Under the gold standard, each country fixed the par
value of its currency against gold, maintained the convertibility
of its currency into gold at this price and linked the domestic money supply
to gold stocks at the central bank. It was a fixed exchange rate regime.
Without capital flows, countries with a trade deficit faced a payments
deficit, lower gold stocks and a lower money supply. Domestic recession then
bid down wages and prices, raising competitiveness, an automatic adjustment
mechanism. Trade surplus countries faced a monetary inflow, higher prices
and lower competitiveness. In practice, this adjustment mechanism was hampered
by capital flows.
The postwar Bretton Woods system was an adjustable
peg in which fixed exchange rates were sometimes adjusted. It was
a dollar standard. But domestic money supplies were no longer linked to forex
reserves, so the adjustment mechanism of the gold standard was weakened.
The purchasing power parity path of the nominal exchange
rate is the path that maintains constant competitiveness by offsetting differential
inflation across countries. In the long run, floating exchange rates return
to the PPP path if no real shocks occur.
In the short run, the level of floating exchange rates
is determined largely by speculation. Exchange rates adjust to ensure interest
differentials are offset by expected exchange rate changes. This chokes off
large speculative flows. In the short run, exchange rates can depart significantly
from their long run level.
Unlike fixed exchange rates, floating exchange rates can cope with permanent
differences in national inflation rates. High-inflation countries have a depreciating
exchange rate in the long run. In practice, floating exchange rates also coped
with the severe real shocks of the 1970s. Floating exchange rate regimes are
more robust than fixed exchange rate regimes.
Critics of floating exchange rates claim they are volatile
in the short run, which discourages international trade and investment. However,
they are volatile because the world is uncertain. Under fixed exchange rates
the uncertainty would show up somewhere else, possibly in volatile domestic
interest rates to maintain the fixed exchange rate.
Fixed exchange rates impose financial discipline by preventing
a country having permanently higher inflation than the rest of the world.
However, there are other ways to commit to low inflation. And fixed exchange
rates do not always survive!
International policy co-ordination is hard to implement
but allows policy makers to take account of the externalities they impose
on each other. It may allow individual governments to commit themselves to
policies that would otherwise not be credible.
The UK was always a member of the European Monetary System
but belonged to its key feature, the Exchange Rate Mechanism,
only during 1990–92. The early survival of the ERM arose only partly
from greater co-ordination of monetary policy by ERM participants. Foreign
exchange controls and exchange rate bands were also important. After 1983
devaluations became harder to obtain and monetary policies had to converge
on the low inflation rate in Germany.
