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International Finance. Tutorial 5.

Qs 5
1. The experiences of fixed exchange-rate system and target zone arrangement
have not been entirely satisfactory
a) What lessons can economists draw from the breakdown of the Bretton
Woods System?
Adjusting monetary growth rates is the principal way to stabilize exchange
rates. (eg: raising the value of the $ relative to the ¥ requires tightening U.S.
monetary policy relative to Japanese monetary policy.)
The experience of Bretton Woods and similar experiments demonstrates
conscious and explicit coordination of monetary policies among sovereign
authorities is difficult. The problem stems from the inability of sovereign
authorities to coordinate their monetary growth rates. An agreement to
stabilize the $ at, say, 150 ¥ would be relatively easy if it did not entail
interdependent monetary policies, robbing the Federal Reserve, or the Bank of
Japan, or both, of important degrees of monetary freedom.
Both Japan and the United States have their own targets for growth and
inflation and their own independent assessment of the macroeconomic policies
required to attain those targets.
Except by coincidence, independent policies and preferences will not mesh at
a stable exchange rate. Given clashing preferences, the only alternatives to the
"chaos" of floating are:
(1) One side persuades the other to change its policies;
(2) One side subordinates its policies to those of the other; or
(3) Both sides subordinate their monetary policies to an external mechanism,
such as a gold standard.
Absent (3), "international monetary reform" is the search for new ways to
implement (1) or (2), or some combination. We saw that Bretton Woods
collapsed because the subordination it entailed was intolerable to the United
State. That is, the United States refused to follow economic policies that
would maintain the value of gold at $35 an ounce.
The basic lesson from Bretton Woods, therefore, is that stabilizing exchange
rates requires dependence and subordination, not the freedom for everybody to

policy objectives. and increasing reserves are less prone to adjust than countries with depreciating currencies. But instead of changing policies to stay with the Bretton Woods system. the other member countries have had to adjust their domestic policies or their exchange rates to remain competitive in international markets. coordination of macroeconomic policies will not necessarily benefit all participant countries equally. Implementing target zones on a wider scale would be all the more difficult. The convergence of inflation rates among the EMS countries supports this view. Another lesson is that in target-zone arrangements such as the EMS. b) What lessons can economists draw from the exchange rate experiences of the European Monetary System? Exchange rate stability requires that monetary policies be coordinated and geared towards maintaining exchange rate parities. inflation rates have tended to converge toward Germany's lower rate.do their own thing. . trade surpluses. and those that benefit the most may not be willing to compensate those that benefit least. The slow progress of the European community with respect to the EMS and policy coordination exemplifies the difficulties of achieving agreements on the many facets of economic policymaking. As a result. or reserve losses. Countries with appreciating currencies. a disproportionately large share of the adjustment burden will fall on the "weak" currency countries. In the EMS. More fundamentally. Differences in preferences. Germany. An equal sharing of the adjustment burden implies that inflation rates among member nations would converge to the average rate. and economic structures account in part for these difficulties. however. Because of Germany's economic importance. however. Germany is less inflation-prone than the other members and is reluctant to cooperate at the risk of increasing its inflation rate. has maintained a domestic monetary target of low or zero inflation. and often has refused to alter domestic monetary policy because of exchange rate considerations. the major countries simply dropped the system. trade deficits.