inflation under fixed and flexible exchange rates - imf elibrary

Inflation Under Fixed andFlexible Exchange Rates

ANDREW D. CROCKETT and MORRIS GOLDSTEIN *

T HIS PAPER is CONCERNED with the generation, transmission, andcontrol of inflation under, alternatively, fixed and floating exchange

rate regimes. More specifically, its primary purpose is to set out and toevaluate the main arguments that have been advanced to support theproposition that flexible exchange rates are more (less) inflationary thanfixed exchange rates.

The issue of the relative merits 'of fixed and flexible exchange rates,of course, is an old and much-discussed one. The classic contributionson the subject (e.g., Friedman (1953), Meade (1955), Caves (1963),and Johnson (1973)), however, were written before the recent experi-ence with generalized floating, and most are concerned primarily withthe role of the exchange rate regime in the adjustment process, ratherthan with its impact on inflation per se. In present circumstances, whenhigh rates of inflation are coexisting with a more flexible exchange ratesystem than at any time since the 1930s, the interrelationship betweenthese two phenomena takes on increased policy interest.

A second, and perhaps more fundamental, reason for re-examiningthis issue is that earlier writing on the subject has, in our view, oftenfailed to draw certain distinctions about the different kinds of priceeffects that could be generated under one exchange rate system as com-pared with another. In particular, we think it important to distinguishbetween: (i) effects on a single country's inflation rate and effects on theworld inflation rate; (ii) effects on the mean rate of world inflation andeffects on the dispersion of world inflation, either across countries orover time; and (iii) effects on the inflation rate that are, more or less,welfare neutral and those effects that are not. This is not to say that all

* Mr. Crockett, Chief of the Special Studies Division of the Research Depart-ment, is a graduate of the University of Cambridge and of Yale University.

Mr. Goldstein, economist in the Special Studies Division, is a graduate ofRutgers University and of New York University. He was formerly a ResearchFellow in Economics at the Brookings Institution.

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arguments or hypotheses about inflation and exchange rate systems canbe neatly placed or classified according to these distinctions, but ratherto suggest that these distinctions may at least guard against some unnec-essary ambiguity in the analysis.

At the outset, it should be stated that our concern in this paper ismore with the impact of the exchange rate system on the generation ofworld inflation than on its role in the transmission of inflation from onecountry to another.1 We accept the widely held view that the nature ofthe exchange rate regime will have a significant impact on the way inwhich inflationary disturbances in any one country are shared through-out the constituent parts of the world economy. We refer here to thegeneral property of flexible rates to "bottle up" inflationary disturbancesin the country of origin vis-à-vis the "sharing" of inflation under fixedrates.2 Thus, it seems clear that the choice between fixed and flexiblerates can, and undoubtedly will, have an effect on the actual rate of infla-tion experienced in individual countries. It is when one turns to thequestion of how the exchange rate regime affects the average level ofworld inflation that definite conclusions are more difficult to establish.Here, the fact that one exchange rate system tends to spread inflationarydisturbances around, while another does not, becomes less importantunless one has strong presumptions both about where the disturbancesare most likely to originate and about how "sending" and "receiving"countries differ with regard to cyclical positions, structural character-istics, efficiency of stabilization policies, etc. In our view, such presump-tions are difficult to justify and, for the purposes of this paper, we shallregard the more mechanical aspects of the transmission issue as beingessentially neutral with respect to the world inflation rate.

The plan of the paper is as follows: Section I discusses possiblesystematic effects of a change in the exchange rate regime on the pricelevel. More specifically, we examine the propositions that flexibleexchange rates will increase the world price level both by increasingthe costs of production (owing to the higher cost of foreign exchangeinsurance) and by reducing either the officiai or private (world) demandfor money (which in turn is presumed to lead to an excess demand forgoods). Factors affecting simply the level of prices do not, of course,have a lasting effect on inflation rates. But if the speed of adjustment toa new equilibrium price level is other than very rapid, then for thepolicymaker's relevant time horizon, the consequences of these factors

1 For a good treatment of the transmission mechanism, see Swoboda (1974) andSweeney and Willett (1974).

2 This is not to say that flexible rates will insulate a country from all types ofexternal disturbance; see, for example, Cooper (1976).


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may be quite similar to those that lead to a change in the rate of infla-tion; for this reason, they are worth looking at. Section II considersvarious arguments as to how the exchange rate regime might affect infla-tion rates by affecting either governments' policy preferences in thedemand management area or the locus of attainable policy objectives 3

(as represented, say, by governments' perceptions of their Phillips curves).4

In particular, attention is focused on the "reserve discipline" argumentand on several "ratchet-effect" arguments—most of which are usuallyassociated with support for fixed exchange rates. Finally, Section IIIattempts to pull together some conclusions and to consider some of thewelfare implications of choosing one exchange regime rather thananother on the basis of expected anti-inflationary behavior.

Before proceeding to the analysis itself, it is perhaps necessary to saya few words about how "fixed" and "flexible" exchange rates are to beinterpreted in what follows. In much theoretical analysis where the pur-pose was to compare and contrast the properties of fixed and flexiblerates, the usual practice has been to define or interpret fixed and flexiblerates in their pure form (e.g., see Mundell (1961) and Kemp (1964)).That is, a fixed rate is defined as one where the authorities maintainthe external value of their currency within a narrow margin of parity,and use means other than parity changes to adjust to external disequi-librium. In a similar vein, a flexible rate is often considered as one thatis determined purely by supply and demand forces in the foreignexchange market, without any interference by the monetary authorities.

While a comparison of polar cases is possible at the theoretical level,and indeed useful in drawing out the implied differences between thetwo adjustment mechanisms, for the purpose of this paper it is notnecessary to restrict so tightly the definitions of the two types ofexchange rate system. In particular, it is not necessary to exclude thepossibilities of limited government intervention in the foreign exchangemarket in the case of flexible rates, nor the alteration (albeit infrequent)of par values under fixed rates.

For our purposes, the distinction is that exchange rate movementsare assumed to be more frequent under flexible than under fixed rates,

3 The obvious analogy here is with the (graphical) analysis of consumer demand,where equilibrium quantities are determined at the tangency of the indifferencecurve and the budget line.

4 We recognize that considerable doubt exists in the theoretical literature(Friedman (1968) and Phelps (1968)), and to a similar extent in the empiricalliterature (Goldstein (1972), Laidler and Parkin (1975), and Rutledge (1975))about whether there is any long-run or "permanent" trade-off between inflationand unemployment. For the purposes of this paper, however, all that is necessaryis that governments act as if they believed that such a trade-off exists, at leastin the short run.



and that more of the burden of balance of payments adjustment will beborne by exchange rate changes under flexible rates. In addition, we donot assume, for the most part, that either exchange rate system operatesin a flawless manner. In other words the fixed rate system we have inmind is approximately the exchange rate regime operating during, say,the period 1958-70, and the flexible rate system is the one in operationsince, say, the second quarter of 1973.

I. Effects of the Exchange Rate Regime on the Price Level

The exchange rate regime can have an effect on the (world) pricelevel if it changes either the supply or demand for goods. Such pricelevel effects should not, in themselves, have any continuing effect onthe world inflation rate. However, insofar as any upward movement inthese supply or demand curves is validated by government policies andrepeated, it may well result in a longer-run shift in the rate of inflation.The question of whether governments' policy responses will be sys-tematically influenced by the exchange rate regime, however, is onethat bears primarily on the rate of inflation and is therefore dealt within Section II. This section begins by considering how an increase inexchange rate uncertainty might influence trade flows and the pricesof tradable goods. It continues by analyzing possible effects of exchangerate uncertainty on the demand for liquidity (both official and private).

EFFECTS ON THE VOLUME AND PRICES OF INTERNATIONAL TRADE

When exchange rates change in an unpredictable manner, both import-ers and exporters face uncertainty because they are not sure about theprice they will have to pay or receive for foreign exchange. In the usualcase where one or both parties are risk averse, and where it is possibleto buy insurance against this exchange rate uncertainty (i.e., where for-ward exchange markets are developed for the relevant maturities), suchinsurance, or "hedging" costs, can simply be added to the costs of pro-duction and distribution, and it should be immaterial whether this pro-tection is purchased by the buyer or seller.5 In either case, the resultwill be an increase in the price of the traded good. Where such insur-ance protection is not available, or where the importer chooses to self-

5 However, even when forward cover is available, it will not provide completeprotection for the buyer against exchange risk unless he is able to forecast at thetime of making the forward contract how much foreign exchange he will needand the date on which he will require it. This point is attributable to Clark(1973).


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insure rather than hedge all his transactions in the forward market,the effect of uncertainty on price is ambiguous, and depends, as Hooperand Kohlhagen (1976) have shown, on which party bears the risk. Ifimporters bear the exchange risk (the usual case, according to Hooperand Kohlhagen), their demand for imported goods will fall and theprice of internationally traded goods should decline. If, on the otherhand, the exchange risk is borne by exporters, the price will rise asexporters add a risk premium to their other costs of production inarriving at a selling price. Where risks are shared, the effect on pricedepends on relative supply and demand elasticities. In all cases,increased uncertainty tends to reduce the volume of world trade (sincea backward shift in either the supply or demand curve produces a fallin quantity). The more elastic is the import supply curve relative to theimport demand curve, the greater will be the volume effects of increaseduncertainty relative to the price effects. Finally, to the extent that a fallin the volume of international trade reduces international specializationin production and prompts a longer-term shift in production to higher-cost locations, it will tend to push up the world price level.

From the foregoing propositions comes the familiar argument thatflexible exchange rates, by way of greater exchange rate uncertainty,will increase the world price level. While easy to grasp intuitively, thisargument assumes that: (i) exchange rates will be more variable (andunpredictable) under flexible rates than under fixed rates, and (ii)exchange rate uncertainty captures all the relevant uncertainties facedby international traders so that the costs of uncertainty are greater underflexible than under fixed rates. Both of these assumptions need to beexamined in somewhat more detail.

Friedman (1953), among many others, has pointed out that the free-dom of exchange rates to move under flexible rates does not imply thatthey will in fact be unstable. Provided that underlying cost and demandconditions at home and abroad are reasonably stable, there is no reasonto expect erratic shifts in either the supply of or demand for foreignexchange, and, thus, no nçed for erratic exchange rate movements.Speculation could, of course, generate fluctuations in rates, but mostadvocates of flexible rates assume that speculation, perhaps after aninitial learning period, will be of the stabilizing rather than of the desta-bilizing variety, that is, it will push rates toward rather than away fromtheir equilibrium position.6

6 In support of this argument, it is said that in a free floating system destabiliz-ing speculators will tend to lose money and thus will ultimately be driven out ofbusiness. (See Friedman (1953).)



Actual experience with floating exchange rates is still quite limited,so that it is far from clear how much exchange rate variability should beexpected under floating rates, especially under reasonably orderly eco-nomic conditions. At the simplest level, it is clear that the advent ofgeneralized floating has been associated with substantial volatility inbilateral exchange rates. Movements in spot exchange rates of as muchas 20 per cent quarter to quarter, 5 per cent week to week, and 1 percent hour to hour have not been unusual, despite the fact that suchmovements are large by historical standards. (See Hirsch and Higham(1974), McKinnon (1974), and Dooley and Shafer (1975).)

This evidence, however, taken by itself is probably a misleadingguide to the amount of exchange rate variability attributable to floatingper se. In the first place, as pointed out in IMF (1975, p. 27) "to assessthe implications for trade flows of the exchange rate movements thathave occurred, indices of effective exchange rates need to be employed";and movements in effective exchange rates have been much less thanbilateral exchange rate changes. For the deutsche mark, for example,quarter-to-quarter swings in its effective exchange rate have typicallybeen only about half as large as swings in its market exchange rateagainst the dollar. Second, the underlying conditions (e.g., the oil priceincrease, the world-wide recession) during this period were quite dis-turbed, and most observers would concede that had a fixed rate systembeen in operation, substantial changes in parity would probably have beenrequired. Finally, the period of floating inherited substantial paymentsdisequilibria from the later years of the fixed rate period, and underthese conditions it was to be expected that markets would take sometime to find the new equilibrium pattern of exchange rates. Despite thesecaveats, however, the evidence with floating so far is consistent with theview that speculators do not typically have sufficient information orresources to smooth exchange rate fluctuations in the manner suggestedby advocates of floating exchange rates.

If it is accepted that flexible rates generate somewhat greater exchangerate uncertainty than do fixed rates, it could still be argued that this typeof uncertainty is no worse than the other types of uncertainty involvedin trying to maintain a fixed pattern of rates. As Friedman (1953, p. 174)put it, "the substitution of flexible for rigid exchange rates changes theform in which uncertainty in the foreign exchange market is manifested;it may not change the extent of uncertainty at all and, indeed, may evendecrease uncertainty." Friedman is suggesting that failure to use theexchange rate as the equilibrating instrument in balance of paymentsadjustment implies that some other adjustment tool, be it aggregatedemand policies, incomes policy, commercial policy, or exchange con-



trol, will have to bear more of the adjustment burden. These alternativemethods of adjustment also create uncertainties for traders that in factmay be more damaging to trade, since exchange risk under floating is,at least in principle, the easiest to provide protection against by hedgingin the futures market. Only if reserve changes were sufficient, by them-selves, to finance balance of payments disturbances, without recourse tothese other adjustment measures, could it be said that any reduction ofuncertainty under fixed rates was not offset by an increase in other kindsof uncertainty for the private sector.

Makin (1974) has put forward a similar defense of flexible rates. Heargues that exchange rate uncertainty may well be less under flexiblerates because the private sector can predict the timing and size ofexchange rate changes better when the inputs for the prediction aremarket forces rather than guesses about political judgments. However,on the other side, Williamson (1974) has argued that a credible par valuemay provide a stabilizing focus for exchange market traders and therebyreduce uncertainty relative to a system where there is no declared refer-ence value. As Williamson himself is aware, a crucial assumption in hisargument is that the parities to be defended are credible—somethingthat was not always true under the Bretton Woods system.7

Just as important as the question of whether uncertainty is higherunder flexible rates is the question of how costly any additional uncer-tainty might be. In principle, the cost of uncertainty might be measuredby the price of purchasing insurance against it. In this regard, Johnson(1973, p. 213) invokes the economic principle that " . . . a competitivesystem will tend to provide any goods or services demanded, at a pricethat yields no more than a fair profit." Similarly, most supporters offlexible rates, writing before the advent of generalized floating, predictedthat floating would induce an expansion of facilities in forward exchangemarkets so that requests for insurance at most maturities could behandled efficiently. Writing in November 1974, McKinnon has shown,however, that such optimism about forward exchange markets has notbeen fully justified. In particular, McKinnon has documented that (i)bid-ask spreads in spot exchange markets have widened significantlyfrom the 1960s, (ii) bid-ask spreads in forward markets8 have risenrelatively more sharply—particularly in the longer-term contracts, and

7 Although, in a better-managed par value system, it is reasonable to hope thatofficially established exchange rates would be more credible than those in effectunder the last years of the Bretton Woods system.

8 The bid-ask spread is the appropriate measure of the social cost of forwardcover, not the gross premium or discount. This is so because the bid-ask spreadmeasures the cost of purchasing insurance against the possibility of the actualrate diverging from the expected rate (which may be regarded as the mean of bidand asked quotations).



(iii) there has been no noticeable expansion in the facilities for forwardtrading across pairs of currencies, or in longer-term contracts. A recentstudy by Fieleke (1975) has similarly used data on foreign exchange(bid-ask) spreads as a proxy for the social cost of the services of foreignexchange traders. In brief, his empirical results support the propositionthat these spreads vary positively with the degree of exchange ratevariability.9

If the evidence suggests that the cost of purchasing protection againstexchange risk has indeed risen, how much has this affected the price oftraded goods? Probably very little. In markets for major currencies, thespread between bid and asked prices for forward exchange is rarelygreater than Vio of 1 per cent of the transaction price.10 If it is borne inmind that the expected spot price is the midpoint of the spread, the costadded to price in each direction is therefore rarely greater than V-io of 1per cent. Further, since hedging will also occur under an adjustable pegsystem, only part of these small cost figures represents the additionalcosts associated with flexible rates. Finally, any resultant increase incosts will be once and for all, and should therefore have no impact onthe continuing rate of inflation.

This still leaves unanswered, however, the question of whether theeffect of greater exchange rate variability in diminishing the quantityof international transactions will result in a significant interference withinternational specialization and thus a rise in unit costs. On the onehand, it could be argued that the cost of exchange rate uncertaintynot covered in the forward market must be less than the price ofinsurance protection. Therefore, the effect of uninsured risks onthe volume of transactions should be small. If, however, insurance pro-tection is unavailable (Say, because of the institutional weakness of for-ward markets in certain currencies or maturities—e.g., see Witteveen(1975)), then more severe quantity effects on trade may result. Thisinvolves not only trade flows but direct and portfolio international invest-ment as well. Suffice it to say that the only empirical studies now avail-able on this issue relate to trade flows—hardly a surprising development,since any discernible effects on plant location decisions and the like are

9Grubel (1966) has also pointed out that under flexible rates more trade willbe covered through the forward market, where spreads are higher, than in thespot market and that this factor will contribute to the relatively high cost offlexible rates. McKinnon (1974) has reported, however, that much of the increasein the demand for forward cover expected under flexible rates seems to have beenshifted to the spot market. In other words, firms that want to hedge seem to bebuying (selling) foreign currencies ahead of their needs and just holding themspot—something that also involves costs, as it ties up liquid assets.

10 McKinnon (1974),



apt to be of longer-term nature. There seems to be no evidence that thevolume of international trade has been adversely affected by exchange ratevariability.11 For example, to quote Whitman (1975, p. 143): "Despitesubstantial fluctuations in exchange rates, the widely feared decline ininternational trade and investment has failed to materialize." However,before-and-after comparisons of trade flows are not likely to be reliablefor testing the independent effect of exchange rate uncertainty on inter-national trade. What one really wants to know is whether flexible ratesaltered the volume of international trade relative to what it would havebeen under fixed rates, other things held equal. To answer this question,it is obviously necessary to control for other factors (besides exchangerate uncertainty) that are known to affect exports and imports, and tofind an adequate proxy for exchange rate uncertainty. The study thatprobably comes closest to meeting at least the first of these two require-ments is the recent paper by Makin (1974). He estimates import equa-tions for the Federal Republic of Germany, Canada, Japan, and theUnited Kingdom on quarterly data for the period 1960-73. The explana-tory variables used were real income, capacity utilization, relative importprices, and two alternative measures of exchange rate variability (onefor the spot market and one for the forward market). The results sug-gested no statistically significant effect of exchange rate variability onreal import demand in any of the four countries studied.12 It is perhapsfair to note that the substantial decline in world trade that occurred in1974-75 has yet to be included and analyzed in empirical studies of thetype just described.

In sum, it would seem that the impact of exchange rate uncertaintyon the prices of traded goods and on the volume of international tradeis likely to be so small that any contribution to inflationary pressuresgenerated by flexible rates via this mechanism can probably be largelyignored. At any event, it should be taken into account only if the otheradvantages and disadvantages of the alternative regimes are finely bal-anced.

11 It should be borne in mind here that any increase in the volume of inter-national trade need not represent an unambiguous improvement in world welfare.In this regard, McKinnon (1974) has brought up the issue of "false trading"—bywhich he means the international movement of goods according to transitoryprice/cost relationships that do not accurately reflect long-run comparative advant-age. If floating contributes to such false trading, before-and-after comparisons oftrade flows become even more difficult to interpret in a welfare sense. See alsoLanyi (1969) on the welfare aspects of the amount of international trade and thegovernment's role in "subsidizing" trade under fixed exchange rates.

12 Clark and Haulk (1972) also examined the effect of exchange rate variabilityon Canadian trade flows (using a methodology similar to Makin's) and obtainedthe same general conclusions as Makin (1974).



EFFECTS ON THE DEMAND FOR LIQUIDITY

In addition to any effect on the demand for and supply of tradablegoods, the nature of the exchange rate regime could also affect theworld price level through its effect on the demand for liquidity (bothofficial and private). Since in a general equilibrium framework thedemand for real goods is the opposite side of the coin to the demandfor money (or financial assets), the exchange rate regime will affect theformer if it affects the latter.13

Both national monetary authorities and the private sector could con-ceivably be affected in their portfolio decisions by a change in theexchange rate regime. Governments may find a reduced need for cur-rency reserves in a floating system where adjustment to balance of pay-ments disequilibrium can take place to a greater extent through changesin the exchange rate. Similarly, the private sector may choose to holdsmaller (larger) money balances because of the lower degree of certaintywith which balances in any one currency can be converted into anothercurrency under a flexible exchange rate regime. We shall consider eachof these arguments in turn.

The traditional argument that the demand for international liquidityby monetary authorities will be reduced by a transition to flexibleexchange rates runs as follows: Under flexible rates, the supply anddemand for foreign currencies can be equilibrated via movements in theexchange rate; therefore, there will be less need for government author-ities to hold foreign exchange reserves. Consequently, governments thathold such reserves (after the introduction of floating) will seek to rundown this unproductive use of the national patrimony by having overalldeficits in their balance of payments.14 Since one country's deficit isanother's surplus, there will be an inconsistency in policy objectives, andthe general attempt to reduce these excess reserve holdings will resultonly in an increase in prices.

Not all observers, however, would agree that this need necessarily beso. Williamson (1974), for example, has argued that if an exchange rateparity provides a credible estimate of the equilibrium exchange rate, the

13 In a world where money and goods were the only two assets, Walras's lawwould insure that the excess demand for goods equaled the excess supply ofmoney. The classic empirical application of this relationship is that of Cagan(1956). When other financial assets (equities) are admitted, the relationshipbetween excess demand in the money market and the rate of inflation is lessdirect; see, for example, Mussa (1975).

14 See Fleming (1975) for a more extensive discussion of reserve use undermanaged floating.



abandonment of the parity may lead to increased reserve use.15 This isso because, if the foreign exchange market is unstable in the short runto medium run (i.e., if private participants have extrapolative expecta-tions concerning rate movements, and act on them), a movement togreater flexibility in exchange rates could conceivably lead to wideroscillations in exchange rates and to greater reserve use than wouldoccur under a par value system. While Williamson's argument cannotbe dismissed out of hand, it represents in our view more the specialcase than the general one. Also, as Williamson himself notes, where theparity being defended is inappropriate (a not unusual occurrence in thelatter years of the Bretton Woods system), the conclusion for reserveneeds is reversed.

The available empirical evidence on reserve use under fixed versusfloating rates is both limited and ambiguous. Williamson (1974), employ-ing three alternative measures of reserve use, found no evidence of adecline in reserve use during the period of generalized floating vis-à-visperiods of fixed rates. In fact, a majority of the countries in his sampleactually displayed an increase in reserve use under floating rates. Sub-sequently, Williamson's results have been both updated (through 1975)and/or recalculated for some alternative definitions of reserve use byIshiyama (1976) and Suss (1976)—and their results run counter toWilliamson's findings, that is, they lend support to the a priori expecta-tion that reserve use would decline under increased exchange rate flexi-bility.16 In interpreting this evidence, one should note that none of theforegoing studies is able to develop a fully satisfactory method for esti-mating the independent effect of either increased exchange rate flexibilityor generalized floating on reserve use. To do so, it would be necessaryto hold constant all other factors affecting reserve use so that the sepa-rate effect of exchange rate flexibility could be identified. This is ofcourse easier said than done but in principle it is likely to be betteraccomplished, or at least better approximated, within the context of amultiple regression model for reserve use than by simple before-and-aftercomparisons. The latter nevertheless will still be useful for indicatingwhat happened to reserve use after generalized floating even if theydo not provide information on why it happened.

15 The view that the need for reserves will be just as great (or, perhaps, evengreater) under flexible rates as under fixed rates had also been put forth earlierby Harrod (1965), pp. 44-45.

16 In addition, there is a considerable empirical literature that suggests that,ceteris paribus, the demand for reserves will vary positively with the variabilityof trade or of payments imbalances. (See Grubel (1971) and Williamson (1973)for reviews of these studies.) To the extent that floating reduces the size of thisvariability, it should reduce the demand for reserves.



If it is accepted that a transition to flexible exchange rates is likely,céleris paribus, to lead to some reduction in reserve needs, to whatextent is this likely to contribute to inflation? The answer depends ofcourse primarily on how large the reduced demand for internationalreserves is—as well as on, inter alia, how much of the excess supplyof reserves translates itself into an excess demand for goods and, inturn, how responsive inflation is to changes in the level of excessdemand. While, as mentioned earlier, there does not as yet seem to be areliable estimate of the impact of floating on the demand for inter-national reserves, several empirical studies do exist on the relationshipbetween changes in world reserves and changes in the world price level.More specifically, Keran (1975) has estimated a reduced form equationthat relates changes in the prices of internationally traded goods (asmeasured by export prices of developed countries) to current and laggedchanges in international reserves (of the developed countries). For theperiod 1962 to 1974, Keran found that an increase of 1 per cent inworld reserves leads over a three-year period to an increase of approxi-mately 1 per cent in world prices. Heller (1976) has also estimatedthe relationship between world reserves (as well as world money stock)and world (consumer) prices using a larger group of countries. In hisequations using annual data for the period 1955-74, he found that anincrease of 10 per cent in world reserves leads, after 2l/2 to 4V2 years,to an increase of about 5 per cent in world prices. In interpreting theresults of these studies, one should note that no explicit account is taken(at least in the equations) of other possible determinants of worldinflation (such as supply factors or inflationary expectations). To theextent that these "omitted" variables are correlated with reservechanges, the resultant estimates of the elasticity of world prices withrespect to world reserves may well be biased. This is not to say that theestimated relationship between world prices and world reserves isillusory, but rather to suggest that at this time we cannot be very confi-dent about its magnitude.

In a related context, the inflationary consequences of an excesssupply of world reserves need not be perfectly analogous to those aris-ing from excess monetary creation in a closed banking system. In fact,in our view the former is apt to be less serious than the latter for atleast two reasons. First of all, monetary authorities having excessreserve holdings are unlikely to run them down quickly (as might anindividual with excess real balances), if only because (relative to indi-viduals) they will be more fearful of setting in train a domestic infla-tionary spiral. This would at least suggest that the speed of adjustment,



if not the long-run effect, will be lower for international reserves.Second, since the greater portion of world reserves forms the liabilities ofanother country ("inside" money in the domestic monetary analogue),holdings in excess of demand can be liquidated without necessarilygiving rise to expenditures on real goods and services. In other words,the world supply of international reserves is an endogenous variablethat can adjust at least in part so as to accommodate shifts in thedemand for reserves. It is quite possible, for example, for a countrywith excess reserves to liquidate some of its excess holdings withoutincreasing the reserves of any other country, thereby realizing a fallin the world stock of reserves.

Turning to the effect of the exchange rate regime on the privatesector's demand for money, it can be argued that increased exchangerate variability implies a reduction in the range of transactions forwhich balances in a given national currency act as an optimum store ofvalue. For this reason, one might expect a transition to floating rates toinduce a fall in the desire of private wealth holders to hold the tradi-tional vehicle currencies. The implications of a move out of traditionalvehicle currencies for world-wide inflation are far from clear, however.This is so because a decline in the usefulness of a single vehicle cur-rency (or group of them) probably has its counterpart in an increasein the incentive to hold a diversified portfolio of currencies. If a privateasset holder (e.g., a multinational corporation) has to hold balances inseveral currencies to meet fluctuations in payments and receipts in eachcurrency separately, then it is likely that the total size of liquid balanceswill be greater than if all transactions were centralized in a singleaccount. The intellectual pedigree of this proposition is in the Baumol-Tobin portfolio literature (including the so-called square-root law ofmoney holdings), but at an intuitive level all that is being suggested isthat flexible rates may lessen the economies in liquidity holding thatcan come from pooling liquid funds in a single currency of denomina-tion.17

To the extent that the diseconomies-of-scale effect predominates overthe substitution effect out of all currencies, then the private demandfor money should, céleris paribus, shift upward after a transition tofloating, thereby decreasing the real demand for goods at a given levelof the world money supply. On empirical grounds, however, we knowof no evidence, one way or the other, on this potential consequence offloating. In particular, we are unaware of any empirical studies that

17 For application of the square-root law to the demand for internationalliquidity, see Heller (1968), Olivera (1971), and Officer (1976).



attempt to account for exchange rate risk or uncertainty in the privatedemand for money.18 Further, it is our suspicion that it would bedifficult to estimate the independent effect of the 1973 transition togeneralized floating on the private demand for money. For one thing,the existence of active Euro-currency markets meant that there wasprobably sufficient flexibility in currency supplies to adapt to the kindsof demand shifts that a change in exchange rate regime might precipi-tate. Similarly, the possibility that monetary authorities might allowthe supply of money to accommodate to shifts in the demand for it mustbe recognized, especially in a world where the authorities have at leasthalf an eye to interest rate targets. Therefore, the task of identifyingdemand shifts from supply shifts is apt to prove troublesome foreconometric work on this issue.

On balance, it seems reasonable to conclude that the net direct effectsof the exchange rate regime on the price level are likely to be small. Asto their direction, the arguments relating to the cost of exchangerate uncertainty and to the effects of exchange rate flexibility ondemand for reserves point perhaps to some relative upward bias forflexible rates. We would readily concede, however, that the evidencehere, be it theoretical or empirical, is sufficiently ambiguous that sucha conclusion can be regarded only as tentative. Furthermore, the pointmade earlier must be recalled, namely, that effects on the price level ofa change in exchange rate regime are once and for all, and thereforeaffect inflation only in the transitional period following the move fromone regime to another. With this in mind, we can now proceed toexamine the probable effects, if any, of the exchange rate regime onthe continuing rate of world inflation.

II. Effects of the Exchange Rate Regime on the Rateof Inflation

As stated earlier, the exchange rate regime can affect the rate ofinflation, either by changing the nature of the perceived trade-offbetween inflation and other policy objectives, or by changing thegovernment's relative preference for its various policy objectives. Inwhat follows, we consider first how the exchange rate regime islikely to affect price pressures at a given level of aggregate demand.

18 Heller (1976) has argued that there was a general reduction in the world-widedemand for dollars in the early 1970s that was not uncorrelated with fears aboutthe dollar as a long-run store of value. His study does not, however, attempt toestimate the effect of exchange rate flexibility per se on the private world demandfor dollars or for other vehicle currencies.



Next, we turn to the question of how exchange arrangements may affectgovernments' demand management policies by influencing the way inwhich balance of payments equilibrium enters into the government'sset of policy objectives.

EFFECTS ON POLICY POSSIBILITIES—RATCHET EFFECTS

Exchange rate changes, by themselves, generate equal and offsettingpressures on costs and demand in appreciating and depreciating coun-tries, respectively. However, if prices react asymmetrically to positiveversus negative changes in costs or demand, then exchange rate move-ments can have a net effect on the world price level. And if oneexchange rate regime leads systematically to larger or more frequentchanges in exchange rates, then there will be an effect on the overalltrend of world inflation.

The existence of such an asymmetry is the basic premise of theso-called ratchet and asymmetries argument. As it is generally inter-preted, this argument holds that flexible exchange rates have a globalinflationary bias compared with fixed rates. This inflationary bias issaid to arise because flexible rates imply more frequent exchange ratechanges than do fixed rates, and because in a world of downward priceinflexibility, devaluations lead to domestic price increases in devaluingcountries that are greater than the corresponding price declines inrevaluing countries. Thus, in contrast to a world where prices wereequally flexible in both directions, and in which, therefore, exchangerate changes would be neutral with respect to the world price level,downward price inflexibility is said to ensure that each exchange ratechange will "ratchet" the world price level to a new higher level. Thisreasoning implies that flexible rates will also produce an inflationarybias for individual countries over time (even if the mean value of theexchange rate remains unchanged), since domestic prices will be raisedmore by depreciations than they will be decreased by appreciations ofthe same size. As a general proposition, the ratchet argument impliesthat the more the exchange rate fluctuates in a positive/negative fashion(for any given mean value of the exchange rate), the more serious willbe the inflationary ratchet effect.

The novel aspect of the ratchet argument lies not in the fact that itforesees price increases in devaluing countries 19 but rather that it failsto predict equivalent price declines in appreciating countries.

10 For empirical work on the extent of devaluation effects on the domesticprice level, see Goldstein (1974), Isard (1974), Kwack (1974), Nordhaus andShoven (1974), Ball and others (1975), Jonson (1976), and Laffer (1975).



Perhaps the best-known recent statement of the ratchet hypothesis isthat (apparently) put forward by Professors Laffer and Mundell andinterpreted by Wanniski (1974).20 Laffer and Mundell begin from theassumption that in an integrated world economy, arbitrage of goods willensure both that the real price of tradable goods (i.e., the price of onegood relative to another) is the same in all markets, and that the "lawof one price" holds true. In aggregate terms, the law of one pricemerely posits that the domestic price level will be equal to the foreign(world) price level times the exchange rate (that is, Pd = P ré). Clearly,if this relationship governs the price of tradable goods in different coun-tries, the effect of exchange rate changes on relative price levels oftradable goods will be immediately offset. However, by itself, this propo-sition says nothing about which price level will do the adjusting. Lafferand Mundell assume that it will be the price level in the devaluingcountry that bears the full burden of the adjustment, and that producersin devaluing countries will quickly raise their prices to the full extentof the devaluation.

Ultimately, the Laffer-Mundell ratchet hypothesis is a question ofthe size of both demand and supply elasticities and marginal spendingpropensities for traded (arid nontraded) goods in the devaluing countryrelative to those in the revaluing country or countries. As long, how-ever, as the size of these parameters is not very different in the twocountries, both the devaluing and revaluing country will share the priceadjustment to an exchange rate change.21 That is, both domestic (Pd)and foreign supply prices (P/) will change (in opposite directions) byless than the amount of the exchange rate change (é). Further, as longas the absolute value of the price elasticity of demand for imports issmall relative to the supply elasticity for imports,22 one would expectimport prices (in local currency) to fall somewhat in the revaluingcountry.23

20 We say "apparently" put forward by Professors Laffer and Mundell becausethis ratchet argument does not, to our knowledge, appear in either Laffer'sor Mundell's published work. Further, it is mentioned in only one of the twopieces, in (1974) but not in (1975), written by Wanniski that seek to summarizethe Laffer and Mundell view of the world economy.

21 See Dornbusch (1975) for the exact expression showing how the countrydistribution of price changes after an exchange rate change is related to the rela-tive sizes (between countries) of the marginal spending propensities on nontradedgoods and of the compensated (excess) supply elasticities for traded goods.

22 Empirical estimates of demand and supply elasticities for exports and importscan be found in Magee (1974), Stern and others (1975), and Goldstein and Khan(1976 a and 1976 b).

23 See Branson (1972) for the expression showing how the elasticity of theimport price (in domestic currency) with respect to an exchange rate change isrelated to the relative size of the demand and supply (price) elasticities for imports.



The Laffer-Mundell hypothesis also carries the empirical implicationthat declines in the domestic currency price of imports should occurinfrequently, if at all. Pigott, Sweeney, and Willett (1975) have docu-mented, however, that such declines occurred in about 35 per cent ofthe quarters during the period 1957-74 (for the United States, theUnited Kingdom, Canada, Japan, the Federal Republic of Germany,and France, taken together). Some empirical evidence on export (sup-plier) price behavior after tariff reductions also casts doubt on theassumption of complete offsetting. For example, in a study of (foreign)export price behavior toward the U. S. market during the 1950s,Kreinin (1961, p. 317) concluded that "it appears plausible that closeto half of the benefit from tariff concessions granted by the UnitedStates accrued to foreign exporters in the form of increased exportprices." Thus, while it may be quite likely that import prices wouldfall less after a revaluation than they would rise after a comparabledevaluation, it seems unlikely that revaluation would produce no declineat all in import prices. The weaker statement, that exchange ratechanges will likely impart some upward bias to the average level ofthe prices of traded goods, therefore seems more appropriate.

An alternative explanation for the ratchet effect focuses not on theasymmetrical effects of exchange rate changes on the prices of tradedgoods but rather on the asymmetrical effect of changes in the prices oftraded goods on domestic prices (i.e., it focuses on downward pricerigidities within national economies rather than at the level of inter-national trade). One reason why changes in import prices might havean asymmetrical effect on final product changes is that there are coststo changing prices in imperfectly competitive markets,24 and that firmswill change their prices only in response to those cost and demandchanges that they view as permanent. To obtain the ratchet or asym-metry conclusion, it is then only necessary to assume that negativeimport price changes are viewed as more temporary than are positivechanges.

There are several reasons for questioning the foregoing asymmetryargument. First of all, the distinction expected in theory is that betweenpermanent and temporary changes, which will not necessarily coincidewith that between positive and negative ones. Second, negative changesin import prices (expressed in domestic currency) have occurred too

~4 For a discussion of these costs, both direct (e.g., information, bookkeeping,printing) and indirect (e.g., danger of upsetting price harmony), see Nordhaus(1972) and Scherer (1973). Also, in imperfectly competitive markets, firms canadjust to demand changes by altering inventories, order backlogs, and output, aswell as by changing price; on this, see Hay (1970).



frequently in the postwar period—Pigott, Sweeney, and Willett (1975)—to be regarded as unusual events. Third, an asymmetry in pricingbehavior as between positive and negative cost changes has the disturb-ing long-run implication that, ceteris paribus, profit rates would risecontinually over time, since firms would be fully passing forward costincreases but would not be passing on cost decreases. One way aroundthis difficulty is to interpret the ratchet argument as denoting an asym-metry in the time response of prices to positive versus negative costchanges. In other words, instead of assuming that the elasticity of pricewith respect to positive cost (or demand) changes is greater than thatfor negative changes, it could be assumed instead that the speed ofadjustment of the actual price to the desired price is faster for positivethan for negative import price changes. In this latter case, the short-runprice elasticity would depend on the direction of the import price changebut the long-run (or equilibrium) price elasticity would not. Unfortu-nately, there is not (to our knowledge) any empirical evidence availablethat would help in determining whether such an asymmetry in timingresponses is of any practical concern. Finally, it is by no means clearon empirical grounds that producers do in fact change prices only inresponse to permanent cost or demand changes. Some empirical studieson pricing behavior (e.g., Nordhaus and Godley (1972)) support sucha hypothesis, while others do not (Gordon (1975)).

In addition to asymmetries on the supply side, there can also be aratchet effect generated by shifts in demand. This possibility has beennoted by Witteveen (1975, pp. 113-14) who put the argument asfollows:

Exchange rates influence the distribution of demand between domestic andforeign products, and rate fluctuations will involve demand shifts which willlater in some measure be reversed. These demand shifts may well exerta ratchet effect on inflation. . . . shifts in purchase patterns brought aboutby the exchange rate changes, or even the expectation of such shifts, maytend to raise prices in the countries of depreciating currency without effect-ing a corresponding price reduction in the countries of appreciating currency.

Witteveen's suggestion is essentially a restatement of Schultze's (1959)concept of "demand shift inflation," in an international setting. In brief,the central idea is that it is possible for inflation to be generated byshifts in the sectoral composition of demand, even if the level of aggre-gate demand remains constant, since prices will rise in those sectorswhere demand is increasing by more than they will fall in those sectorswhere demand is declining. One of the proximate consequences of anexchange rate shift will be to change the relative price of tradable andnontradable goods. The more pronounced and frequent are exchange



rate changes, the more significant will be these intersectoral demandshifts and therefore the more serious will be the inflationary ratcheteffect.

Evaluation of the Witteveen hypothesis is severely hampered by theabsence of empirical work on demand asymmetries in industry pricebehavior.25 Not only have few empirical studies been done on the effectof positive versus negative changes in demand on industry price changesbut those that do exist (e.g., Schultze (1959), Schultze and Tryon(1965)) relate almost entirely to manufacturing industries and thereforeprovide little information on pricing behavior for nontradables. To theextent that the ability to resist price cuts when demand falls is an indi-cation of market power, there is probably a better a priori case forexpecting such price behavior in nontradables, since these productsare, by definition, not subject to international competition.26 Further,the fact that the share of services in gross national product has beenrising steadily in most advanced industrial nations, despite the fact thatthe relative price of services has been rising at the same time, suggeststhat the price elasticity of demand for services (nontradables) is low,and/or that the income elasticity is quite high. On the other hand, asa general proposition, excess market power, even if it existed in non-tradables, should have more to do with determining the level of prices(or the relative price of nontradables) than with the rate of inflation.

Some more general empirical evidence on the combined effect ofthese various (positive/negative) ratchet hypotheses is provided in arecent study by Goldstein (1976). Using alternatively the GDPdeflator and the consumer price index as dependent variables, andemploying a wide variety of alternative inflation models, specific asym-metry tests were conducted for five countries—the United States, theUnited Kingdom, the Federal Republic of Germany, Italy, and Japan—over the period 1958-73. In brief, the results point to the presence ofan asymmetry between the effects of positive and negative import pricechanges on domestic price changes for Italy and Japan but not for theFederal Republic of Germany and the United Kingdom. The results forthe United States are too ambiguous to support a definite conclusion.

2Γ> There are many empirical studies on the question of whether demand changes(independent of their effect on factor costs) are a significant determinant ofindustry price changes; for a review of this literature, see Nordhaus (1972) andde Menil (1974). Obviously, however, this is not the same as asking whetherpositive changes in demand have a different impact on prices than do negativechanges.

2G Of course, as long as producers of nontradables are subject to sufficientlystrong domestic competition, one would not expect them to be able to set pricesindependently of demand conditions.



Further, even for those countries where there is some evidence of anasymmetry, the results are quite sensitive to the choice of sample period,the level of aggregation, and the particular inflation model used.

Moving from the direction of the exchange rate change to its size,the argument has been advanced that large changes in exchange rates(and hence in import prices) will have a greater proportionate effect ondomestic prices than will small exchange rate changes. Again, theimplicit notion behind this propostion is that there are costs associatedwith changing prices and that producers respond to these costs bychanging prices only when cost or demand changes are viewed as largeand permanent.27 Following Nordhaus (1972), stable prices can also beviewed as a service that producers offer their customers in order toobtain a larger share of the market.

It is immediately apparent that if the large/small ratchet effect is toimpart an inflationary bias to one exchange rate regime compared withanother, it is necessary (but not sufficient) to demonstrate that there isa difference in the size of the rate movements between the two regimes.It is obviously true that flexible exchange rates generate larger ratechanges if fixed rates are permanently fixed. But if fixed exchangerates are interpreted as the adjustable peg system, then the conclusioncould well be reversed. That is, flexible rates could be less inflationary,ceteris paribus, because the exchange ¡rate movements necessary to equili-brate the balance of payments would come in small steps at frequentintervals rather than in large discrete jumps under conditions of funda-mental disequilibrium. As mentioned earlier, in Section I, exchangerate changes have probably been larger under managed floating thanthey were at most times under the Bretton Woods system. However,these recent exchange rate movements obviously owe something to theincreased uncertainties of the more recent past, uncertainties that areattributable to a variety of causes apart from the exchange rate regime.If there is any difference between the two systems in regard to theprobable size of exchange rate changes, it is certainly not an obviousone.28

Even if it could be demonstrated, however, that one exchange rateregime produced larger exchange rate changes than the other, and evenif a large/small ratchet effect did exist, this would not necessarily implythat larger exchange rate changes produce an inflationary bias for the

27 For a clear statement of this argument as applied to price elasticities ininternational trade, see Orcutt (1950) and Liu (1954).

28 Katz (1972), for example, also seems to share the view that there is no apriori reason to expect the size of exchange rate movements to be significantlydifferent between a par value system and a flexible rate system.



world economy. The reason is that, in the absence of a positive/negativeratchet effect, the price consequences of a large downward movement ina bilateral exchange rate for one country will be offset by the largeupward movement for the other. Thus, as far as the world inflationrates goes, it is the positive/negative ratchet that is important and notthe large/small distinction.

Individual country inflation rates could of course still be affected bythe presence of a large/small ratchet effect. At this point, however,there is no clear evidence that a ratchet effect related to the size ofexchange rate changes exists. More specifically, the available empiricalstudies that have tested for large/small or "threshold" effects generallyrelate either to the labor market or to the demand for traded commodi-ties, rather than to the relationship between import price changes anddomestic price changes; furthermore, these studies relate for the mostpart only to the economy of the United States. For example, Hamer-mesh (1970), Eckstein and Brinner (1972), and Gordon (1972) havefound some evidence for the United States that the money wageresponse to price changes is greater when inflation is high than when itis low. Sumner (1972) has obtained a similar finding for U. K. wagebehavior, but Goldstein (1974) has obtained contrasting results. Spitäl-ler (1975), also in a U. S. study, finds that the dependence of currentinflation on past inflation rates rises when the inflation rate exceeds4 per cent. Since exchange rate movements give rise to wage-priceinteractions,-9 these studies lend some (indirect) support to the existenceof a large/small ratchet effect. On the other hand, some other empiricaltests of the large/small hypothesis in different but still related settingspoint to a contrasting conclusion. For example, Goldstein and Khan(1976 b) in a study of aggregate import demand of 12 industrial coun-tries found no evidence that either the relative price elasticity of demandor the speed at which actual imports adjust to the desired level wasrelated to the size of the relative price changes. Finally, Goldstein(1974), in a study of price behavior in the United Kingdom, found that

29 As a more general matter, the presence of a wage-price spiral magnifies what-ever inflationary effect is produced from a ratchet effect operating on the priceof traded goods. Indeed, it is sometimes argued that deficit countries can by thismechanism find themselves in a vicious circle of deficits and inflation. An initialdeficit causes a depreciation in the exchange rate, which pushes up domestic pricesthus provoking wage claims that accelerate the process of inflation. Althoughcertain countries (Italy and the United Kingdom may be recent examples) havefaced serious problems resulting from the wage-price spiral effect, it would beincorrect to say that this factor, by itself, can impart an inflationary bias to aflexible rate regime. The nature of the regime may affect the size of the infla-tionary disturbances; but it will affect the strength of the subsequent wage-pricespiral only if there are threshold effects in wage and price determination.



large changes in import prices did not have a greater proportionateeffect on retail prices than did small changes.

All things considered, the empirical evidence for the existence ofratchet effects, be they of the positive/negative or of the large/smallvariety, is not particularly compelling. Nevertheless, if these ratchetsdo exist—and the empirical evidence certainly does not preclude thispossibility—the net price effects would seem to point in only one direc-tion. That is, since no one suggests that negative import price changeswill have a greater proportionate effect on domestic prices than positivechanges, we are inclined to conclude that flexible rates (because of theirgreater propensity to induce positive/negative oscillations) are likely tocontain some inflationary bias for the world economy. Having said this,however, we must immediately qualify it by noting that other welfareconsiderations may be important (Section III) and that the empiricalevidence is not strong enough to put this consideration forward on morethan a tentative basis.

EFFECTS ON GOVERNMENT'S POLICY CHOICE

The exchange rate regime may influence a government's choice ofpolicy objectives in two main ways. The first results from the fact thatany upward price bias imparted by the exchange rate regime will changethe nature of the short-run inflation/unemployment trade-off confront-ing policy authorities, and thus will prompt a re-evaluation of policytargets. The second results from the fact that balance of paymentsequilibrium requires more active use of domestic policy instrumentsunder fixed exchange rates than it does under a floating regime. Thesetwo influences are considered in turn.

If one exchange rate regime leads to higher prices at a given levelof nominal demand (say, because of ratchet effects) it will lead to lowerreal income and, hence, will tend to generate an increase in unemploy-ment. If the policy authorities attach high importance to maintaining agiven rate of unemployment, they may react to the deflationary effect ofrising prices by providing for an increase in nominal demand. Thishypothesis has been put forward by Shields, Tower, and Willett (1974),among others. To illustrate this point, Shields and others consider thecase of a country that revalues when there is no excess demand in thetradable goods sector. Assuming the usual substitution effects in con-sumption and production, the revaluation should lead to a fall in outputand employment in the export and import competing sectors (of therevaluing country). Faced with this situation, the authorities may wellreact by increasing the money supply and aggregate demand so as to pre-



vent any increase in unemployment. The result of such an expansionarypolicy will be an exacerbation of inflationary pressures.30 In this policyscenario, it is not structural factors but rather the unwillingness of thegovernment to accept any increase in unemployment above its targetrate that allows revaluation to be inflationary.

More generally, if one accepts the assumption that the governmentwill expand aggregate demand whenever there is a prospective increasein unemployment above the target rate, any factor that tends to worsenthe inflation/unemployment trade-off will cause the government torespond in such a way as to increase the rate of inflation.31 Thus, tosome observers (e.g., Kenen (1974)), the analysis of Shields and othersprovides just a further illustration of how the politics of full employ-ment can generate inflation when all other factors would or shoulddrive prices downward. A second point of qualification is that unlessone can identify what the government's target unemployment rate is, theforegoing hypothesis will be of limited value in predicting the demand-management response to a revaluation. This in turn is apt to be quitedifficult to do, since the target rate may change quite markedly overa short period. In this connection, one could interpret the unusuallyhigh unemployment rates of 1974 and 1975 in most industrial countriesas suggesting that these countries have shifted upward their definitionsof the target unemployment rate. In any case, the recent unemploymentexperience does seem to suggest that governments do not automaticallyincrease aggregate demand in response to every prospective increase inunemployment, be it revalution-induced or otherwise.

The second, and perhaps more important, way in which the exchangerate regime may affect inflation is through the different constraints thatalternative regimes introduce on governments' freedom of policy choice.This argument is usually referred to as the "discipline argument" andhas long been prominent in the debate on fixed versus flexible rates.Indeed, even such supporters of flexible rates as Sohmen (1963),Haberler (1964), and Yeager (1968) view it as perhaps the most potentobjection to a system of flexible rates.32

The reserve discipline hypothesis can be stated as follows: Underfixed exchange rates, a country that inflates at a rate higher than thatof its trading partners will, ceteris paribus, suffer a deterioration in its

30 Shields, Tower, and Willett (1974) also assume throughout their analysis thatthere is no factor mobility between the traded and nontraded goods sectors, andthat money wages and prices are inflexible downward in both sectors.

;n The authors seem to be well aware of this. In fact, one of their centralpoints is that under the assumptions typically employed to show that devaluationis inflationary, revaluation can also be shown to be inflationary.

32 For further discussion of the reserve discipline argument, see Phaup (1974).



balance of payments and a loss of international reserves. As long asthere is an inhibition about using the exchange rate to restore equilib-rium in the foreign exchange market, the high-inflation country willultimately have to discipline itself by restraining aggregate demand soas to bring its inflation rate into line with that of its trading partners.Implicit here is the notion that the fixed exchange rate and the decliningreserve stock provide the rallying points necessary to convince the publicin the high-inflation country to willingly accept the imposition ofunpopular domestic restraints. (See, for example, IMF (1970).) Bycontrast, it is claimed that a much weaker discipline exists for surpluscountries, since there is no equivalent constraint on the almost indefiniteaccumulation of reserves.

Under a flexible exchange rate regime, this asymmetry of reservediscipline is said to be absent. When rates are floating, the immediateconsequence of a relatively high inflation rate is a depreciation of thecurrency concerned and, in turn, a higher nominal price level in thehigh-inflation country. As long as the familiar Marshall-Lerner condi-tions for exchange market stability are satisfied, a flexible exchangerate will equilibrate supply and demand in the foreign exchange marketautomatically, and hence will remove the balance of payments as aconstraint upon domestic policy decisions for both surplus and deficitcountries. Thus, the external pressures to reduce the inflation rate willdisappear and, according to the discipline argument, inflation will behigher with flexible exchange rates than it would have been with fixedrates.

The validity of the reserve discipline hypothesis rests essentially ontwo propositions. The first is that a fixed exchange rate regime willreduce the dispersion of inflation rates across countries because, in con-trast to a floating regime, it does not permit countries whose desiredinflation rates are different from the world average to exercise thesepreferences. The second is that such dispersion is narrowed more byreducing the inflation rate of high-inflation countries than by increasingthe rate of low-inflation countries. The evidence bearing on these propo-sitions can be examined in turn.

To judge from the evidence currently available, the period sincegeneralized floating began (early 1973) has indeed been accompaniedby an increase in the dispersion of inflation rates across countries.Studies by Pigott, Sweeney, and Wille« (1975), Teigen (1975), andHeller (1976) have documented that inflation rates, as measured bothby consumer and wholesale price indices, have shown greater inter-country variation in the period 1973-75 than during most of the fixedrate period (e.g., 1960-70). Here again, however, one must be cautious



about ascribing this increase in the dispersion of inflation rates to float-ing per se, both because the exchange rate regime is only one amongseveral factors that can cause shifts in relative policy preferences aboutinflation, and because observed inflation rates also reflect other exogen-ous shocks.

Even if it is accepted that fixed rates reduce the dispersion of infla-tion across countries, this would not itself make them anti-inflationaryunless the second proposition also held. Fixed rates tend to tie allcountries to a common rate of inflation but, as Johnson (1973) haspointed out, there is no presumption that this rate should be high, low,moderate, or even positive. What then are the arguments for supposingthat the reserve discipline works asymmetrically, and specifically that itworks more strongly on high-inflation countries? It is certainly true thatthe transition to floating rates has been accompanied by high rates ofprice inflation, but it is much less clear whether this can be attributedto a loosening of policy restraints. As Witteveen (1975, pp. 112-13)has summarized:

. . . there is not much evidence that the transition to floating rates in 1973has led to a perceptible loosening in demand management. The expansionin money stocks which laid the foundation for the boom took place from1970 to 1972 which, despite an interlude of floating in 1971, was on thewhole a period of fixed rates.33

Taking a somewhat longer historical perspective, it is possible toargue that the nature of the adjustment mechanism as it actually oper-ated under the Bretton Woods system did in fact place a greater adjust-ment burden (discipline) on deficit than on surplus countries. This wasdue to the fact that deficit countries (at least those that were not reservecenters) were limited in their ability to resist adjustment because theirreserve holdings were finite; surplus countries, on the other hand, couldcontinue to accumulate reserves without sanctions other than those ofthe moral suasion variety. There has also been the tendency in politicaldiscussions of payments questions to equate balance of payments sur-pluses with good, and deficits with bad, economic management. Partly,this reflects a simple application of the economics of Mr. Micawber;in part, also, it has been buttressed in some countries by economicarguments based on the theory of export-led growth (Lamfalussy (1963)and Kaldor (1966)). But, whatever the reason, the political pressurehas frequently fallen more heavily on countries suffering from balanceof payments deficits and rapid inflation rates. Among major countries

33 Using data reported by Heller (1976) on the world money stock, it turns outthat the annual increase in the world money stock averaged 12.8 per cent for theperiod 1970-72 versus 11.5 per cent for the years 1973 and 1974.



that have been led to adopt restrictive domestic policies for balance ofpayments reasons have been the United Kingdom (1954-55, 1957,1960-61, 1965-66), Italy (1963-64), Japan (1956-57, 1963-64,1966-67), and France (1956-57). Finally, during much of the BrettonWoods period the international monetary system was operating with adeclining ratio of reserves to world trade; and in such an environmentof limited liquidity, it could be argued that reserve pressure wouldoperate most strongly on deficit countries.

Although the foregoing reserve discipline argument is often made, ithas not gone unanswered. In the first place, it has been claimed that thenature of the adjustment process under the Bretton Woods system inpractice imposed precious little discipline on deficit countries—and eventhat the main discipline was brought to bear on the surplus countriesthat wished to have lower than average inflation rates. Second, it hasbeen suggested that flexible rates contain their own brand of anti-inflationary discipline, which may even be more effective than the disci-pline of reserve availability. We shall consider each of these points inturn.

From our earlier discussion, it follows that if reserve discipline werepracticed only by surplus countries, or more strongly by them than bydeficit countries, then, in a reversal of the conventional case, one wouldbe led to the conclusion that fixed rates are likely to be more inflation-ary. To some observers this portrayal of the distribution of adjustmentis a better description both of the past operation of the Bretton Woodssystem and of future prospects for fixed rates than is the alternativeassumption that deficit countries will make the adjustments. In brief,the rationale for this position proceeds as follows.34 Because moneywages and prices are inflexible (or at least sticky) in a downward direc-tion and because modern governments are unwilling to tolerate theemployment losses associated with deflationary policies, it is unrealisticto expect deficit countries to adopt the discipline of deflation. Rather,their response to reserve losses is more likely to take the form of deval-uation or of direct controls on trade and payments. Therefore, ifbalance of payments equilibrium is to be re-established without alteringexchange rates, it will be incumbent upon surplus countries to adoptexpansionary policies such that their inflation rates increase vis-à-visthe deficit countries.

Clearly this view of how the Bretton Woods system operated is atvariance with the one advanced earlier, and concerns essentially the

34 See, for example, Friedman (1953), Johnson (1973), and Haberler (1974 a;1974 b).



interpretation of historical fact. We noted earlier several instances inwhich deficit countries were led to restrain domestic demand in theinterests of balance of payments equilibrium. On other occasions, how-ever (the United States is the most prominent but not the only example),deficit countries were enabled to maintain their exchange rates withoutdomestic measures, by running down reserves or borrowing abroad.Furthermore, particularly in the later years of the Bretton Woods sys-tem, many countries chose devaluation rather than trying to maintaintheir existing exchange rates through changes in domestic policies.Turning to the case of surplus countries, there is also something to besaid on both sides of the argument. The Federal Republic of Germanyprobably felt during much of the 1960s that it was being required tohave more domestic inflation than was desirable as the price of main-taining a fixed exchange rate; but nevertheless it was still able to run aconsiderable surplus on its balance of payments during this period.France, during the period 1960-66, and Sweden, during the period1950-66, also provide examples where demand-management policywas not adjusted to counter balance of payments surpluses.

All in all, the Bretton Woods experience is probably best viewed asproviding qualified support for the argument that balance of paymentsdeficits are likely to prompt stronger demand-management adjustmentmeasures than are comparable surpluses. This conclusion is essentiallythe one reached by Michaely (1971, pp. 63-64) in an empirical studyof the responsiveness of demand policies to balance of payments devel-opments in nine industrial countries over the period 1950—66: 35

Countries whose monetary policy generally responds to changes in the bal-ance of payments tend to make exceptions to this pattern of behavior mainlywhen they are in surplus. Similarly, compliance of monetary policy withbalance-of-payments requirements in generally noncomplying countries tendsto be found at times of deficits. . . . It also appears that this tendency is notnecessarily related to the level of external reserves. . . . It seems that coun-tries tend to regard as their external target not so much the attainment ofbalance-of-payments equilibrium as the avoidance of deficits. . . . The lossof reserves is viewed with concern; but their accumulation . . . is viewed, infact, with satisfaction or indifference.

Whatever asymmetries in reserve discipline are felt to have existedin the past, it is important to note that the same biases need not exist

35 The nine countries studied by Michaely (1971) were Belgium, France, theFederal Republic of Germany, Italy, Japan, the Netherlands, Sweden, the UnitedKingdom, and the United States. Michaely found that monetary policy was mostclosely adjusted to balance of payments conditions in the United Kingdom andJapan; less responsive to the balance of payments in France, Belgium, the Nether-lands, and Italy; and least responsive in the United States, the Federal Republicof Germany, and Sweden.



in any future fixed rate system. The asymmetries in the sharing of theadjustment burden under the Bretton Woods system were essentiallythe result of a malfunctioning of that system, and international monetaryauthorities are now well aware of them. It is accepted that in any futurepar value system, care should be taken to ensure that adjustment pres-sures fall equally on deficit and surplus countries.

In order for the discipline argument to yield an inflationary bias ina fixed exchange rate system, it is necessary not only that there beasymmetric pressures on surplus and deficit countries but also thatthese asymmetries have a stronger anti-inflationary bias when rates arefixed than when they are floating. This latter proposition has beenquestioned by Emminger (1973).3G Emminger points out that under apar value system the only immediate consequence of a high-inflationpolicy is a rundown of the stock of reserves of the country concerned.Under flexible rates, however, such behavior will result in a deprecia-tion of the exchange rate, and, in turn, an increase in domestic pricesin the high-inflation country. Thus, the cost of a high-inflation policy—the declining purchasing power of domestic incomes over foreigngoods—will be more easily and quickly noticed by the public underflexible rates. Assuming that inflation is unpopular, and that the govern-ment is responsive to public opinion, the foregoing implies in turn thatinflationary policies will be more quickly restricted under flexible ratesthan when there is the option of financing them by reserve depletion,as under fixed rates.

Once one admits, however, the reasonable possibility that the high-inflation country will ultimately have to devalue (if the fixed rate systemis of the adjustable peg variety), then the issue simply reduces to oneof whether a given increase in inflation now will have a greater disci-plinary effect than the perceived cost of a devaluation later. Further-more, even if policy makers are influenced by a desire to avoid inflationnow, it is still not clear that flexible rates are asymmetrical in theirinducements to adjust. Under flexible rates, countries may be equallykeen to avoid deflationary policies that cause their exchange rates toappreciate, because the safety valve of exports will not be available totake up slack in employment when domestic demand is inadequate.

The conclusion to be drawn is that flexible rates tend to magnifythe domestic consequences of policy mistakes; but it is not clear whythe authorities should be more concerned with inflationary than defla-

36 Also, see Crockett and Nsouli (1975) for a presentation of this point of view.



tionary mistakes, as would have to be true for flexible rates to generatean anti-inflationary bias.37

In summary, we find that there are quite good arguments on bothsides of the reserve discipline issue. On the whole, however, it seems tous that there is more reason to expect anti-inflationary discipline to bepracticed by deficit countries under fixed exchange rates than whenrates are floating—unless, of course, the exchange rate system includessome (new) additional feature designed to promote balance of paymentsadjustment by surplus countries. Again, however, such a conclusion istentative and does not touch on the welfare implications of reducingthe dispersion of inflation rates across countries—a point about whichmore is said in the concluding section.

III. Conclusions

This paper has addressed the question, "Are flexible exchange ratesmore inflationary than a system of fixed exchange rates?" Not surpris-ingly, the answer is, "It all depends," and in the preceding two sectionswe have sought to identify and evaluate the more important factors thatbear on the issue. Yet despite the numerous arguments and counter-arguments from one exchange rate system to the other and despite theimportance attached to this issue in discussions concerning internationalmonetary reform, we find it hard to escape the overall conclusion thatthe type of exchange rate system has relatively little influence on theaverage rate of world inflation. Having said this, there does appear tous to be a case—resting more on a priori plausibility and past experi-ence than on strong empirical evidence—for supposing that flexibleexchange rates make it easier for inflationary pressures to arise andto be accommodated than do fixed rates. In a world in which priceshave become less flexible over time in both directions, but especiallyso in a downward direction,38 the notion that devaluations (deprecia-tions) will produce a larger proportionate effect on domestic prices thanwill revaluations (appreciations) of the same size carries a certain intui-

37 If there is a nonlinearity in the relationship between the rate of inflation andthe level of excess demand, then policy errors in one direction may be judgedto be more serious than errors in the other direction. Such a nonlinearity wouldalso imply that it would be more inflationary (for the World as a whole) to"bottle up" inflationary disturbances in one country (as under flexible rates) thanto spread these disturbances around (as under fixed rates); see, for example, Flem-ing (1971) on this point.

38 Empirical support for this proposition, at least for the United States, can befound in Cagan (1974).



tive appeal. Similarly, it seems to us easier to find examples under fixedrates of the (reserve) discipline effect working to restrain demand thanthe reverse. But we would concede in all of this that our conclusion istentative and that other observers might interpret past history differ-ently.

Even if, however, it could be demonstrated that one exchange ratesystem was less inflationary than the other, this would not necessarilyimply that there would be a clear welfare advantage in choosing the lessinflationary system for at least two reasons. In the first place, theexchange rate regime has implications for the dispersion of individualcountry inflation rates about the world mean. If there is consideredto be an advantage in permitting countries to follow their own prefer-ences concerning inflation and unemployment targets, then there areclearly costs involved in constraining countries toward a common infla-tion rate as a fixed exchange rate regime implies.39 Thus, the "disciplineof conformity" required in a fixed exchange rate regime should beregarded, in our view, as a cost to be set against any benefits asso-ciated with fixed rates, including the possibility of a lower average rateof world inflation. Further, the extent of this cost will depend on howwidely dispersed countries' preferences concerning the desired rate ofinflation are about the world average. Second, most of the costs tradi-tionally associated with inflation (for example, the misallocation ofresources, the redistribution of income and wealth) relate for the mostpart to ¿/^anticipated inflation. A perfectly foreseen inflation will pre-sumably be discounted in all contracts relating to the future, and theonly welfare loss associated with it should be the wasteful use ofresources to economize on holdings of currency and of other noninterest-bearing means of payment. (See, for example, Tobin (1972).) To arguetherefore that a lower average rate of world inflation represents a clearwelfare gain is to imply that the average amount of unanticipatedinflation will fall with it. While there is mounting historical evidence(e.g., see Okun (1971), Logue and Willett (1976)) that higher meanrates of inflation are associated with greater variance (instability) ininflation rates (across countries), the strength of this relationship andthe explanation for it remain sufficiently cloudy (Gordon (1971)) topreclude drawing definite welfare implications.

Several other relationships between inflation and the exchange rateregime are also worth repeating. First, from the viewpoint of an indi-

:!n However, as long as there is no long-run trade-off between inflation andunemployment, there will be no permanent unemployment cost (or benefit) ofbeing obliged (by fixed rates) to adhere to a common inflation rate. See, forexample, De Grauwe (1975).



vidual country, the exchange rate regime may well influence how muchinflation it generates, transmits, or receives. For example, if a country'sdesired inflation rate is higher (lower) than the actual inflation rateprevailing in the rest of the world, one would expect, ceteris paribus,that country's actual inflation rate to be lower (higher) under fixed(flexible) rates. Similarly, if the source of a country's inflationary distur-bances are typically of external (domestic) origin, then, ceteris paribus,one would expect flexible (fixed) rates to be less inflationary. Second,in considering the transition from one exchange rate regime to another,say, that from fixed to flexible rates, one might expect the exchangerate regime to have a once and for all effect on the world price level.For example, if flexible rates are associated with both a higher uncer-tainty cost (for producers and consumers) and a lower demand forinternational reserves, than a move from fixed to flexible rates is aptto cause a once and for all upward jump in the world price level.Finally, while we have concentrated here on the effect of alternativeexchange rate systems on the rate of inflation, the dominant line ofcausation probably runs the other way. That is, as events of recentyears have dramatically demonstrated, where inflation is high, variable,and different across countries, it may well be the exchange rate regimethat adjusts before the rate of inflation.

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