Exchange Rate Coordination - Target Zones

Greater exchange rate stability has been the aim of a number of recent proposals for international monetary reform. These range from a return to a system of irrevocably fixed exchange rates to the establishment of target zones within which the fluctuations of real exchange rates could be confined. The need for short-run flexibility in a world characterized by high capital mobility is a major argument against the return to a system of pegged exchange rates. Target zones have attracted the attention of both academic economists and policy-makers because they seem to reconcile long-run stability of real exchange rates with a degree of short-run flexibility.

Target zone proposals assign monetary policy the role of stabilizing the real exchange rate around a target level related to the economy's international competitiveness, called the fundamental equilibrium real ex-change rate. In such a system monetary policy is used to control a real variable (the real exchange rate), so it cannot provide a nominal anchor for the economy. This anchor should be provided instead by fiscal policy, which is assigned the role of keeping the level of economic activity at the 'non-accelerating-inflation rate of unemployment', or NAIRU. At a workshop on 16 January, the Centre brought together some of the leading advocates of target zones to discuss their proposals with policy-makers as well as academic and private sector economists.

Fred Bergsten {Institute for International Economics, Washington) discussed the need for reform of the world monetary system. The Versailles summit emphasized the need for a convergence of inflation rates and growth rates. By the time of the Plaza agreement such convergence had been achieved, but misalignments and imbalances had actually worsened. Policy-makers recognized the need for direct intervention in the foreign exchange markets. The Baker-Miyazawa pact of October 1986 suggested that progress had been made towards the adoption of target zones, although the pact featured no policy commitments by the United States or Japan.

The magnitude and persistence of exchange rate misalignments was evidence of the need for reform. So too was the volatility of exchange rates, although economists tend to view this as less important. The misalignments created by floating exchange rates were estimated to be twice as large as those of the Bretton Woods system. This problem affected surplus as well as deficit countries, since the surplus economies were damaged by sudden appreciations of their exchange rates. Recent reforms liberalizing capital flows had exacerbated this problem, and there was a danger that pressure for protectionism would increase and that trade flows would be restricted as a result. The international monetary system, Bergsten argued, not cope with liberalized capital flows. The aim of reforms should be to create an international monetary system in which exchange rates accurately reflect competitiveness, with the external account in balance.

It was unreasonable to blame current problems on national policies, because each country's policies affected the economy of every other country. It is often argued that reform of the exchange rate system would result in a loss of national sovereignty, particularly with regard to real economic variables. This was an illusion, according t? Bergsten: even the United States could not export its problems forever. A new International monetary system should be designed to make national policies more harmonious. The conditions for the adoption of a new system seemed particularly auspicious at present, Bergsten suggested, since the United States appeared to be keener on cooperation that it had been in the recent past.

John Williamson (Institute for International Economics) then outlined more detailed proposals for a reformed monetary system. The 'indicator system' adopted at the Tokyo summit required each member of the 'Group of Seven' to produce targets (or forecasts) for each of ten indicators several years ahead. The policy coordinator then had to discuss how these 70 variables could be made consistent. Such an approach might not work; it may prove to be over-determined, unless some Intermediate targets were adopted that could override the other indicators.

Williamson noted that this problem was of a kind first analysed by Meade and Mundell. Indicators of internal and external balance were needed, he suggested. Money GDP may be an appropriate internal indicator: such a target need not be exogenous but could be chosen as a positive function of the degree of spare capacity in the economy, so as to achieve gradual disinflation. Evidence suggested that money GDP could be predicted more reliably than either its real output or price components; this increased its suitability as a target variable. The appropriate external variable was the real effective exchange rate, and this target should be centred around the level of the exchange rate compatible with current account balance.

Two main policy instruments were available to achieve these targets. Fiscal policy could be used to regulate money GDP in individual countries; this would rely on the use of automatic stabilizers as well as some degree of fiscal activity, but need not include any attempt at 'fine-tuning'. Interest rate differentials between countries, with some help from intervention in the foreign exchange markets, could be used to maintain real exchange rates near their target levels. Finally, the world level of money GDP would be regulated by x changes in the level of world interest rates.

The essential features of the 'indicator' proposal could be implemented through an international agreement in which monetary authorities would attempt to keep exchange rates within target zones centred on equilibrium real effective exchange rates. To this end John Williamson and Fred Bergsten proposed a wide target band of 10% on each side of the equilibrium real exchange rate. A 'crawling' wide band, which was adjustable in response to real shocks but not to speculation, should maintain the system's flexibility. It should ease balance of payments adjustment, allow for cyclical differences in monetary policy, and provide a means of absorbing speculative shocks. Movements outside the wide band would be resisted by means of interest rate changes and intervention in the foreign exchange markets. Williamson argued that such movements were, in any case, less likely in his proposed system, because international agreements would enhance the credibility of the system.

Richard Portes (CEPR and Birkbeck College, London) suggested two issues for discussion: Williamson's suggested assignment of instruments to targets, with particular reference to the role of fiscal policy; and the use of the exchange rate as a tool for controlling inflation. Both Portes and Simon Broadbent (Foreign and Commonwealth Office) were concerned about the ability of Williamson's proposed system to absorb large and sudden capital movements. Bergsten replied that the width of the target bands should provide sufficient flexibility to avoid any need for restrictions on capital mobility.

Samuel Brittan {Financial Times) pointed out that some countries, such as Japan, were now long-term capital exporters: current account balance was not necessarily desirable for these countries or for the world economy. He was also concerned about the difficulties involved in distinguishing 'equilibrium' from 'disequilibrium' capital flows.

Pen Kent {Bank of England) thought that even in the reformed system surplus countries might remain unwilling to adjust. Adam Ridley (Hambros Bank and CEPR) suggested that the Bretton Woods system had collapsed because US hegemony had broken down. Any new system might also founder through the lack of a hegemon. Christopher Bliss (Nuffield College, Oxford, and CEPR) noted that there were fundamental problems in securing agreements over targets, and that rules were needed to allocate policy responses. Bergsten agreed on the difficulty in reconciling current account targets but added that the issue could not be evaded. The cost of pursuing internationally inconsistent national policies probably outweighed the difficulties of resolving the fundamental problems described

Christopher Johnson (Lloyds Bank) wondered whether the target  exchange rate zones would be expressed In nominal or in real terms. Williamson replied that they were set In real terms, although these could obviously be converted to nominal values. There was some debate over the appropriate deflator to be used In calculating a real exchange rate. Johnson suggested a deflator based on unit labour costs, but Williamson noted that the use .of such a deflator created difficulties: in  some countries labour productivity grows more rapidly In the. traded than in the non-traded sector. Movements In overall unit labour costs may therefore be an inaccurate indicator of changes in the level of competitiveness.

Patrick Minford (University of Liverpool and CEPR) argued that target exchange rate zones, expressed in real terms, would accommodate inflation. But Williamson replied that local inflationary surges would be suppressed by the use of fiscal policy, and Marcus Miller (University of Warwick and CEPR) added that world inflation would be controlled by use of world monetary policy. David Vines (University of Glasgow and CEPR) thought it more sensible to regulate world inflation in the same way as local inflation, i.e. through the use of fiscal policy. Christopher Taylor (Bank of England) was concerned that the use of fiscal policy to control domestic GDP might disturb the exchange rate: Williamson contended that it would be easy to set monetary policy to prevent this.

Michael Anis {University of Manchester and CEPR) argued that both Bretton Woods and the European Monetary System had tended to operate so as to reduce inflation levels. In the case of the EMS, however, the long-term commitment seemed to be to a real rather than a nominal rate. Christopher Taylor was concerned that a money GDP target might not appear to be a credible basis for a domestic counter-inflation inflation policy, if at the same time it were known that the exchange rate would accommodate inflation. Martin Weale (University of Cambridge and Bank of England) suggested that the use of taxes as a means of stabilization could cause difficulties, if tax increases had a 'cost-push' effect on wages. Williamson responded that fiscal policy was an adequate means of controlling local money GDP and thus Iocal inflation. The use of the exchange rate to this end was particularly damaging to the traded-goods sector and led to a balance of payments which would probably not be permanently sustainable. Definition of exchange rate target zones In. real terms did not imply acquiescence to Inflation, Williamson concluded.