries with acti-e internationa$ !inancia$ marets wo&$d bene!it more !rom this #ri-i$eged access to ca#ita$ than ag rarian co&ntries with no s&ch marets, and a$so that the s#ecia$ interests !rom !inanciers and #o tentia$ borrowers o! ca#ita$ to ee# that #ri-i$eged stat&s wo&$d be m&ch stronger in the ind&stria$ ind&stria$ co&ntries) 8owe-er, the reasons that ex#orters o! #rimary #rod&cts wo&$d want to de-a$&e their c&rrencies more than ex#orters o! ind&stria$ #rod&cts wo&$d are somewhat more s&bt$e)
:ne ey di!!erence is the o!ten.mentioned -o$ati$ity o! #rimary #rod&ct #rices) "om#etiti-e de-a$&ations are e!!ecti-e on$y in the short r&n, a s e-ent&a$$y the higher #rices o! !oreign goods wi$$ ca&se in!$ation e'&i-a$ent to the de-a$&ation, o!!setting o!!setting its initia$ e!!ects) e!!ects) Th&s com#etiti-e de-a$&ations can be high$y e!!ecti-e !or #rimary #rod&ct #rod&cers, great$y red&cing the negati-e e!!ects o! a s&dden dro# in #rices, b&t !or ind&stria$ goods #rod&cers, there are !ewer s&dden shocs ca&sing -oters to cry !or com#etiti-e de-a$&ation, and it is di!!ic&$t to bring an &n com#etiti-e ind&stry to com#etiti-e $e-e$s in the $ong r&n sim#$y by re-a$&ing c&rrencies witho&t ca#ita$ contro$s) +$so, the o$igo#o$istic nat&re o! marets !or ind&stria$ goods made them inherent$y $ess com#etiti-e and th&s $ess sensiti-e sensiti-e to sma$$ #rice #rice di!!erences) So why wo&$d a $ess de-e$o#ed co&ntry want to !ix to si$-er, which was ex#ected to dec$ine contin&a$$y against go$d< :ne, s&ch dec$ines, #ossib$y !ixed !ixed by occasiona$ inter-entions in the the s&##osed$y !ixed rate, co&$d o!!set o!!set the shocs as described described abo-e) *&t it is a$so a$so tr&e that !arm #rices in genera$ were contin&a$$y dec$ining in that #eriod, so ha-ing an in!$ating c&rrency acted towards ee#ing them steady and he$#ed a-oid de!$ation)
+nother reason is the !act that many o! the #rimary #rod&ct #rod&cing co&ntries #rod&ced a !ew ma=or #rod&cts !or ex#ort which together made &# most o! their
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internationa$ economies, whi$e the ind&stria$ co&ntries genera$$y #rod&ced a $arge n&mber o! man&!act&red goods, each o! which was a sma$$ #art o! their their ex#orts) Th&s when a #rice shoc a!!ected a sing$e agric&$t&ra$ good, it wo&$d not be &nreasonab$e !or a co&ntry that de#ended hea-i$y on that good to de-a$&e its c&rrency !or the bene!it o! the #rod&cers o! that good at the ex#ense o! the in!$ation this wo&$d ca&se !or the rest o! the economy) For an ind&stria$ economy, economy, s&ch a de-a$&ation wo&$d on$y ha##en i! i! a $arge n&mber o! goods were were im#acted sim&$taneo&s$y) sim&$taneo&s$y) + third reason is is that all the the ind&stria$ co&ntries were on the go$d standard, so that the #rices o! ind&stria$ goods rose and !e$$ sim&$taneo&s$y with no co&ntry ha-ing a com#etiti-e ad-antage) Since most #rimary #rimary #rod&ct #rod&cers were not on the go$d standard, any s&ch #rod&cer on the go$d standard wo&$d '&ic$y be #&t o&t o! b&siness when the c&rrencies o! its com#etitors de-a$&ed against go$d)
E-idence and exam#$es !or this theory abo&nd) hen the #rice o! co##er in "hi$e !e$$ !rom 0 to 40 #o&nds #o&nd s ster$ing, the #ercentage #rice change was wa s #recise$y the same in a$$ the co&ntries on go$d) *&t the "hi$ean go-ernment de-a$&ed the #eso against the go$d c&rrencies !rom )1> to )10 #o&nds #o &nds ster$ing, ca&sing the #rice o! co##er to remain a$most exact$y the same) Simi$ar$y, Simi$ar$y, when wor$d wheat #rices #rices dro##ed by ha$! in the $ate $ate nineteenth cent&ry, +rgentina dro##ed the go$d standard in order to de-a$&e the #eso to ee# $oca$ wheat #rices steady, steady, which it did) Since co##er and wheat were enormo&s$y im#ortant com#onents o! the economies o! "hi$e "h i$e and +rgentina res#ecti-e$y, res#ecti-e$y, it seems $ie$y that there was in !act a ca&sa$ re$ationshi# between the #rice dec$ines and the monetary res#onse) The di!!erence o! o#inion o#inion between ind&stria$ists and !armers was #artic&$ar$y star in +merica, +merica, which was &n&s&a$ in ha-ing both $arge man&!act&ring and $arge agric&$t&ra$ sectors) sectors) /n +merica, +merica, the o#&$ist anti.go$d mo-ement, encom#assing basica$$y the !armers and miners in the so&th and the %idwest, was bro&ght into -io$ent con!$ict with the #ro.go$d ind&stria$ied northeast and west, maing go $d the #rimary iss&e o! the 1>? #residentia$ cam#aign)
*&t the %&nde$$.F$eming choice o! monetary inde#endence -ers&s !ixed exchange rates was not the on$y exchange rate system choice !aced by these co&ntries)
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hy did some co&ntries choose to !ix to si$-er and others to !$oat< +nd why did the co&ntries choose to !ix c&rrencies to go$d, as o##osed to creating a sing$e c&rrency as is m&ch more common now< The answer to the !irst !irst '&estion is that the decision was based $arge$y on tradition) tradition) "hina and /ndia had &sed si$-er !or ages, and they sim#$y e#t it) %exico(s decision to stic to the si$-er standard, tho&gh, was #robab$y based more on the !act that it was a ma=or si$-er #rod&cer) #rod&cer) The answer to the second '&estion is com#$icated, and not entire$y re$e-ant to the to#ic at hand, b&t b &t the answer $ies in se-era$ !actors) First, there was tradition, tradition, as go$d had been &sed as c&rrency !or most o! history) There was a$so a !ear o! in!$ation and a genera$ $ac o! con!idence in the abi$ity o! go-ernments to maintain the -a$&e o! !$oating c&rrencies) erha#s most im#ortant$y, im#ortant$y, the $ac o! internationa$ #o$itica$ organiation made the go$d standard, which re'&ired no internationa$ centra$ ban, m&ch easier to im#$ement than a new c&rrency)
The a##arent c&rrency o#tions d&ring the #eriod a!ter 13 were '&ite di!!erent !rom those d&ring the #re.114 #eriod) @irt&a$$y @irt&a$$y a$$ co&ntries chose to !$oat 5e)g), +merica, Ja#an 5most$y66, to #eg or !ix their c&rrency to another one 5+rgentina, 8ong Aong, etc)6, to create a new internationa$ c&rrency 5E&ro$and6, or to do$$arie 5+rgentina, %exico, er&, etc,6) 8owe-er, when -iewed in in terms o! the %&nde$$.F$eming %&nde$$.F$eming conditions, the o#tions were not rea$$y so di!!erent) +$$ o! these choices ty#ica$$y ty#ica$$y went with high ca#ita$ mobi$ity, so the choice was rea$$y between the monetary inde#endence o! the !irst o#tion and the !ixed exchange rates o! the the other three o#tions) The e!!ects o! each o! these o#tions were a$so simi$ar simi$ar to what they they were in the #re.114 #eriod) 8owe-er, the costs and bene!its o! each o! these e!!ects had changed dramatica$$y in the inter-ening years, and so co&ntries made di!!erent choices !rom the ones they made be!ore 114)
Booing at which co&ntries chose to !$oat and which to !ix a!ter 13, it is c$ear that the economic sie o! the co&ntry corre$ates strong$y with with this decision) Barger co&ntries are m&ch more $ie$y to choose !$oating rates, and one ex#$anation !or this is that c&rrencies are goods with economies o! o ! sca$e)2 hy sho&$d sho&$d a c&rrency ha-e economies o! sca$e< There are se-era$ reasons) First, sma$$ sma$$ c&rrencies tend to be treated 2
+$esina, *arro, et a$)), Optimal Currency Area. Cationa$ Area. Cationa$ *&rea& *&rea& o! Economic Research, woring woring #a#er 02! 02! 4
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as higher ris, th&s mistr&sted by internationa$ !inance, based on #re-io&s ex#erience) +$so, since $arge c&rrencies are he$d as reser-e c&rrencies, &sing a $arge c&rrency means that a co&ntry can borrow money in its own c&rrency, great$y red&cing the rea$ #rice o! so-ereign debt) The -a$&e o! sma$$er c&rrencies c&rrencies is contro$$ed by a sma$$er tota$ -o$&me o! exchange, $eading to greater -o$ati$ity) +nd sma$$er c&rrencies c&rrencies tend to be s&##orted by sma$$er and $ess e!!icient centra$ centra$ bans) + di!!erent reason why $arger co&ntries sho&$d be more $ie$y to choose !$oating rates is that sma$$er co&ntries are $ess se$!.s&!!icient than $arger co&ntries and there!ore trade more th&s, the decreased transactions costs in trading that come with !ixed c&rrencies are more im#ortant to sma$$ co&ntries)
+rmed with this &nderstanding o! the e!!ects o! the %&nde$$.F$eming conditions and how they re$ate to a co&ntry(s sie, we can readi$y ex#$ain most o! the exchange rate system choices in this #eriod) :ne o! the most dramatic dramatic c&rrency e-ents in this #eriod, indeed in the who$e cent&ry, cent&ry, was the ado#tion o! the E&ro) *&t the e&ro maes a great dea$ o! sense9 it is a c&rrency &nion o! a n&mber o! re$ati-e$y sma$$ co&ntries that e-en be!ore its ado#tion were high$y integrated in trading #atterns3) 8ere the bene!its o! !ixed exchange rates on trade, combined with the economies o! sca$e !or a c&rrency, were most im#ortant) The do$$ariation and do$$ar #egs common in Batin +merica +merica can be ex#$ained !or a di!!erent reason) Trade is &ndo&bted$y im#ortant im#ortant here too, b&t more im#ortant are #robab$y the stabi$ity #ro-ided by &sing the do$$ar instead o! an in!$ation.#rone nationa$ c&rrency and the abi$ity to mani#&$ate mani#&$ate exchange rates by changing the #eg) n$ie in the #re 114 #eriod, Batin +merican +merican co&ntries ha-e &s&a$$y mani#&$ated the #eg to ee# their c&rrency o-er.-a$&ed, in order to ee# im#orts chea# and red&ce the -a$&e o! the nationa$ debt, with sometimes disastro&s res&$ts) 4 Biewise, the 8ong Aong Do$$ar(s do$$ar #eg was instit&ted to maintain monetary stabi$ity) stabi$ity) *y contrast, we can see why the do$$ar, the e&ro, and the yen ha-e remained inde#endent and !$oating against each other9 these c&rrencies are $arge eno&gh to en=oy most o! the economies o! sca$e, they can easi$y borrow money, and their centra$ centra$ bans #&rs&e di!!erent eno&gh #o$icies that combining them wo&$d be a signi!icant cost)
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Frieden, cha#) 1?, #) 33 "arodo, E$iana, et a$), "atin a$), "atin America# America# Economy! Economy! $i%erity& $i%erity& Trend Trend and Con'lict. Con'lict. >0
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:! co&rse, as in the #eriod be!ore 114, co&ntries a!ter 13 ha-e !aced not on$y the genera$ %&nde$$.F$eming trade.o!!s trade.o!!s b&t a$so more s#eci!ic s#eci!ic c&rrency decisions) /n #artic&$ar, those who decided to !ix rates had to decide whether to #eg to a c&rrency 5and which c&rrency to #eg to6, to do$$arie 5to the extent this is a cho ice o! the go-ernment6, or to !orm a new c&rrency) :ne interesting '&estion is why the e&ro is &ni'&e as the on$y $arge.sca$e c&rrency &nion in this this time #eriod) This is '&ite '&ite sim#$y beca&se there is no other gro&# o! nations simi$ar to the E&ro#ean ones 7 no other gro&# g ro&# o! co&ntries with re$ati-e$y sma$$, tight$y integrated economies that together !orm a $arge economic b$oc, and a $ac o! strong #o$itica$ #o$itica$ and mi$itary tensions between them) For exam#$e, one #ossib$e other c&rrency &nion that might come to mind wo&$d be the nations o! %ercos&r, b&t this wo&$d $ie$y be too sma$$ a &nion to rea$ie economies o! sca$e, and it might we$$ be dominated #o$itica$$y by *rai$); Th&s, other nations nations that ha-e wanted to !ix rates rates ha-e !ixed to other c&rrencies, and most ha-e chosen the do$$ar beca&se it has been the #redominant c&rrency !or many decades)
"ertain as#ects o! exchange rate choices cho ices are di!!ic&$t to com#are across the two time #eriods) Do$$ariation, !or instance, has no ob-io&s e'&i-a$ent in the #re.114 time time #eriod) 8owe-er, one as#ect that can be readi$y com#ared is the choice between the two com#eting %&nde$$.F$eming conditions9 !ixed exchange rates and monetary inde#endence) /n the #re.114 #eriod, #eriod, this choice was #rimari$y determined by the ind&stria$iation o! a co&ntry 7 more ind&stria$ co&ntries chose !ixed rates) /n the #ost. 13 #eriod, this choice was #rimari$y #rimari$y determined by a co&ntry(s economic sie 7 sma$$er co&ntries co&ntries chose !ixed !ixed rates) hy this dramatic change< :ne, #rimary #rod&cts are m&ch $ess im#ortant in today(s economy, and so the moti-e o! &sing the exchange rate as a too$ to o!!set changes in those #rices is m&ch m&ch $ess #otent) Two, Two, co&ntries ha-e rea$ied o-er time the economies o! sca$e in c&rrencies, and sma$$ co&ntries now genera$$y ado#t $arger c&rrencies in order to maintain stabi$ity and attract in-estment) Fina$$y, the the three #rimary c&rrencies are now so $arge that the ind&stria$ economies rea$ie m&ch o! the bene!it o! ha-ing a sing$e c&rrency 5as in the go$d.standard6 by instead ha-ing three s&#er.c&rrencies) s&#er.c&rrencies) hi$e the %&nde$$.F$eming %&nde$$.F$eming conditions and their ;
%&nde$$, Robert) Currency Currency Area& E(chan)e *ate +ytem and ,nternational Monetary *e'orm) *e'orm) Jo&rna$ o! +##$ied Economics, @o$) /// 5200069 234
im#$ications are -irt&a$$y time$ess tr&ths, the changing aims o! nationa$ #o$itics wi$$ $ead to changes in exchange rate #o$icies)
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