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

do their own thing. But instead of changing policies to stay with the Bretton
Woods system, the major countries simply dropped the system.
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. 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.
Implementing target zones on a wider scale would be all the more difficult.
Differences in preferences, policy objectives, and economic structures account
in part for these difficulties. More fundamentally, however, coordination of
macroeconomic policies will not necessarily benefit all participant countries
equally, and those that benefit the most may not be willing to compensate
those that benefit least. In the EMS, Germany is less inflation-prone than the
other members and is reluctant to cooperate at the risk of increasing its
inflation rate.
Another lesson is that in target-zone arrangements such as the EMS, a
disproportionately large share of the adjustment burden will fall on the "weak"
currency countries. Countries with appreciating currencies, trade surpluses,
and increasing reserves are less prone to adjust than countries with
depreciating currencies, trade deficits, or reserve losses. The convergence of
inflation rates among the EMS countries supports this view. An equal sharing
of the adjustment burden implies that inflation rates among member nations
would converge to the average rate.
Germany, however, 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. Because of Germany's economic importance,
the other member countries have had to adjust their domestic policies or their
exchange rates to remain competitive in international markets. As a result,
inflation rates have tended to converge toward Germany's lower rate.