Managed Exchange Rates
Asymmetry affects outcomes

Despite the theoretical appeal of flexible exchange rates, the historical experience of purely floating rates has been limited and disappointing. The IMF's classifications of exchange rate arrangements provide the most eloquent evidence that purely floating rates are an appealing theoretical concept rather than a common occurance. The most common regime in practice is one of managed exchange rates: since 1980 over 140 countries have been classified as pegging their currencies in some way.

Most research on internatinal policy conflicts and coordination focusses on models of purely floating exchange rates or fixed exchange rates. In a world of interdependent countries, however, a regime where countries manage their exchange rates by pegging to a numeraire currency and adjusting the peg at will may be empirically more relevant than a regime of rigidly fixed rates, or than a "clean float".


Studies international policy interactions in a two-country world characterized by the following rules: one country sets its own money supply independently, but gives up control of the exchange rate; the other country sets the exchange rate independently but gives up control of the domestic money stock.

This asymmetry is an important feature of managed exchange rate regimes, and the authors suggest that the evaluation of alternative exchange rate regimes should concentrate on the asymmetries which arise when exchange rates are neither floating, nor irrevocably fixed. Losses which arise from an absence of international coordination in a regime of managed exchange rates differ significantly from those arising under flexible rates. The analysis also sheds light on the costs and benefits (for any one country) of controlling the domestic money stock as opposed to the exchange rates. Perhaps the most interesting result

Whenever N countries actively manage their exchange rates, at most N-1 countries can independently affect their exchange rates because there are only N-1 independent bilateral rates. Consisting between the N-1 policy (the exchange rates) and N policy instruments can only achieved in an asymmetric system, in which one country gives up control of its own exchange rate and instead controls its own money supply, while the other N-1 countries control the price of their currency in terms of the Nth country's currency. Such asymmetry appears to have characterized the Bretton Woods system, Giavazzi and Giovannini argue, and asymmetry seems to be a feature also of the EMS. The issue of asymmetry is also central to international monetary reform. The international conflicts generated when countries try to pursue independent policy targets arise from a shortage of independent instruments.

Giavazzi and Giovannini first examine in a two-country model the effects of a shock to aggregate demand. In this case the country which controls its exchange rate (the 'home' country) is worse off than the country controlling its money stock (the 'foreign' country). The foreign country is able, through control of its money supply, to avoid the problems of overcontraction or overexpansion that affect the equilibria under managed exchange rates.

In contrast, the foreign country is worse off after a shock affecting aggregate supply. In this case the home country can manage its the exchange rate so as to control domestic price levels, but this occurs at the expense of the foreign country. This result is of interest for two reasons, Giavazzi and Giovannini note. First, it offers what they describe as 'the first example in a two-country model of a successful disinflation through an exchange rate appreciation.' The asymmetry of the system is essential to this result, the authors argue: in a symmetric floating rate regime, the two countries' efforts to alter their exchange rates to control inflation would offset each other. Second, in their model, countries have an incentive to export inflation through a real appreciation of their exchange rate, even while they expecting the inflation to return in the long run.

Giovannini and Giavazzi conclude that recent proposals to limit exchange rate flexibility cannot be fully evaluated without explicitly addressing the issue of asymmetry and the assignment of money and exchange rate instruments to the countries involved in cooperative agreements.


Monetary Policy Interactions under Managed Exchange Rates
Francesco Giavazzi and Alberto Giovannini

Discussion Paper No. 123, August 1986 (IM)