An undervalued exchange rate may be a form of a protectionism: a country may deliberately pursue policies which lead to undervaluation, in order to encourage a surplus on the current account of its balance of payments and the growth of its tradable goods sector. Little attention, however, has been given to the implications for the world economy if more than one country pursues such exchange rate protection. In Discussion Paper No. 195, Research Fellow Christopher Bliss and Vijay Joshi use a simple theoretical model to investigate what happens if two trading partners use exchange rates as a protectionist device.

Corden has argued that international laissez-faire (i.e. non- cooperative behaviour by governments in setting their exchange rates) would lead to an efficient equilibrium despite the pursuit of exchange rate protection. Suppose, for example, that the US seeks to protect its tradable industries by reducing interest rates and consequently devaluing the exchange rate and improving its current account. This may be incompatible with the Japanese government's desire to run a current account surplus for a similar purpose. But the reduction in the US interest rate would reduce the return to Japanese lending to the US (the counterpart to its trade surplus) and consequently increase the cost to the Japanese government of protecting its own tradable industries. This, it is argued, would make the Japanese government willing to reduce protection of its tradable sector and render the two exchange rate protection policies compatible. Corden's argument rests on the ability of the international monetary system to coordinate the decentralized decisions governments same fashion a market system. Bliss and Joshi argue that this analogy is only convincing in a world of many small countries. If two or more large countries use the exchange rate as a protectionist device, an inefficient equilibrium may result.

Bliss and Joshi focus on the medium term, in which money wages and prices are assumed to be flexible and all resources find employment somewhere in the economy. Governments are assumed to value both the size of the tradable sector and private consumption. Exchange rate protection can be achieved by a country increasing its national saving rate and exporting capital: the resulting depreciation of the real exchange rate would protect the tradable sector. The government will adopt exchange rate protection if the benefit of this intervention (as evaluated by the government) exceeds its cost. Bliss and Joshi also consider a more general model which takes account of the possible terms of trade effects of exchange rate protection: in this model a country may wish to operate with an overvalued exchange rate which squeezes its tradable sector in order to enjoy the benefits of cheaper imports.

Bliss and Joshi argue that although both models are highly stylized, they may throw light on current policy questions. The first model may reflect the experience of countries such as Germany (before 1969 and again in the mid-1970s) and Japan (until 1986), which have apparently pursued policies leading to medium- run undervaluation of their exchange rates and persistent balance of trade surpluses. The more complex model is relevant to countries such as the United States (until 1986), which could be held to have pursued the opposite policy of overvaluation in order to reap the benefits flowing from improved terms of trade. The models may also help explain why, despite much rhetoric, there was for a long time no active conflict between the US and Japan over exchange rates. The US, for example, may penalize its tradable sector by increased borrowing on the world market: the employment and anti-inflationary benefits of its terms of trade improvement may outweigh the costs of the rise in the interest rate and the reduction in tradable output. Japan, on the other hand, may not retaliate because the benefits from tradable output expansion and higher interest rates outweigh the costs of its terms of trade deterioration.