The large dollar misalignment of the early 1980s and the persistence of current account imbalances have focused attention on the unsatisfactory performance of floating exchange rates since the collapse of the Bretton Woods system in 1973. In response, McKinnon and Williamson have proposed influential blueprints for more stable nominal exchange rates. McKinnon proposes that exchange rates be set at levels consistent with approximate purchasing power parity in internationally traded goods, and that they stay permanently fixed at those nominal rates. The G3 countries will cooperate over monetary policy in order to achieve price stability in traded goods and, according to McKinnon, inflation differentials will disappear. Williamson, on the other hand, favours setting target nominal rates consistent with fundamental equilibrium exchange rates (FEERs). These exchange rate targets, which may have to change from time to time, are those that will produce a current account exactly matched by equilibrium medium-term capital flows.
Critics of a return to stable nominal exchange rates have noted the absence of successful fiscal policy coordination among the G3 in practice as well as in the blueprints of McKinnon and Williamson. They argue that fixed nominal exchange rates will not solve problems caused by inappropriate fiscal policies. In Discussion Paper No. 322, Research Fellow George Alogoskoufis investigates the relation between fiscal policies and FEERs and the vulnerability of fixed exchange rate regimes to `extravagant' fiscal policies.
Alogoskoufis's analytical results confirm some of the criticism. He finds that fundamental equilibrium exchange rates cannot be defined independently of the path of fiscal policies: an expansionary fiscal policy in one country will affect its external debt through the accumulation of current account deficits. If the external debt stabilizes at a higher level in the medium run, the real exchange rate will have to depreciate and the natural rate of unemployment to rise in order to finance higher interest payments. Even temporary disequilibria in the balance of payments affect external debt accumulation and thereby the sustainable medium-term real exchange rate.
Alogoskoufis evaluates the empirical significance of these effects using a generalized dynamic model of the G5 industrial economies. For each economy in turn, he models the effects of a five-year, 3% p.a. fiscal expansion a more `extravagant' fiscal policy than that actually pursued in the United States since 1982. The results suggest that in a fixed exchange rate regime, the medium-run effects of misaligned fiscal policies and debt accumulation on equilibrium real exchange rates and unemployment are actually quite small for all the G5 economies, and are unlikely seriously to undermine the regime. Alogoskoufis finds that short-run misalignments of actual exchange rates are also small, especially when compared with the dollar misalignment of the mid-1980s, and at no point do they exceed 10% half the width of band suggested by Williamson in the extended target zones proposal.

On Fiscal Policies, External Imbalances and Fundamental Equilibrium Exchange Rates
George S Alogoskoufis

Discussion Paper No. 322, June 1989 (IM)