Exchange Rate Management
A return to gold?

The classical `gold standard' and the postwar Bretton Woods system of fixed but adjustable exchange rates are widely regarded in retrospect as examples of successful fixed exchange rate regimes, with sufficient flexibility to ensure the smooth adjustment of income, employment and the balance of payments. In contrast, the international monetary systems of the interwar period and the `Jamaica' system of managed exchange rates, which succeeded Bretton Woods, are criticized for their failure to combine stability with flexibility.
In Discussion Paper No. 390, Research Fellow George Alogoskoufis examines the performance of these regimes to investigate whether fixed or managed exchange rates are more conducive to the control of inflation. Time series for the UK and the US over the past century indicate that inflation has generally been less `persistent' (i.e. less dependent on its past value), and the variance of inflationary shocks much smaller, in periods of fixed exchange rates than in comparable periods with managed exchange rates. Time series for 21 OECD countries in the postwar period confirm this finding with regard to the persistence of inflation, but are far less clear on the variance of inflationary shocks.
Alogoskoufis tests the thesis that it is the use of exchange rate management to accommodate domestic inflation (or deflation) that has caused the persistence of inflation to increase. He does this by employing an overlapping contracts model of the inflationary process, in which wage setters are assumed to take account of future inflation in setting nominal wages, but prices are a mark-up on unit labour costs, and thus depend both on productivity and on recent wage settlements. Under fixed exchange rates, domestic inflation displays very low persistence, as workers are assumed to understand the dependence of prices on wages, and an inflationary shock will cause only a temporary blip in prices. Under managed exchange rates, however, the persistence of inflation will increase: an exchange rate depreciation raises the domestic prices of imports, thus exerting a cost-push influence on domestic inflation; and the accommodation of a domestic inflationary shock by the exchange rate weakens the `automatic' stabilizing effect of the reduction in aggregate demand that would otherwise result from the appreciation of the real exchange rate.
Alogoskoufis finds strong empirical support for the hypothesis that flexible exchange rate regimes are characterized by persistent inflation in the results of an examination of UK exchange rate policy from the end of World War I to the restoration of the gold standard in 1925, and in econometric estimates of accommodation coefficients for 21 OECD economies over the period 1972-87. Almost without exception, exchange rates tend to accommodate a significant percentage of inflation differentials in the short run.

Exchange Rate Regimes and the Persistence of Inflation
George S Alogoskoufis

Discussion Paper No. 390, March 1990 (IM)