International Monetary Relations — 2: The Turbulent Float
After the final collapse of the Bretton Woods system in 1973, the exchange rates of the major countries of the world floated relatively freely against each other. In Section 1, we recount the disturbed record of this float. Prior to 1973, it had been expected that the nominal exchange rate would respond quite sensitively to nominal (relative price) shocks, leaving the real exchange rate more stable than under the previous adjustable peg system. Those hopes were dashed. Real exchange rates fluctuated widely and over long periods, causing major misalignments which had severe adverse effects on tradeable goods sectors and national and world economies.
We turn next in Section 2 to the not-very-successful attempts of economists to model these developments. Much of the volatility of exchange rates appeared to spring from massive capital movements. In line with this, exchange rate models shifted from Keynesian-type flow models, emphasising current account adjustments, to more monetarist stock-adjustment models, emphasising capital flows to restore asset equilibrium. The simple monetary-approach-to-the-balance-of-payments models, assuming instantaneous Purchasing Power Parity (PPP), could not, however, account for ‘overshooting’. The development by Dornbusch of ‘sticky-price’ versions of the monetary-approach models could explain overshooting. But there were several aspects of forex market developments (e.g., the behaviour of forward rates) that the Dornbusch model could not explain. More complex portfolio balance models proved little better able to explain these facts. Some recent theories have suggested that the interplay between speculators using different analytical approaches (e.g., fundamental analysis vs Chartism) may help to explain events, but this last approach is in its infancy.
Given the discomforts of the floating exchange rate system, it was inevitable that commentators would see some advantages in returning to a more managed regime. Recent efforts in that direction are surveyed in Section 3. Particularly with the intervention reserve funds available to Central Banks being dwarfed by the size of potential capital flows, the achievement of greater exchange rate stability requires n − 1 countries in an n country exchange rate system to predicate their monetary policy primarily to that end, thereby giving up at least some domestic autonomy. The European Monetary System has been the foremost regional system of adjustable pegged exchange rates and we examine the various reasons advanced to explain its comparative success. In the early 1980s, American and English politicians tended to doubt the wisdom of co-operative official intervention. Even since opinions changed around 1985, attempts to establish a basis for international monetary co-operation have not gotten far or achieved much. There has been too much national political discordance owing to differences in national perceptions and preferences. The prospects for improved international co-operation in the future are not bright.
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