Chapter 10 Outline

The Floating Exchange Rate Regime

The floating exchange rate regime that followed the collapse of the fixed exchange rate system was formalized in January 1976 when IMF members met in Jamaica and agreed to the rules for the international monetary system that are in place today. We will discuss the Jamaica agreement before looking at how the floating exchange rate regime has operated.

The Jamaica Agreement

The Jamaica meeting revised the IMF's Articles of Agreement to reflect the new reality of floating exchange rates. The main elements of the Jamaica agreement include the following:

1. Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange market to even out "unwarranted" speculative fluctuations.

2. Gold was abandoned as a reserve asset. The IMF returned its gold reserves to members at the current market price, placing the proceeds in a trust fund to help poor nations. IMF members were permitted to sell their own gold reserves at the market price.

3. Total annual IMF quotas--the amount member countries contribute to the IMF--were increased to $41 billion. (Since then they have been increased to $195 billion while the membership of the IMF has been expanded to include 182 countries.) Non-oil-exporting, less developed countries were given greater access to IMF funds.

After Jamaica, the IMF continued its role of helping countries cope with macroeconomic and exchange rate problems, albeit within the context of a radically different exchange rate regime.

Exchange Rates since 1973

Since March 1973, exchange rates have become much more volatile and less predictable than they were between 1945 and 1973.⁴ This volatility has been partly due to a number of unexpected shocks to the world monetary system, including:

1. The oil crisis in 1971, when the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of oil. The harmful effect of this on the US inflation rate and trade position resulted in a further decline in the value of the dollar.

2. The loss of confidence in the dollar that followed the rise of US inflation in 1977 and 1978.

3. The oil crisis of 1979, when OPEC once again increased the price of oil dramatically--this time it was doubled.

4. The unexpected rise in the dollar between 1980 and 1985, despite a deteriorating balance-of-payments picture.

5. The rapid fall of the US dollar against the Japanese yen and German deutsche mark between 1985 and 1987, and against the yen between 1993 and 1995.

6. The partial collapse of the European Monetary System in 1992.

7. The 1997 Asian currency crisis, when the Asian currencies of several countries, including South Korea, Indonesia, Malaysia, and Thailand, lost between 50 percent and 80 percent of their value against the US dollar in a few months.

Figure 10.1 summarizes the volatility of four major currencies--the German mark, Japanese yen, British pound, and US dollar--from 1970 to 1998. The Morgan Guaranty Index, the basis for Figure 10.1, represents the exchange rate of each of these currencies against a weighted basket of the currencies of 19 industrial countries (the index was set equal to 100 in 1990). All four currencies have been quite volatile over the period. The index value of the Japanese yen, for example, has ranged from a low of 44 in 1970 to a high of 170 in June 1995. Similarly, the US dollar index has been as low as 89.3 in 1995 and as high as 158 in 1985.

Perhaps the most interesting phenomena in Figure 10.1 are the rapid rise in the value of the dollar between 1980 and 1985 and its subsequent fall between 1985 and 1988, and the similar rise and fall in the value of the Japanese yen between 1990 and 1998. We will briefly discuss the rise and fall of the dollar, since this tells us something about how the international monetary system has operated in recent years. The rise and recent fall of the yen are profiled in the accompanying Country Focus.⁵

The rise in the value of the dollar between 1980 and 1985 is particularly interesting because it occurred when the United States was running a large and growing trade deficit, importing substantially more than it exported. Conventional wisdom would suggest that the increased supply of dollars in the foreign exchange market as a result of the deficit should lead to a reduction in the value of the dollar, but it increased in value. Why? A number of favorable factors temporarily overcame the unfavorable effect of a trade deficit. Strong economic growth in the United States attracted heavy inflows of capital from foreign investors seeking high returns on capital assets. High

Figure 10.1

Long-Term Exchange Rate Trends

Source: JP Morgan, Effective Exchange Rate Index, 1970 - 98. (1990=100.)

real interest rates attracted foreign investors seeking high returns on financial assets. At the same time, political turmoil in other parts of the world, along with relatively slow economic growth in the developed countries of Europe, helped create the view that the United States was a good place to invest. These inflows of capital increased the demand for dollars in the foreign exchange market, which pushed the value of the dollar upward against other currencies.

The fall in the value of the dollar between 1985 and 1988 was caused by a combination of government intervention and market forces. The rise in the dollar, which priced US goods out of foreign markets and made imports relatively cheap, had contributed to a dismal trade picture. In 1985, the United States posted a record-high trade deficit of over $160 billion. This led to growth in demands for protectionism in the United States. In September 1985, the finance ministers and central bank governors of the so-called Group of Five major industrial countries (Great Britain, France, Japan, Germany, and the United States) met at the Plaza Hotel in New York and reached what was later referred to as the Plaza Accord. They announced that it would be desirable for most major currencies to appreciate vis-à-vis the US dollar and pledged to intervene in the foreign exchange markets, selling dollars, to encourage this objective. The dollar had already begun to weaken in the summer of 1985, and this announcement further accelerated the decline.

The dollar continued to decline until early 1987. The governments of the Group of Five even began to worry that the dollar might decline too far, so the finance ministers of the Group of Five met in Paris in February 1987 and reached a new agreement known as the Louvre Accord. They agreed that exchange rates had been realigned sufficiently and pledged to support the stability of exchange rates around their current levels by intervening in the foreign exchange markets when necessary to buy and sell currency. Although the dollar continued to decline for a few months after the Louvre Accord, the rate of decline slowed, and by early 1988 the decline had ended. Except for a brief speculative flurry around the time of the Persian Gulf War in 1991, the dollar has been relatively stable since then against most major currencies with the notable exception of the Japanese yen.

Thus, we see that in recent history the value of the dollar has been determined by both market forces and government intervention. Under a floating exchange rate regime, market forces have produced a volatile dollar exchange rate. Governments have responded by intervening in the market--buying and selling dollars--in attempting to limit the market's volatility and to correct what they see as overvaluation (in 1985) or potential undervaluation (in 1987) of the dollar. The frequency of government intervention in the foreign exchange markets explains why the current system is often referred to as a managed-float system or a dirty float system.