Exchange Rates
Speculative pressures

Fixed exchange rate agreements enable governments to commit to low inflation at the cost of abandoning a policy instrument for stabilizing output fluctuations. The Exchange Rate Mechanism of the EMS proved successful in reducing inflation, and its effective collapse in August 1993 renewed interest in the role of speculative pressures. If capital market liberalizations and market fundamentals such as high interest rates, terms-of-trade changes and a recessionary policy stance are primary causes of such pressures, an exchange rate regime that is viable in `normal' periods may break down when pressure to use the exchange rate instrument becomes ovewhelming. In Discussion Paper No. 969, Research Fellow Torben Andersen shows that the incentive to participate in a fixed exchange rate system is indeed `state dependent' in this sense, since the likelihood of breaking the commitment is greatest under adverse shocks such as the substantial terms-of-trade shocks that afflicted European currency markets in 1992-3.

Member countries of a fixed rate system abandon their ability to alter their exchange rates with non-members, but the latter may still change their exchange rates unilaterally. A country that abandons (formal or informal) membership by devaluing induces an appreciation in the remaining members' effective exchange rates and a terms-of-trade shock. It also has an incentive to devalue to mitigate the shocks arising from devaluations by countries with which it has significant trade, so devaluations may be contagious. Andersen cites the example of Denmark, which in 1992-3 had the lowest inflation in Europe and a current account in substantial surplus. Nevertheless, substantial intervention and interest rate rises were needed to protect the krone once devaluations by its major trading partners (Norway, Sweden and the UK) raised its effective exchange rate by some 6% within a year, which led to speculation over whether policy-makers would accept such a recessionary shock when unemployment was already substantial. Similar stories apply to the other Nordic countries, whose fixed rates had been based on unilateral pegs rather than formal membership of the ERM. Finland was the first to float its currency in September 1992, in response to developments in the then Soviet Union. This devaluation significantly affected Sweden, which switched to a float in November and was followed by Norway in December.

Shocks and the Viability of a Fixed Exchange Rate Commitment
Torben M Andersen

Discussion Paper No. 969, June 1994 (IM)