Jared FriedmanDecember 13, 2004Exchange 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$$y desirab$e '&a$ities o! ca#ita$ mobi$ity, !ixed exchange rates, and an inde#endentmonetary #o$icy can ne-er a$$ 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$ity !or the !irst time) /n the years between 114 and 13, ca#ita$ mobi$ity #$&nged wor$dwide, destroyed by the wor$d wars and the reat De#ression, and then restricted by the ca#ita$ contro$s o! the *retton oods !ixed.exchange rate system) +!ter the demise o! the *retton oods go$d.do$$ar system, the rise in the sie and im#ortance o! !inancia$ marets has made restricting ca#ita$ mobi$ity di!!ic&$t, and !ree ca#ita$ exchange has beenthe r&$e 5ob-io&s$y with some exce#tions6) There are th&s two #eriods o! high ca#ita$ mobi$ity, where the choice o! exchange rate system has been $arge$y between !ixed exchange rates and an inde#endent monetary #o$icy 7 the decades be!ore 114, and the decades a!ter 13) This #a#er examines the moti-ations !or exchange rate system choices in these time #eriods)First, it is he$#!&$ to consider in the abstract what maes each %&nde$$.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$$ see, the e!!ects a co&ntry saw as most im#ortant, and th&s which c&rrency o#tion it chose to ado#t, changed considerab$y across the two time #eriods)/n the decades be!ore 114, there were essentia$$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 $ess ind&stria$ied, #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#);, ##)11.1)2

 

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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