II The Current Exchange Rate Regime he current exchange rate system came about especially between the three major currencies, Tas a result of the collapse of the Bretton which has continued to the present. One charac- Woods system of fixed but adjustable exchange teristic of the current system is that countries are rates.6 Under the Bretton Woods system, countries free to choose their own bilateral exchange rate generally pegged their exchange rates within nar- relationships. This was codified in the Second row margins (plus or minus 1 percent) against the Amendment to the Articles of Agreement of the U.S. dollar, while the value of the U.S. dollar was IMF, as stated in Section 2(b) of Article IV: fixed in terms of gold. Exchange rates were main- Under an international monetary system of the tained near their pegs by using official reserve kind prevailing on January 1, 1976, exchange assets in exchange market intervention and by arrangements may include (i) the maintenance by a influencing private capital flows through both member of a value for its currency in terms of the changes in domestic policies and outright controls special drawing right or another denominator, other on capital movements. Changes in the pegs were than gold, selected by the member, or (ii) coopera- subject to international surveillance by the IMF tive arrangements by which members maintain the and permitted only under conditions of "funda- value of their currencies in relation to the value of mental disequilibrium." This system, which was ini- the currency or currencies of other members, or (iii) tiated at the Bretton Woods conference in 1944, other exchange arrangements of a member's choice. served the world quite well through the early 1960s, as it provided agreed rules of conduct that were The choice of exchange rate regime reflects to a widely shared and thereby imparted a stability to considerable extent individual countries' assessments of the benefits and costs of a fixed or flexible the postwar trading system that was notably absent 8 in the 1930s. However, the underlying tensions in exchange rate. The benefits that can stem from a the system became evident during the late 1960s. fixed but adjustable exchange rate regime typically This tension reflected a number of factors, includ- include enhanced trading and investing opportunities ing the expansionary nature of U.S. macro- with the other countries within the arrangement, economic policy, the increase in the resources owing to reduced uncertainty, and the stability that a available to private capital markets in relation to nominal anchor in the form of a pegged rate can official reserve holdings, and divergences in policy provide for monetary policy and inflation expecta- objectives among some of the major participants in tions. The main cost of such an arrangement is the the system.7 Despite attempts to maintain the sys- loss of flexibility in orienting policies toward achiev- tem in the early 1970s, agreed parities between the ing domestic rather than exchange rate objectives. currencies of the major industrial countries were While these costs may be relatively small if the coun- finally abandoned in early 1973. try in question experiences underlying disturbances similar to those in countries against which it is fixing its exchange rate, they are likely to increase substan- Characteristics of the Current tially in the face of shocks that impinge only on its Exchange Rate Regime economy, although such disturbances can be dealt with by changes in the parity. These considerations, The Bretton Woods system was replaced by an which predict that fixed exchange rates are more exchange rate system of managed floating, likely to develop in regions of the world with close economic ties and similar disturbances, form the basis 6The papers in Bordo and Eichengreen (1993) provide a detailed discussion of many aspects of the Bretton Woods 8There are some limits on the options available. In particular, system. as each of the three largest countries allows its exchange rate to 7Garber (1993) and Solomon (1982) discuss the factors that float against the others', smaller countries do not have the led to the breakup of the Bretton Woods system. option of participating in a global system of pegged rates. 4 ©International Monetary Fund. Not for Redistribution Characteristics of the Current Exchange Rate Regime of the literature on optimum currency areas.9 As rate system. In the early 1980s, however, the focus countries face different economic circumstances, the switched to controlling inflation, with realignments result is a mixed international monetary system in becoming less frequent and smaller than the per- which some countries allow their exchange rates to sistence of underlying inflation differentials would float relatively freely while others fix the value of have warranted.11 Most recently, the ERM has their currency against another currency or basket of been seen as an essential part of the movement currencies. toward economic integration of the EU. Member- The defining characteristic of the present system, ship in the ERM is one of the explicit conditions however, is the existence of floating exchange rates for entry into the European Monetary Union writ- between the world's three most important curren- ten into the Treaty on European Union, which was cies. While the external values of their currencies signed in February 1992. are not a matter of indifference to these countries, as Until the period of sustained market pressures shown by the Plaza Agreement of 1985 and the starting in September 1992, the ERM had worked Louvre Accord of 1987, significant fluctuations in well in successfully reducing exchange rate vol- the relative values of the dollar, yen, and deutsche atility between members, providing a useful nomi- mark have occurred throughout the floating nal anchor for high-inflation countries, and exchange rate period. Clearly, the three largest encouraging economic integration. In particular, industrial countries have not felt a strong need to 10 between early 1987 and early 1992, the ERM stabilize their bilateral exchange rates. In particu- became both more anchored and more broadly lar, they make no consistent or determined effort to based, in that there were no changes in parities and manipulate domestic economic policies with the a number of new currencies either joined the ERM intent of constraining exchange rates within rela- itself (the pound sterling, peseta, and escudo all tively narrow limits. joined in 1990) or, in the case of the currencies of Several smaller industrial countries also have the Nordic countries, were unilaterally pegged floating exchange rates, most notably Australia, against the European Currency Unit (ECU). How- Canada, New Zealand, and Switzerland. In the ever, the ERM came under sustained market pres- aftermath of the European exchange rate crises of sures starting in mid-1992, as cyclical divergences, 1992-93, Finland, Italy, Norway, Sweden, and the caused in part by the macroeconomic conse- United Kingdom have also adopted this arrange- quences of German reunification, led to conflicts ment. This decision does not imply that the level of the exchange rate is unimportant for these countries. between the domestic and external requirements In Canada, for example, the level of the exchange for monetary policy in both Germany and the other rate is clearly perceived as a key macroeconomic member countries of the ERM. These pressures led variable. Official intervention is used to moderate Italy and the United Kingdom to suspend their exchange rate movements ("leaning against the ERM membership; Finland, Norway, and Sweden wind"), and the authorities take into account to abandon their pegs to the ECU; and Spain and exchange rate movements in formulating and imple- Portugal to devalue their parities. Continuing spec- menting monetary policy. However, while the ulative pressures in the summer of 1993 led to a behavior of the exchange rate may at times affect widening of the intervention bands to their current decisions regarding domestic policies, economic pol- values of 15 percent (except for the rate of the icy is not explicitly geared toward maintaining a par- Netherlands guilder against the deutsche mark). ticular value or range of values for the currency. The Exchange arrangements in developing countries same approach generally applies to other countries are also varied. In addition to the considerations with floating exchange rates. already discussed in relation to industrial countries, The most important regional arrangement for developing countries must also take into account limiting exchange rate fluctuations is the ERM. large terms of trade shocks and thin underlying When instituted in 1979, the ERM was seen largely financial markets in choosing the appropriate as a method of reducing the volatility in exchange exchange rate regime. As can be seen from Table 1, rates between European currencies following the about 55 percent of developing countries, including breakdown of the Bretton Woods fixed exchange many smaller countries, pegged the value of their currencies to the currencies of other countries or 9This literature was initiated by Mundell (1961). Taken liter- baskets of other currencies in 1992—an arrange- ally, the literature refers to the option of permanently fixing ment that provides a nominal anchor for the con- exchange rates through a common currency. However, most of duct of monetary policy. Meanwhile, the remaining the arguments are also relevant for the choice between fixed but adjustable and floating exchange rates. See Goldstein and oth- ers (1992) and Tavlas (1993) for surveys of the literature. 10See Goldstein and others (1992) for further discussion of 11Ungerer and others (1986,1990) discuss the ERM in consid- this point. erable detail. 5 ©International Monetary Fund. Not for Redistribution II THE CURRENT EXCHANGE RATE REGIME Chart I. Major Industrial Countries: Nominal and Real Effective Exchange Rates, January 1973-June 1994 (1985 = 100; logarithmic scale)) 6 ©International Monetary Fund.