Chapter 20
Government Policies toward the Foreign Exchange Market
Overview
The first half of this chapter examines types of government policies toward the foreign exchange
market and provides analysis of government intervention and exchange controls. The second half
examines the actual policies that governments have adopted during the past 145 years.
Government policies toward the foreign exchange market exist for a variety of reasons, including
to reduce variability in exchange rates, to keep the exchange value of its currency either high or
low, or to raise national pride in a steady or strong currency. The two major aspects of
government policies toward the foreign exchange market are policies toward the exchange rate
itself and policies that permit or restrict access to the foreign exchange market.
Government-imposed restrictions on the use of the foreign exchange market are called exchange
controls, which may be broad-based or may be applied only to some types of transactions (e.g.,
capital controls).
The basic choice that a government faces with its policy toward the exchange rate itself is
between an exchange rate that is floating and one that is set or fixed by the government. In the
polar case of a clean float the government permits private market demand and supply to set the
exchange rate with no direct involvement by government officials. In a managed float or dirty
float the government officials do intervene at times to try to influence the exchange rate, which
otherwise is driven by private demand and supply.
If the government chooses to impose a fixed exchange rate, there are three additional choices that
the government faces. First, what to fix to? Answers could include gold (or some other
commodity), the U.S. dollar or some other single currency, or a basket of currencies. (With the
exception of the specific examination of the gold standard, subsequent discussion assumes that a
fix is to one or several foreign currencies.) Second, when to change the fixed exchange rate?
Never is a polar case, but it probably is not completely credible (and we often then speak of a
pegged exchange rate instead of a fixed exchange rate). If occasionally, we call the system an
adjustable peg. If often, we have a crawling peg. The choice of when to change the peg is closely
related to how wide is the band around the central or par value chosen for the fix. Third, how to
defend the fixed rate? There are four basic ways—official intervention in which the government
buys and sells currencies; exchange controls, in which the government tries to suppress excess
demand or supply; altering domestic interest rates to influence short-term international capital
flows; and adjusting the country’s macroeconomic position to make it fit the fixed exchange rate.
Of course, the government also has a fifth option—to alter the fixed rate value or shift to a
floating rate.
The first line of defense is often official intervention. If the country’s currency is experiencing
pressure toward depreciation, the country’s monetary authority can defend the fixed rate by
entering the foreign exchange market to buy domestic currency and sell foreign currency. The
intervention is financing the country’s official settlements balance deficit and preventing this
excess private demand for foreign currency from driving the foreign currency’s value above the
top of the band. The monetary authority obtains the foreign currency that it sells into the market
by using its holdings of official reserves or by borrowing foreign currency. In addition, by buying
domestic currency, the monetary authority is removing domestic money from the economy,
which tends to lower the domestic money supply. (Chapter 23 takes up the implications of this
induced change in the domestic money supply.) Analysis of defending against appreciation of the
country’s currency follows similar logic, with “the directions reversed.”
If the imbalance in the country’s official settlements balance is temporary, then official
intervention that smoothes the time path of the exchange rate can enhance the country’s
economic well-being (although stabilizing private speculation could do the same thing without
government intervention). If the disequilibrium is ongoing or fundamental rather than temporary,
then intervention alone is not likely to be able to sustain the fixed exchange rate. Instead, the
government must shift to one of the other defenses or devalue. A key problem here is that it is not
easy for officials to judge whether a payments imbalance is temporary or fundamental.
Exchange controls are used by many countries, especially developing countries. They cause
economic inefficiency analogous to quantitative limits (quotas) on imports. They also incur
substantial administrative costs. Efforts to evade them lead to bribery and parallel markets.
The second half of the chapter surveys exchange rate regimes used during the past 140 years.
During the gold standard era (1870-1914), most countries pegged their currencies to gold, with
each central bank willing to buy and sell gold in exchange for its own currency. This implies that
the exchange rates between currencies are also fixed (within a band resulting from the
transactions costs of moving gold). Britain was at the center of the system. The gold standard
looked successful because it was not subject to severe shocks (until it was suspended during
World War I) and because success was defined leniently, given that governments were not so
concerned with stabilizing their macroeconomies.
The interwar period brought instability. In the years after the World War I Britain made the
mistake of attempting to return to its prewar gold parity. Germany suffered from hyperinflation,
and other European countries also experienced substantial inflation. The early 1930s brought
turbulence that led to the general abandonment of the gold standard. Compared with the gold
standard era, exchange rates were quite variable. Experts at the time concluded that this
experience showed the instability of flexible exchange rates, so that the world should return to
fixed exchange rates. More recent analysis of this period concludes almost the opposite—that it
shows the futility of trying to keep exchange rates fixed in the face of severe shocks and unstable
domestic monetary and fiscal policies. In addition, recent research shows that the workings of
the gold standard contributed to the global spread and the severity of the Great Depression.
A compromise between the United States and Britain led to an agreement in 1944 that
established the Bretton Woods System, a regime of adjustable pegged exchange rates. While this
system looked successful for almost two decades, it also had two defects. One was that it set up
one-way speculative gambles when currencies were in trouble. The second arose from the role of
the U.S. dollar in the system. As the system developed, other countries pegged their currencies to
the dollar, and the U. S. government was committed to buy or sell gold for dollars with other
central banks. Continuing U.S. payments deficits in the 1960s led some other countries to amass
large holdings of U.S. dollar-denominated assets as official reserves. Confidence that the U.S.
government could continue to honor the official gold price dwindled. The U.S. government was
unwilling to contract the U.S. economy to reduce the U.S. payments deficits. Instead, the private
market for gold was freed in 1968. U.S. payments deficits continued. In 1971 the U.S.
government suspended convertibility of dollars into gold and imposed a temporary tariff on all
imports until other countries agreed to revalue their currencies (so that the dollar would be
devalued). The Smithsonian Agreement of December 1971 attempted to reestablish the system
(with many other currencies being revalued), but the pegged rate system was abandoned by the
major countries in 1973.
The box on “The International Monetary Fund,” another in the series on Global Governance,
presents the objectives of the IMF, the multilateral organization created at Bretton Woods in 1944
to oversee the international monetary system. This box also describes the IMF’s activities in
pursuit of orderly foreign exchange arrangements and current account convertibility. (A second
box on the IMF, in the next chapter, examines IMF lending practices.)
The current system is often described as a system of managed floating exchange rates, and the
trend is generally in this direction. But there is also much official resistance to market-driven
exchange rates. Some of the resistance is seen in the active management of floating exchange
rates. More dramatically, the countries of the European Union have attempted to create a zone of
stability in Europe, first by using the snake within the tunnel, then through the Exchange Rate
Mechanism of the European Monetary System, and now with European Monetary Union and the
euro. A goodly number of countries maintain fixed or heavily managed exchange rates. However,
the series of exchange rate crises during the 1990s and early 2000s show how difficult it is for a
government to defend a fixed or a heavily managed exchange rate in the face of wide swings in
speculative international financial flows.
The actual current system is in many ways a nonsystem—countries can choose almost any
exchange rate policies that they want, and there is much variety. Two major blocs of currencies
exist—one is the U.S. dollar and the currencies fixed to it, and the other is the countries adopting
the euro and other currencies fixed to the euro. A growing number of countries have floating
exchange rates for their currencies, with a greater or lesser degree of “management.” Yet other
countries use a fixed exchange rate to another currency, a fixed exchange rate to a basket of
currencies, or a crawling pegged exchange rate. A few countries are “dollarized”—each simply
uses the currency of some other country as its own.
Tips
This is a long chapter. For reading assignments it is possible to split the chapter into two or three
assignments. The first would cover the concepts and analysis of government policies toward the
foreign exchange market (through the section on “Exchange Control”). The second would cover
the evolution of the international monetary system since 1870, and this could be either the rest of
the chapter or all but the last section on the current system. If the latter is used, then a third
reading assignment would cover the current system. The two-assignment approach presumably
would be useful if all of this material is covered in class in the order that it is presented in the
text. The three-assignment approach would be useful, for instance, if the material on the history
of regimes is deferred until later in the course. In this latter approach, it still seems useful to
describe the current system before the material of Chapters 22-25 is covered in the course, but
the sections on regime history would be shifted to later in the course.
Figure 20.9 is a useful summary description of the current system. Although it is based on the
table in the Annual Report on Exchange Arrangements and Exchange Restrictions, we reworked
this information and added other information to create Figure 20.9.
An instructor could decide to combine the box on the IMF in this chapter with the box “Short of
Reserves? Call 1-800-IMF-LOAN” in Chapter 21, for the reading assignment and/or for class
presentation and discussion.