Views differ on the consequences of the shift from the Bretton Woods system to flexible exchange rates in the early 1970s. Continued disagreement over the real effects of nominal exchange rates has impeded convergence to a common theoretical model, while the alternative approach of focusing on correlations in the data allows any empirical pattern to conform to several theoretical interpretations. Changes in macroeconomic variables may reflect differences in the economic environment unrelated to the exchange rate regime. In Discussion Paper No. 729, Tamim Bayoumi and Research Fellow Barry Eichengreen stake out a middle ground by fitting the textbook aggregate supply/demand framework to historical time-series data for the G7 economies to assess the relative importance of disturbances under both fixed and floating rates. They find that a positive demand shock raises both output and prices in the short run and raises prices while leaving output unchanged in the long run, which is consistent with the theoretical framework in which supply shocks have permanent effects on output while demand shocks have only temporary effects.

They find a modest increase in the cross-country dispersion of supply shocks, but no increase in their average magnitude accompanying the regime change to floating rates. There was little change in either the cross-country dispersion or the average magnitude of demand shocks. Factors heightening the impact of shocks on the external accounts were more important, and they forced governments to respond to supply shocks by managing demand to stabilize prices and exchange rates at the expense of increased output volatility. Bayoumi and Eichengreen therefore maintain that the markedly greater volatility of prices and lower volatility of output after the breakdown of Bretton Woods reflected the different incentives and constraints imposed by flexible rates. Under fixed rates, monetary policy adjusted to stabilize the exchange rate, thus flattening the aggregate demand curve, increasing the output response and reducing the price response to supply shocks. The shift to floating rates freed monetary policy, thus steepening the aggregate demand curve, and other things equal increasing the volatility of prices relative to output.

Macroeconomic Adjustment Under Bretton Woods and the Post-Bretton-Woods Float: An Impulse-Response Analysis
Tamim Bayoumi and Barry J Eichengreen

Discussion Paper No. 729, November 1992 (IM)