Exchange-Rate Systems

Robert Mundell, Canadian Professor and 1999 Nobel Prize Winner, died April 3 2020, after a long illness. He was 88.

For over 40 years, the seminal Mundell-Fleming model has served as a template for research in international macroeconomics. The early works of Robert Mundell and J.M. Fleming on the fixed-exchange-rate system were particularly important in explaining the Bretton Woods exchange-rate system and how inconsistent policies led to the system’s collapse. Their model is also important today in explaining how surplus countries like China use their international reserves to keep their currencies relatively fixed at a devalued level. Mundell’s work on common currency areas also provided the foundation for the development of the euro, and his macroeconomic work was the foundation for supply-side economics. As Maurice Obstfeld states: “a testament to the lasting influence of their work is that much of the current discussion on exchange-rate systems can be framed to what Fleming and especially Mundell accomplished in their work of the 1960s and 1970s (….) No wonder this body of work has been honored through the award to Mundell of the 1999 Nobel Prize in Economic Sciences.” This article examines the fixed and flexible exchange rates system and the Nobel contributions of Mundell, as well as Fleming, in providing a template for understanding how they each work.

Exchange-Rate Systems

In the late 19th and early 20th centuries, many of the world’s major economies operated under the fixed-exchange-rate gold standard. Under the gold standard, each country maintained a reserve of gold and agreed to exchange one unit of its currency for a specified amount of gold. For example, the U.S. Treasury stood ready to buy and sell an ounce of gold for $10 and the Bank of England stood ready to buy and sell an ounce of gold for £10. Together, these commitments fixed the rate between the USD and British pound at $1 = £1. If the gold-determined parity was not maintained, then there was an arbitrage opportunity to buy gold in one currency and sell it in another. During this period, the international transport of gold by arbitrageurs was the mechanism for adjusting the country’s money supply and stabilizing the exchange rate. The Depression, in turn, changed the commitments by governments to the fixed system. Germany, France, Italy, and the Netherlands tried to maintain their exchange rates, while the U.K., Sweden, and Norway devalued their currency by lowering their currency’s price for gold. In the U.S., the Hoover Administration maintain the gold standard, while the Roosevelt Administration took the U.S. off the system. The years between World War I and World War II marked a period of world-wide depression and nationalism: the passage in 1930 of the Smoot-Hawley Tariff Act, leading to an increase in import duties to as high as 60%, the replacement of the gold standard of fixed exchange rates with a fragmented system of floating exchange rates, and the United States’ refusal to be an international lender of last resort.

In July 1944, 44 delegates from the allied countries convened for a world conference at the Mount Washington Hotel in Bretton Woods, New Hampshire. The objective of the Bretton Woods Conference was to establish an integrated international system that allowed countries to pursue domestic policies aimed at promoting full employment. The principal architects of the new system were John Maynard Keynes and Harry Dexter White. In the Bretton Woods Agreement that emerged from the conference, signatory nations agreed to a system of fixed but adjustable exchange rates. Deficit countries were required to intervene in the foreign currency market to stop their currency from depreciating by buying it with their international reserve holdings (central bank holdings of gold and currency). For the system to function, countries would need to have a sufficient amount of international reserves. To ensure adequate reserves, the International Monetary Fund (IMF) was created. The IMF worked like a banking system, in which each country contributed capital based on their proportion of world trade and created a fund from which central banks could borrow currency to support their exchange rates.

The Bretton Woods fixed-exchange-rate system also created the need for countries to impose capital controls. In the 1950s and early 1960s, New York was the most accessible market for corporations to raise capital. As a result, many foreign companies issued dollar-denominated bonds in the United States. The popularity of the Yankee bond market began to decline when the U.S. government imposed the Interest Equalization Tax on foreign securities purchased by U.S. investors. The tax was aimed at reducing the interest rate differences between higher-yielding foreign bonds and lower-yielding U.S. bonds—a difference that U.S. investors could take advantage of given the fixed exchange rates. Predictably, it led to a decline in the Yankee bond market. However, it also contributed to the later development of the Eurobond market as more foreign borrowers began selling dollar-denominated bonds outside the United States. The Interest Equalization Tax was repealed in 1974.

This Bretton Woods system, however, led to persistent external imbalances amongst countries that had inconsistent stabilization policies. For example, a deficit country fighting unemployment with expansionary monetary and fiscal policies found its policies offsetting the normal monetary contraction to the balance of payments deficit. These countries would eventually run out of the international reserves needed to maintain the system and be forced to either allow for the monetary contraction or petition the IMF to allow it to devalue. This was the case in 1972 when the U.S. devalued the dollar by allowing it to be determined in the foreign currency market. In 1973, the U.S. announced that it would no longer support the dollar. This marked the collapse of the fixed-exchange-rate system and the de facto move to the flexible-exchange-rate system where the exchange rate is determined in the foreign currency market.

Today, the world is a combination of fixed and flexible exchange rate regimes. Most advanced nations operate with a flexible system in which the exchange rate is determined in the currency market. Others peg their currency to USD, euro, British pound, or other currency, using their international reserves to maintain their currency’s value. Others, such as Switzerland, oil-exporting countries, and China used their FC holdings to stabilize their currencies. Finally, for the countries in the European Monetary Union, the acceptance of the euro represents the most complete fixed system.

Robert Mundell

In a 1949 address to the House of Commons, Winston Churchill remarked that “there is no sphere of human thought in which it is easier to show superficial cleverness and the appearance of superior wisdom than in discussing questions of currency and exchange.” The history of different exchange rate systems certainly attests to Churchill’s sentiments. Churchill’s comment notwithstanding, one of the enduring contributions to economic literature are the economic models derived by Robert Mundell and J.M. Fleming that explain how alternative exchange rate systems operate. The Mundell-Fleming model and related works represent an extension of the seminal work of James Meade (1951). Meade’s treatise on the balance of payments combined Keynesian economic conditions with monetary factors to explain the balance of payments, the economic impacts of devaluations, and the factors governing the flexible exchange rate system. As Frenkel and Razin (1987) point out, Mundell’s model extended Meade’s work by providing the explanation of how international capital flows and monetary changes worked to restore internal and external equilibriums. Related works by Mundell subsequently addressed how fixed and flexible exchange-rate systems adjusted to exogenous shocks, the importance of fiscal policy for restoring a full-employment under a fixed-exchange-rate system, and the monetary approach to the balance of payments equilibrium. The earlier works by Mundell (1960, 1961, 1962, 1963, and 1968)), along with Fleming (1962) on the fixed-exchange-rate system are particularly important in explaining the monetary adjustment to an imbalance under the Bretton Woods system and how inconsistent policies led to the system’s collapse. Today, the Mundell-Fleming fixed-exchange rate model is important in explaining how surplus countries like China use their international reserves to keep their currencies relatively fixed at a devalued level.

Mundell-Fleming Models of Exchange-Rate Systems

At a macroeconomic level, the major distinction between international trade and intra-national trade is that the former involves two different monetary units. A U.S. importer buying BMWs manufactured in Germany creates a simultaneous demand for euros and a willingness to supply USDs. A German manufacturer buying IBM software creates a simultaneous demand for USDs and a supply of euros. For an exchange to occur, there has to be a market for the trading of euros and USDs—a foreign exchange market. This is not the case in intra-national trade. Thus, international trade creates a market for foreign currency. The foreign currency market consists of large commercial banks and central banks that act as dealers, maintaining inventories of foreign currencies.

In general, when a country has an international balance of payments deficit where its imports and capital outflows (domestic residents’ purchases of foreign securities) exceed its exports and capital inflows (foreign purchases of domestic securities), the deficit can have three economic impacts:

1. The deficit, by increasing the demand for foreign currency (FC), can cause the domestic price of FC to increase.

2. The money supply can decrease as domestic banks go into the foreign currency market to buy the currency; this results in a local currency outflow and an increase in the domestic interest rate.

3. International reserves (the central bank’s holdings of foreign currency, gold, and credits) can decrease if the central bank sells its FC to banks or intervenes into the exchange market to buy its currency with its FC reserves.

When a country has a balance of payments surplus, the surplus can have the opposite impacts:

1. The surplus can cause the FC price of the local currency to increase as foreigners try to buy the local currency with their currency.

2. Foreign currency holdings can increase. With a surplus, domestic banks will be selling domestic currency to foreigners (or their banks). The foreigners then use the currency to buy imports or foreign capital. These actions would not necessarily change the money supply since foreigners would be buying the local currency from banks and then using the currency to buy their imports or foreign capital. The surplus would, however, increase the FC holdings of domestic banks. If the domestic banks were to convert the FC to local currency (with the central bank or with foreign banks), then the money supply would increase.

3. The surplus can cause the international reserves of the central bank to increase if banks sell their FC to the central bank.Whether a deficit or surplus changes the money supply, exchange rate, or international reserves, depends on the type of exchange rate system that exists.

Mundell-Fleming Flexible Model

Under a flexible system, a balance of payment deficit or surplus leads to changes in the exchange rate and money supply. As explained by Mundell, in the foreign currency market, a deficit reflects excess demand for FC. This excess demand increases the domestic price of FC and decreases the country’s money supply as its banks and financial institutions go into the currency market to buy FC with their local currency holdings. On the other hand, if a country has a surplus, then it will be reflected by an excess supply of FC. This excess lowers the domestic price of FC (increases the FC price of the domestic currency) and increases the FC holdings of the country’s banks and financial institutions. If banks and financial institutions subsequently convert their FC holdings to local currency, then the money supply will increase.

Mundell-Fleming's flexible-exchange-rate model is particularly useful in explaining how monetary and fiscal policies affect the balance of payments and the exchange rate. In terms of the model, the impact on the exchange rate from tax policies, government expenditure increases, and central bank monetary policies of increasing or decreasing interest rate can be explained in terms of four effects:

1. The internal impact the policy change has on GDP, inflation, and interest rates.

2. The balance of payments impacts that the resulting changes in GDP, inflation, and interest rates have on imports, exports, and capital flows.

3. The foreign currency impact that the resulting changes in the balance of payments items have on the supply and demand for FC.

4. The equilibrium adjustment impact in which the resulting excess supply or demand for FC leads to new equilibrium levels for interest rate and exchange rate.

For example, an economic policy, such as an expansionary monetary policy, that expands the economy and lowers the interest rate, also increases the demand for imports and domestic investments in foreign securities and decreases the demand in foreign investments. This, in turn, leads to excess demand for foreign currency and an increase in the domestic price of foreign currency.

Mundell-Fleming Fixed Model

Under the Bretton Woods fixed-exchange-rate system, a deficit country was required to intervene in the currency market to stop its exchange rate from increasing by using its international reserve holdings. Corrections to a balance of payments deficit and surplus then worked through changes in the money supply and international reserves. This monetary adjustment to a deficit or surplus was first pointed out by the Canadian economist Harry Johnson (1972) and then later used by Mundell and Fleming to explain the equilibrium adjustment process under a fixed-exchange-rate system.

In the Mundell-Fleming fixed-exchange-rate model, the contraction in the deficit country's money supply, in turn, would cause interest rates to increase, leading to decreases in capital investments, and via a multiplier, decreases in GDP and aggregate income. The income and price decrease and the interest rate increase work in the same direction to correct the deficit. That is, the income decrease would lower imports, the price decrease would increase exports and lower imports, and the interest rate increase would augment net capital flows. A surplus, in contrast, would cause foreign currency holdings to increase, which would cause the money supply to increase if it were converted. For a surplus country, the expansion in the money supply (if allowed by the central bank) would cause aggregate income and prices to increase and interest rates to decrease. The income increase would augment imports, the price increase would increase imports and decrease exports, and the interest rate decrease would lower net capital flow. The income, price, and interest rate effects on the balance of payments thus would work in the same direction to correct the surplus.

In a fixed-exchange-rate system, the equilibrium adjustment works through changing the money supply. As Mundell points out, under the fixed system, the cause of persistent imbalances is inconsistent policies. For example, a surplus country fighting inflation with contractionary monetary or fiscal policies, or with its central bank policy sterilizing its reserves by refusing to convert foreign currency, would find its policies offsetting the normal monetary expansion resulting from the surplus. In the Mundell-Fleming model, the country has a balance of payments surplus. On the other hand, a deficit country fighting unemployment with expansionary monetary policy or fiscal policy would find its policies offsetting the normal monetary contraction resulting from the deficit. The country would have an internal equilibrium but a balance of payments deficit.

A corollary of the Mundell-Fleming fixed model is the “Impossible Trinity.” This is a doctrine in international economics that states that it is impossible for three of the following to occur at the same time: a fixed foreign exchange rate, free capital movement, and an independent monetary policy.

Collapse of the Bretton Woods System

Under the Bretton Woods system, a deficit country fighting unemployment could maintain this position as long as it had sufficient international reserves. Eventually, though, the country would run out of reserves and be forced to either allow for the monetary contraction or petition the IMF to allow it to devalue. This was the case in the late 1960s as U.S. economic policies turned highly expansionary (government financing of “The Great Society” programs and the Vietnam War). During this period, the US federal budget shifted into deficit, while the Federal Reserve pursued an accommodating monetary policy, supplying liquidity to the financial system. U.S. interest rates rose as the economy boomed, but not enough to contain inflation, which accelerated to 4%. The U.S.’s monetary and fiscal policies also created problems in Europe, especially in Germany, Netherlands, and Switzerland, where the primary objective of monetary policy was to keep inflation low, typically at 2% or less. These countries accumulated international reserves, as their trade surpluses expanded. The Bundesbank, Swiss National Bank, and other central banks attempted to counter this trend by draining liquidity from the financial system. However, the upward pressure on European interest rates attracted international capital flows from abroad, which made it increasingly difficult for these central banks to control their money supplies. By 1970, U.S. inflation reached 5% and the U.S. began to run a trade deficit for the first time. Under the Bretton Woods System, European central banks were obliged to buy dollars at a fixed exchange rate, and the U.S. was not constrained by the balance of payments from creating more dollars. As a result, European and Japanese foreign central banks accumulated unwanted dollar foreign exchange reserves, and they increasingly sold their dollars for gold. In 1972 and 1973, the U.S. devalued the dollar by allowing it to be determined in the foreign currency market. Finally, in 1973, the U.S. announced that they would no longer support their currency. This marked the collapse of the fixed-exchange-rate system and the de facto move to the flexible-exchange-rate system. In retrospect, the Bretton-Woods system was unsustainable.

China’s Quasi Fixed System

Under the current flexible system, a surplus country with a central bank policy of sterilizing its reserves to keep its currency devalued could maintain such a position as long as there is no retaliation. As noted, this has been the case in China, where over the last 20 years the country has maintained large international reserve holdings, a stable but devalued currency, and persistent surpluses. From 1995 to 2001, for example, the yuan was pegged to the USD at 8.25 yuan/$, precipitating US threats with tariffs. In 2005, China announced a policy of permitting a gradual increase of the yuan relative to a currency basket. This, in turn, has led to a de facto fixed-exchange-rate system for China with its trading countries. Just as the Bretton Woods system collapsed because of inconsistent policies, the current system may also be unsustainable if deficit countries retaliate with trade restrictions against what they see as currency manipulation.

Conclusion

In addition to explaining how the Bretton Woods System collapsed and how today China uses its reserves to maintain a devalued currency, the Mundell-Fleming model has also been used to explain how countries in the European Monetary Union lose their monetary control and the policy implications such a loss had on countries like Greece when they were faced with economic stagnation, how the 1994-1995 Mexican financial crisis forced the Mexican Central Bank to devalue its pegged currency after it lost its dollar reserves, and the how the 1997-1998 Asian financial crisis impacted Thailand, South Korea, and Indonesia. The Mundell-Fleming model is also a valuable pedagogical model for explaining international macroeconomics and the “Impossible Trinity.” Their model is presented in several international and macroeconomic texts (see Mankiw 2013, Appleyard et al. 2005, and Pugel 2004), and is even included as prep material for the Chartered Financial Analyst (CFA) level 2 exam.

Mundell’s body of work also provided the foundation for the integration of James Tobin’s (1969) portfolio balance approach with monetary flows in explaining floating exchange rates, the extensions of Black’s (1973) rational expectation’s argument to exchange rates and Dornbush’s (1976) exchange rate overshooting model. Finally, Mundell’s work on common currency areas provided the foundation for the development of the euro, and his work on monetary and fiscal policy was the foundation for supply-side economics.

Numerous academic papers have applauded the enduring contributions of Mundell and Fleming. In his overview of international macroeconomics, Maurice Obstfeld states: “Mundell and Fleming provided the basic template for much of the subsequent research in both theory and policy.” Obstfeld further notes that “a testament to the lasting influence of their work is that much of the current discussion can be framed to what Fleming and especially Mundell accomplished in their work of the 1960s and 1970s (….) No wonder this body of work has been honored through the award to Mundell of the 1999 Nobel Prize in Economic Sciences.” (Obstfeld 2001, p. 2).

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