Jared Friedman

December 13, 2004

Exchange Rate Systems in Two eriods o! "a#ita$ %obi$ity
"hoosing an exchange rate system is &n'&estionab$y among a co&ntry(s more
im#ortant #o$icy decisions) The choice o! exchange rate system has direct e!!ects on
exchange rates, interest rates, and in!$ation) *&t the choice is a$so o!ten di!!ic&$t, as each
c&rrency o#tion has distinct costs and bene!its which can be 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) The genera$ #re-a$ence o! the !irst
o! these conditions, ca#ita$ 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$ mar,ets had not yet de-e$o#ed) /n the $ate nineteenth and ear$y twentieth
cent&ries, internationa$ !inance and the g$oba$ economy ca&sed signi!icant ca#ita$
mobi$ity !or the !irst time) /n the years between 1014 and 1013, ca#ita$ mobi$ity #$&nged
wor$dwide, destroyed by the wor$d wars and the 2reat De#ression, and then restricted by
the ca#ita$ contro$s o! the *retton 3oods !ixed.exchange rate system) +!ter the demise
o! the *retton 3oods go$d.do$$ar system, the rise in the si4e and im#ortance o! !inancia$
mar,ets has made restricting ca#ita$ mobi$ity di!!ic&$t, and !ree ca#ita$ exchange has been
the r&$e 5ob-io&s$y with some exce#tions6) There are th&s two #eriods o! high ca#ita$
mobi$ity, where the choice o! exchange rate system has been $arge$y between !ixed
exchange rates and an inde#endent monetary #o$icy 7 the decades be!ore 1014, and the
decades a!ter 1013) This #a#er examines the moti-ations !or exchange rate system
choices in these time #eriods)
First, it is he$#!&$ to consider in the abstract what ma,es each %&nde$$.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 de!icits) Fixed exchange rates
genera$$y increase internationa$ trade and #artic&$ar$y internationa$ in-estment by
red&cing the ris, o! c&rrency !$&ct&ation in those transactions) Fixed exchange rates a$so
o!ten red&ce the ris, o! in!$ation and genera$$y increase the stabi$ity o! the money s&##$y)
+n inde#endent monetary #o$icy a$$ows co&nter.cyc$ica$ management o! the economy,
and wi$$ a$so a$$ow some contro$ o! exchange rates i! &sed in a system witho&t !ixed rates)
These basic e!!ects were e'&a$$y tr&e in both time #eriods) 8owe-er, as we sha$$ see, the
e!!ects a co&ntry saw as most im#ortant, and th&s which c&rrency o#tion it chose to
ado#t, changed considerab$y across the two time #eriods)
/n the decades be!ore 1014, there were essentia$$y three choices !or exchange rate
systems9 the go$d standard, a !ree.!$oating c&rrency, or a si$-er.bac,ed c&rrency) The
#attern !or which co&ntries chose which was c$ear9 the ind&stria$ co&ntries were
in-ariab$y on the go$d standard, and $ess ind&stria$i4ed, #rimary #rod&ct ex#orting
co&ntries were either !ree.!$oating or si$-er.bac,ed)
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/t might initia$$y seem that both
go$d and si$-er bac,ed c&rrencies re#resent a choice o! !ixed exchange rates, and !ree
!$oating c&rrencies re#resent a choice o! monetary inde#endence) This is tr&e to some
degree, b&t si$-er.bac,ed c&rrencies are #robab$y better c$assi!ied as a choice o!
inde#endent monetary #o$icy o-er !ixed exchange rates) :ne reason !or this is that
si$-er.bac,ed c&rrencies were '&ite sma$$ in tota$ monetary -a$&e -ers&s go$d.bac,ed
c&rrencies, ma,ing 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$i,e with the go$d standard, i! 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.bac,ed
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)
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The section on this time #eriod draws most$y !rom Frieden, The Modern World Economy 1896-200. cha#)
;, ##)11.10)
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Th&s, the ind&stria$ co&ntries were essentia$$y choosing !ixed exchange rates o-er
an inde#endent monetary #o$icy, and the de-e$o#ing co&ntries were choosing the abi$ity
to de-a$&e their c&rrencies o-er !ixed exchange rates) The reasons !or this s#$it ha-e to
do with the re$ati-e bene!its !or di!!erent co&ntries o! being ab$e to &se com#etiti-e
de-a$&ation to increase their ex#orts -ers&s ha-ing the #ri-i$eged access to wor$d
!inancia$ mar,ets that came with adherence to the go$d standard) /t is not hard to see that
wea$thy ind&stria$ co&ntries with acti-e internationa$ !inancia$ mar,ets wo&$d bene!it
more !rom this #ri-i$eged access to ca#ita$ than agrarian co&ntries with no s&ch mar,ets,
and a$so that the s#ecia$ interests !rom !inanciers and #otentia$ borrowers o! ca#ita$ to
,ee# that #ri-i$eged stat&s wo&$d be m&ch stronger in the ind&stria$ co&ntries) 8owe-er,
the reasons that ex#orters o! #rimary #rod&cts wo&$d want to de-a$&e their c&rrencies
more than ex#orters o! ind&stria$ #rod&cts wo&$d are somewhat more s&bt$e)
:ne ,ey di!!erence is the o!ten.mentioned -o$ati$ity o! #rimary #rod&ct #rices)
"om#etiti-e de-a$&ations are e!!ecti-e on$y in the short r&n, as e-ent&a$$y the higher
#rices o! !oreign goods wi$$ ca&se in!$ation e'&i-a$ent to the de-a$&ation, o!!setting its
initia$ e!!ects) Th&s com#etiti-e de-a$&ations can be high$y e!!ecti-e !or #rimary #rod&ct
#rod&cers, great$y red&cing the negati-e e!!ects o! a s&dden dro# in #rices, b&t !or
ind&stria$ goods #rod&cers, there are !ewer s&dden shoc,s ca&sing -oters to cry !or
com#etiti-e de-a$&ation, and it is di!!ic&$t to bring an &ncom#etiti-e ind&stry to
com#etiti-e $e-e$s in the $ong r&n sim#$y by re-a$&ing c&rrencies witho&t ca#ita$ contro$s)
+$so, the o$igo#o$istic nat&re o! mar,ets !or ind&stria$ goods made them inherent$y $ess
com#etiti-e and th&s $ess sensiti-e to sma$$ #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$$y
against go$d< :ne, s&ch dec$ines, #ossib$y !ixed by occasiona$ inter-entions in the
s&##osed$y !ixed rate, co&$d o!!set the shoc,s as described abo-e) *&t it is a$so tr&e that
!arm #rices in genera$ were contin&a$$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 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, s&ch a de-a$&ation wo&$d on$y ha##en i! a $arge
n&mber o! goods were im#acted sim&$taneo&s$y) + third reason is that all the ind&stria$
co&ntries were on the go$d standard, so that the #rices o! ind&stria$ goods rose and !e$$
sim&$taneo&s$y with no co&ntry ha-ing a com#etiti-e ad-antage) Since most #rimary
#rod&ct #rod&cers were not on the go$d standard, any s&ch #rod&cer on the go$d standard
wo&$d '&ic,$y be #&t o&t o! b&siness when the c&rrencies o! its com#etitors de-a$&ed
against go$d)
E-idence and exam#$es !or this theory abo&nd) 3hen the #rice o! co##er in "hi$e
!e$$ !rom 10 to 40 #o&nds ster$ing, the #ercentage #rice change was #recise$y the same in
a$$ the co&ntries on go$d) *&t the "hi$ean go-ernment de-a$&ed the #eso against the go$d
c&rrencies !rom )1> to )10 #o&nds ster$ing, ca&sing the #rice o! co##er to remain a$most
exact$y the same) Simi$ar$y, when wor$d wheat #rices dro##ed by ha$! in the $ate
nineteenth cent&ry, +rgentina dro##ed the go$d standard in order to de-a$&e the #eso to
,ee# $oca$ wheat #rices steady, which it did) Since co##er and wheat were enormo&s$y
im#ortant com#onents o! the economies o! "hi$e and +rgentina res#ecti-e$y, it seems
$i,e$y that there was in !act a ca&sa$ re$ationshi# between the #rice dec$ines and the
monetary res#onse) The di!!erence o! o#inion between ind&stria$ists and !armers was
#artic&$ar$y star, in +merica, which was &n&s&a$ in ha-ing both $arge man&!act&ring and
$arge agric&$t&ra$ sectors) /n +merica, the o#&$ist anti.go$d mo-ement, encom#assing
basica$$y the !armers and miners in the so&th and the %idwest, was bro&ght into -io$ent
con!$ict with the #ro.go$d ind&stria$i4ed northeast and west, ma,ing go$d the #rimary
iss&e o! the 1>0? #residentia$ cam#aign)
*&t the %&nde$$.F$eming choice o! monetary inde#endence -ers&s !ixed
exchange rates was not the on$y exchange rate system choice !aced by these co&ntries)
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3hy did some co&ntries choose to !ix to si$-er and others to !$oat< +nd why did the
co&ntries choose to !ix c&rrencies to go$d, as o##osed to creating a sing$e c&rrency as is
m&ch more common now< The answer to the !irst '&estion is that the decision was based
$arge$y on tradition) "hina and /ndia had &sed si$-er !or ages, and they sim#$y ,e#t it)
%exico(s decision to stic, to the si$-er standard, tho&gh, was #robab$y based more on the
!act that it was a ma=or si$-er #rod&cer) The answer to the second '&estion is
com#$icated, and not entire$y re$e-ant to the to#ic at hand, b&t the answer $ies in se-era$
!actors) First, there was tradition, as go$d had been &sed as c&rrency !or most o! history)
There was a$so a !ear o! in!$ation and a genera$ $ac, o! con!idence in the abi$ity o!
go-ernments to maintain the -a$&e o! !$oating c&rrencies) erha#s most im#ortant$y, the
$ac, o! internationa$ #o$itica$ organi4ation made the go$d standard, which re'&ired no
internationa$ centra$ ban,, m&ch easier to im#$ement than a new c&rrency)
The a##arent c&rrency o#tions d&ring the #eriod a!ter 1013 were '&ite di!!erent
!rom those d&ring the #re.1014 #eriod) @irt&a$$y a$$ co&ntries chose to !$oat 5e)g),
+merica, Ja#an 5most$y66, to #eg or !ix their c&rrency to another one 5+rgentina, 8ong
Aong, etc)6, to create a new internationa$ c&rrency 5E&ro$and6, or to do$$ari4e 5+rgentina,
%exico, er&, etc,6) 8owe-er, when -iewed in terms o! the %&nde$$.F$eming conditions,
the o#tions were not rea$$y so di!!erent) +$$ o! these choices ty#ica$$y went with high
ca#ita$ mobi$ity, so the choice was rea$$y between the monetary inde#endence o! the !irst
o#tion and the !ixed exchange rates o! the other three o#tions) The e!!ects o! each o!
these o#tions were a$so simi$ar to what they were in the #re.1014 #eriod) 8owe-er, the
costs and bene!its o! each o! these e!!ects had changed dramatica$$y in the inter-ening
years, and so co&ntries made di!!erent choices !rom the ones they made be!ore 1014)
Boo,ing at which co&ntries chose to !$oat and which to !ix a!ter 1013, it is c$ear
that the economic si4e o! the co&ntry corre$ates strong$y with this decision) Barger
co&ntries are m&ch more $i,e$y to choose !$oating rates, and one ex#$anation !or this is
that c&rrencies are goods with economies o! sca$e)
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3hy sho&$d a c&rrency ha-e
economies o! sca$e< There are se-era$ reasons) First, sma$$ c&rrencies tend to be treated
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+$esina, *arro, et a$)), Optimal Currency Area. Cationa$ *&rea& o! Economic Research, wor,ing #a#er
0012! 4
;
as higher ris,, th&s mistr&sted by internationa$ !inance, based on #re-io&s ex#erience)
+$so, since $arge c&rrencies are he$d as reser-e c&rrencies, &sing a $arge c&rrency means
that a co&ntry can borrow money in its own c&rrency, great$y red&cing the rea$ #rice o!
so-ereign debt) The -a$&e o! sma$$er c&rrencies is contro$$ed by a sma$$er tota$ -o$&me o!
exchange, $eading to greater -o$ati$ity) +nd sma$$er c&rrencies tend to be s&##orted by
sma$$er and $ess e!!icient centra$ ban,s) + di!!erent reason why $arger co&ntries sho&$d
be more $i,e$y to choose !$oating rates is that sma$$er co&ntries are $ess se$!.s&!!icient
than $arger co&ntries and there!ore trade moreD th&s, the decreased transactions costs in
trading that come with !ixed c&rrencies are more im#ortant to sma$$ co&ntries)
+rmed with this &nderstanding o! the e!!ects o! the %&nde$$.F$eming conditions
and how they re$ate to a co&ntry(s si4e, we can readi$y ex#$ain most o! the exchange rate
system choices in this #eriod) :ne o! the most dramatic c&rrency e-ents in this #eriod,
indeed in the who$e cent&ry, was the ado#tion o! the E&ro) *&t the e&ro ma,es a great
dea$ o! sense9 it is a c&rrency &nion o! a n&mber o! re$ati-e$y sma$$ co&ntries that e-en
be!ore its ado#tion were high$y integrated in trading #atterns
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) 8ere the bene!its o! !ixed
exchange rates on trade, combined with the economies o! sca$e !or a c&rrency, were most
im#ortant) The do$$ari4ation and do$$ar #egs common in Batin +merica can be ex#$ained
!or a di!!erent reason) Trade is &ndo&bted$y im#ortant here too, b&t more im#ortant are
#robab$y the stabi$ity #ro-ided by &sing the do$$ar instead o! an in!$ation.#rone nationa$
c&rrency and the abi$ity to mani#&$ate exchange rates by changing the #eg) En$i,e in the
#re 1014 #eriod, Batin +merican co&ntries ha-e &s&a$$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)
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Bi,ewise, the 8ong Aong Do$$ar(s do$$ar #eg
was instit&ted to maintain monetary stabi$ity) *y contrast, we can see why the do$$ar, the
e&ro, and the yen ha-e remained inde#endent and !$oating against each other9 these
c&rrencies are $arge eno&gh to en=oy most o! the economies o! sca$e, they can easi$y
borrow money, and their centra$ ban,s #&rs&e di!!erent eno&gh #o$icies that combining
them wo&$d be a signi!icant cost)
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Frieden, cha#) 1?, #) 33
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"arodo, E$iana, et a$), "atin America# Economy! $i%erity& Trend and Con'lict. >0
?
:! co&rse, as in the #eriod be!ore 1014, co&ntries a!ter 1013 ha-e !aced not on$y
the genera$ %&nde$$.F$eming trade.o!!s b&t a$so more 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$$ari4e 5to the extent this is a choice o! the go-ernment6,
or to !orm a new c&rrency) :ne interesting '&estion is why the e&ro is &ni'&e as the on$y
$arge.sca$e c&rrency &nion in this time #eriod) This is '&ite sim#$y beca&se there is no
other gro&# o! nations simi$ar to the E&ro#ean ones 7 no other gro&# o! co&ntries with
re$ati-e$y sma$$, tight$y integrated economies that together !orm a $arge economic b$oc,,
and a $ac, o! strong #o$itica$ 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 $i,e$y be too sma$$ a &nion to rea$i4e economies o! sca$e, and it might we$$
be dominated #o$itica$$y by *ra4i$)
;
Th&s, other nations that ha-e wanted to !ix rates
ha-e !ixed to other c&rrencies, and most ha-e chosen the do$$ar beca&se it has been the
#redominant c&rrency !or many decades)
"ertain as#ects o! exchange rate choices are di!!ic&$t to com#are across the two
time #eriods) Do$$ari4ation, !or instance, has no ob-io&s e'&i-a$ent in the #re.1014 time
#eriod) 8owe-er, one as#ect that can be readi$y com#ared is the choice between the two
com#eting %&nde$$.F$eming conditions9 !ixed exchange rates and monetary
inde#endence) /n the #re.1014 #eriod, this choice was #rimari$y determined by the
ind&stria$i4ation o! a co&ntry 7 more ind&stria$ co&ntries chose !ixed rates) /n the #ost.
1013 #eriod, this choice was #rimari$y determined by a co&ntry(s economic si4e 7
sma$$er co&ntries chose !ixed rates) 3hy this dramatic change< :ne, #rimary #rod&cts
are m&ch $ess im#ortant in today(s economy, and so the moti-e o! &sing the exchange
rate as a too$ to o!!set changes in those #rices is m&ch $ess #otent) Two, co&ntries ha-e
rea$i4ed o-er time the economies o! sca$e in c&rrencies, and sma$$ co&ntries now
genera$$y ado#t $arger c&rrencies in order to maintain stabi$ity and attract in-estment)
Fina$$y, the three #rimary c&rrencies are now so $arge that the ind&stria$ economies
rea$i4e m&ch o! the bene!it o! ha-ing a sing$e c&rrency 5as in the go$d.standard6 by
instead ha-ing three s&#er.c&rrencies) 3hi$e the %&nde$$.F$eming conditions and their
;
%&nde$$, Robert) Currency Area& E(chan)e *ate +ytem and ,nternational Monetary *e'orm) Jo&rna$
o! +##$ied Economics, @o$) /// 5200069 234
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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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