Government Policies Toward
the Foreign Exchange Market

Overview

The first half of this chapter examines types of government policies toward the foreign exchange market and provides analysis of government intervention and exchange controls. The second half examines the actual policies that governments have adopted during the past 130 years.

Government policies toward the foreign exchange market exist for a variety of reasons, including to reduce variability in exchange rates, to keep the exchange value of its currency either high or low, or to raise national pride in a steady or strong currency. The two major aspects of government policies toward the foreign exchange market are policies toward the exchange rate itself and policies that permit or restrict access to the foreign exchange market. Government-imposed restrictions on the use of the foreign exchange market are called exchange controls, which may be broad-based or may be applied only to some types of transactions (e.g., capital controls).

The basic choice that a government faces with its policy toward the exchange rate itself is between an exchange rate that is floating and one that is set or fixed by the government. In the polar case of a clean float the government permits private market demand and supply to set the exchange rate with no direct involvement by government officials. In a managed float or dirty float the government officials do intervene at times to try to influence the exchange rate, which otherwise is driven by private demand and supply.

If the government chooses to impose a fixed exchange rate, there are three additional choices that the government faces.

First, what to fix to? Answers could include gold (or some other commodity), the U.S. dollar or some other single currency, or a basket of currencies. (With the exception of the specific examination of the gold standard, subsequent discussion assumes that a fix is to one or several foreign currencies.)

 Second, when to change the fixed exchange rate? Never is a polar case, but it probably is not completely credible (and we often then speak of a pegged exchange rate instead of a fixed exchange rate). If occasionally, we call the system an adjustable peg. If often, we have a crawling peg. The choice of when to change the peg is closely related to how wide is the band around the central or par value chosen for the fix.

Third, how to defend the fixed rate? There are four basic ways

• official intervention in which the government buys and sells currencies;

• exchange controls, in which the government tries to suppress excess demand or supply;

• altering domestic interest rates to influence short-term international capital flows; and

• adjusting the country's macroeconomic position to make it fit the fixed exchange rate.

Of course, the government also has a fifth option:  to alter the fixed rate or shift to a floating rate.

The first line of defense is often official intervention. If the country's currency is experiencing pressure toward depreciation, the country's monetary authority can defend the fixed rate (at least, at the edge of the band) by entering the foreign exchange market to buy domestic currency and sell foreign currency. The intervention is financing the country's official settlements balance deficit and preventing this excess private demand for foreign currency from driving the foreign currency's value above the top of the band. The monetary authority obtains the foreign currency that they sell into the market by using their holding of official reserves or by borrowing foreign currency. In addition, by buying domestic currency, the monetary authority is removing domestic money from the economy, which tends to lower the domestic money supply. (Chapter 22 takes up the implications of this induced change in the domestic money supply.) Analysis of defending against appreciation of the country's currency follows similar logic, with "the directions reversed."

If the imbalance in the country's official settlements balance is temporary, then official intervention that smoothes the time path of the exchange rate can enhance the country's economic well-being (although stabilizing private speculation could do the same thing without government intervention). If the disequilibrium is ongoing or fundamental rather than temporary, then intervention alone is not likely to be able to sustain the fixed exchange rate. Instead, the government must shift to one of the other defenses or devalue. A key problem here is that it is not easy for officials to judge whether a payments imbalance is temporary or fundamental.

Exchange controls are used by many countries, especially developing countries. They cause economic inefficiency analogous to quantitative limits (quotas) on imports. They also incur substantial administrative costs. Efforts to evade them lead to bribery and parallel markets.

■ The second half of the chapter surveys exchange rate regimes used during the past century.

During the gold standard era (1870-1914), most countries pegged their currencies to gold, with each central bank willing to buy and sell gold in exchange for its own currency. This implies that the exchange rates between currencies are also fixed (within a band resulting from the transactions costs of moving gold). Britain was at the center of the system. The gold standard looked successful because it was not subject to severe shocks (until it was suspended during World War I) and because success was defined leniently, given that governments were not so concerned with stabilizing their macroeconomies.

The interwar period brought instability. In the years after the World War I Britain made the mistake of attempting to return to its prewar gold parity. Germany suffered from hyperinflation, and other European countries also experienced substantial inflation. The early 1930s brought panics that led to the general abandonment of the gold standard. Compared with the gold standard era, exchange rates were quite variable. Experts at the time concluded that this experience showed the instability of flexible exchange rates, so that the world should return to fixed exchange rates. More recent analysis of this period concludes almost the opposite-that it shows the futility of trying to keep exchange rates fixed in the face of severe shocks and unstable domestic monetary and fiscal policies.

A compromise between the United States and Britain led to an agreement in 1944 that established the Bretton Woods System, a regime of adjustable pegged exchange rates with the International Monetary Fund as a multilateral organization to oversee the system and provide additional reserves to finance temporary deficits.

While this system looked successful for almost two decades, it also had two defects. One was that it set up one-way speculative gambles when currencies were in trouble The second concerned the role of the U.S. dollar in the system. As the system developed, other countries pegged their currencies to the dollar, and the U. S. government was committed to buy or sell gold for dollars with other central banks. Continuing U.S. payments deficits in the 1960s led some other countries to amass large holdings of U.S. dollar-denominated assets as official reserves. Confidence that the U.S. government could continue to honor the official gold price dwindled. The U.S. government was unwilling to contract the U.S. economy to reduce the U.S. payments deficits. Instead, the private market for gold was freed in 1968. U.S. payments deficits continued.

In 1971 the U.S. government suspended convertibility of dollars into gold and imposed a temporary tariff on all imports until other countries agreed to revalue their currencies (so that the dollar would be devalued). The Smithsonian Agreement of December 1971 attempted to reestablish the system (with many other currencies being revalued), but the pegged rate system was abandoned by the major countries in 1973.

The current system is often described as a system of managed floating exchange rates, and the trend is generally in this direction. But there is also much official resistance to market-driven exchange rates. Some of the resistance is seen in the active management of floating exchange rates. More dramatically, the countries of the European Union have attempted to create a zone of stability in Europe, first by using the snake within the tunnel, then through the Exchange Rate Mechanism of the European Monetary System, and now with European Monetary Union and the euro. A goodly number of countries maintain fixed or heavily managed exchange rates. However, the series of exchange rate crises of the 1990s show how difficult it is for a government to defend a fixed or a heavily managed exchange rate in the face of wide swings in speculative international financial flows.

The actual current system is in many ways a nonsystem − countries can choose almost any exchange rate policies that they want, and there is much variety. Two major blocs of currencies exist − one is the U.S. dollar and the currencies fixed to it, and the other is the countries adopting the euro and other countries fixed to the euro. A number of countries have floating exchange rates for their currencies, with a greater or lesser degree of "management." Yet other countries use a fixed exchange rate to another currency, a fixed exchange rate to a basket of currencies, or a crawling pegged exchange rate.

Key Terms

True or False?

1. T / F In its most strict form an exchange control would require you to turn over all your foreign currencies to your government.

2. T / F A country that fixes its currency to a basket of other currencies will experience more severe swings in currency value than if it were fixed to a single other currency.

3. T / F A clean float and a permanently fixed exchange rate are the polar cases of possible exchange rate systems.

4. T / F Maintaining par may be pretty good for monetary authorities, but it is pretty bad for golf authorities.

5. T / F The stability of the gold standard era proves that pegging currencies to gold ensures international economic tranquility.

Multiple Choice

1. A government might want to keep the value of its currency high if it:

A. Is nuts.
B. Wants to help exporters.
C. Wants to punish buyers of imports.
D. Cares about national pride and honor.

2. A government might want to devalue its currency if

A. Exporters have a strong lobbying arm.
B. Import buyers have a strong lobbying arm.
C. Policymakers worry about high domestic inflation rates.
D. Foreign governments tell it not to.

3. If monetary authorities in the U.S. want to "lean against the wind," they should:

A. Sell the dollar when it is depreciating relative to the yen.
B. Sell the dollar when it is appreciating relative to the yen.
C. Buy the yen when it is appreciating relative to the dollar.
D. Buy the dollar when it is appreciating relative to the yen.

4. Indicators that a government could use to "crawl" the pegged value of its currency include:

A. Domestic holdings of the international reserve currency.
B. Changes in the country's own money supply.
C. The difference between domestic inflation rate and the inflation rate of the currency it pegs itself to.
D. All of the above.

5. Which of the following is not used as a government strategy to defend a fixed exchange rate?

A. Imposing exchange controls.
B. Buying and selling foreign currencies.
C. Changing the demand for or supply of its currency by altering domestic interest rates.
D. Swords and crossbows.

Additional multiple choice questions:

6. If a country is to fix its exchange rate, its currency must be pegged to:

A. Gold
B. US dollars
C. the Special Drawing Right (SDR), a basket established by the IMF
D. none of the above (i.e., its currency may be pegged to something else)

7. When a country decrees that its importers must buy the needed foreign currency at some special exchange rate, this is:

A.a measure of the country’s trade policy that has nothing to do with exchange rate policy
B. an intervention in the foreign exchange market.
C. a way to make its currency stronger
D. the only way it can interfere with international trade allowed by the WTO

Problems

 1. Because Leinster produces its phones in a solar-powered factory, exports to Saxony fall off in winter and hit a peak in the summer. Consequently, Saxon demand for foreign exchange is relatively low in January but quite high in July. This is illustrated below.

a. If Saxony and Leinster are on a clean float, how will this seasonality affect the exchange rate between the scudo and the lira? b. Could Saxony defend a fixed exchange rate of Ss 100/ LI under these circumstances? How? Why might the country want to defend a fixed rate? 1. How does a change in the price level eliminate payments imbalances under the gold standard? 3. As a matter of pride, Saxony government officials decide to fix the scudo's value at Ss 100/ Ll. However, the popularity of telephone communication (Saxon kids have become hooked on "chat lines") caused a sudden increase in the need for lira to import telephones. If the exchange rate were still determined in a clean float, this would force the scudo down to Ss 150 / Ll. What options could officials use to defend the scudo at Ss 100 / Ll?

4. Some political commentators in the U.S. who are concerned about economic instability have called for a return to the gold standard. Evaluate this proposal. What would be the costs and the benefits? Would we be assured of greater economic stability as a result? 5. Consider the following hypothetical data from a gold standard system: • Value of the British pound in gold = 1/7 ounce. • Value of the American dollar in gold = 1/28 ounce.

a. What is the fixed exchange rate between the British pound and the U.S. dollar? b. If the U.S. government is committed to maintaining the convertibility of the dollar, what is the maximum supply of dollars that can safely be printed if Fort Knox holds ten billion ounces of gold bullion?

Suggested Answers to Questions and Problems (in the textbook)

2. We often use the term pegged exchange rate to refer to a fixed exchange rate, because fixed rates generally are not fixed forever. An adjustable peg is an exchange rate policy in which the "fixed" exchange rate value of a currency can be changed from time to time, but usually it is changed rather seldom (for instance, not more than once every several years). A crawling peg is an exchange rate policy in which the "fixed" exchange rate value of a currency is changed often (for instance, weekly or monthly), sometimes according to indicators such as the difference in inflation rates.

4. Disagree. If a country is expected to impose exchange controls that will make it more difficult to move funds out of the country in the future, investors are likely to try to shift funds out of the country now before the controls are imposed. The increase in supply of domestic currency into the foreign exchange market (or increase in demand for foreign currency) puts downward pressure on the exchange rate value of the country's currencythe currency tends to depreciate.

6. a. The market is attempting to depreciate the pnut (appreciate the dollar) toward a value of 3.5 pnuts per dollar, which is outside of the top of the allowable band (3.06 pnuts per dollar). In order to defend the pegged exchange rate, the Pugelovian monetary authorities could use official intervention to buy pnuts (in exchange for dollars). Buying pnuts prevents the pnut's value from declining (selling dollars prevents the dollar's value from rising). The intervention satisfies the excess private demand for dollars at the current pegged exchange rate. b. In order to defend the pegged exchange rate, the Pugelovian government could impose exchange controls in which some private individuals who want to sell pnuts and buy dollars are told that they cannot legally do this (or cannot do this without government permission, and not all requests are approved by the government). By artificially restricting the supply of pnuts (and the demand for dollars), the Pugelovian government can force the remaining private supply and demand to "clear" within the allowable band. The exchange controls attempt to stifle the excess private demand for dollars at the current pegged exchange rate. c. In order to defend the pegged exchange rate, the Pugelovian government could increase domestic interest rates (perhaps by a lot). The higher domestic interest rates shift the incentives for international capital flows toward investments in Pugelovian bonds. The increased flow of international financial capital into Pugelovia increases the demand for pnuts on the foreign exchange market. (Also, the decreased flow of international financial

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capital out of Pugelovia reduces the supply of pnuts on the foreign exchange market.) By increasing the demand for pnuts (and decreasing the supply), the Pugelovian government can induce the private market to clear within the allowable band. The increased domestic interest rates attempt to shift the private supply and demand curves so that there is no excess private demand for dollars at the current pegged exchange rate value.

8. a. The gold standard was a fixed rate system. The government of each country participating in the system agreed to buy or sell gold in exchange for its own currency at a fixed price of gold (in terms of its own currency). Because each currency was fixed to gold, the exchange rates between currencies also tended to be fixed, because individuals could arbitrage between gold and currencies if the currency exchange rates deviated from those implied by the fixed gold prices. b. Britain was central to the system, because the British economy was the leader in industrialization and world trade, and because Britain was considered financially secure and prudent. Britain was able and willing to run payments deficits that permitted many other countries to run payments surpluses. The other countries used their surpluses to build up their holdings of gold reserves (and of international reserves in the form of sterling-denominated assets). These other countries were satisfied with the rate of growth of their holdings of liquid reserve assets, and most countries were able to avoid the crisis of running low on international reserves. c. During the height of the gold standard, from about 1870 to 1914, the economic shocks to the system were mild. A major shock-World War I-caused many countries to suspend the gold standard. d. Speculation was generally stabilizing, both for the exchange rates between the currencies of countries that were adhering to the gold standard, and for the exchange rates of countries that temporarily allowed their currencies to float.

10. a. The Bretton Woods system was an adjustable pegged exchange rate system. Countries committed to set and defend fixed exchange rates, financing temporary payments imbalances out of their official reserve holdings. If a "fundamental disequilibrium" in a country's international payments developed, the country could change the value of its fixed exchange rate to a new value. b. The United States was central to the system. As the Bretton Woods system evolved, it became essentially a gold-exchange standard. The monetary authorities of other countries committed to peg the exchange rate values of their currencies to the U.S. dollar. The U.S. monetary authority committed to buy and sell gold in exchange for dollars with other countries' monetary authorities at a fixed dollar price of gold. c. To a large extent speculation was stabilizing, both for the fixed rates followed by most countries, and for the exchange rate value of the Canadian dollar, which floated during 1950-62. However, the pegged exchange rate values of currencies sometimes did come under speculative pressure. International investors and speculators sometimes believed that they had a one-way speculative bet against currencies that were considered to be "in trouble." If the country did manage to defend the pegged exchange rate value of its currency, the investors betting against the currency would lose little. They stood to gain a lot of profit if the currency was devalued. Furthermore, the large speculative flows against the currency required large interventions to defend the currency's pegged value, so 98

that the government was more likely to run so low on official reserves that it was forced to devalue.

12. a. A number of countries (37 countries at the beginning of 1999) peg their currencies to the U.S. dollar. A number of European countries have fixed their currencies to the new euro (and will replace their national currencies with the euro), and, in addition, a number of other countries peg their currencies to the euro. b. The other major currencies that float independently include (as of the beginning of 1999) the Japanese yen, the British pound, the Canadian dollar, and the Swiss franc. c. The exchange rates between the U.S. dollar and the other major currencies have been floating since the early 1970s. The movements in these rates exhibit trends in the long run-over the entire period since the early 1970s. The rates also show substantial variability or volatility in the short and medium runs-periods of less than one year to periods of several years. The long run trends appear to be reasonably consistent with the economic fundamentals emphasized by purchasing power parity-differences in national inflation rates. The variability or volatility in the short or medium run is controversial. It may simply represent rational responses to the continuing flow of economic and political news that has implications for exchange rate values. The effects on rates can be large and rapid, because overshooting occurs as rates respond to important news. However, some part of the large volatility may also reflect speculative bandwagons that lead to bubbles that subsequently burst.