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Section 2

The International Monetary SystemIn May 2001, the International Monetary Fund (IMF) agreed tolend $8 billion to Turkey to help the country stabilize itseconomy and halt a sharp slide in the value of its currency. Thiswas the third time in two years that the international lendinginstitution had put together a loan program for Turkey, and itwas the 18th program since Turkey became a member of theIMF in 1958.Many of Turkey’s problems stemmed from a large andinefficient state sector and heavy subsidies to various privatesectors of the economy such as agriculture. Although theTurkish government started to privatize gram, using theproceeds to pay down debt; the reduction state-owned compa-nies in the late 1980s, the programs proceeded at a glacial pace,hamstrung by political opposition within Turkey. Instead ofselling state-owned assets to private investors, successivegovernments increased support to unprofitable state-ownedindustries and raised the wage rates of state employees. Nor didthe government cut subsidies to politically powerful privatesectors of the economy, such as agriculture. To support stateindustries and finance subsidies, Turkey issued significant valuethe lira by a predetermined amount each month amounts ofgovernment debt. To limit the amount of debt, the govern-ment simply printed money to finance spending. The resultpredictably, was rampant inflation and high interest rates.During the 1990s, inflation averaged over 80 percent a year whilereal interest rates rose to more than 50 percent on a number ofoccasions. Despite this, the Turkish economy continued to‘grow at a healthy pace of 6 percent annually in real terms, aremarkable achievement given the high inflation rates andinterest rates.By the late 1990s, however, the “Turkish miracle” of sustainedgrowth in the face of high inflation and interest rates wasrunning out of steam. Government debt had risen to 60,percent of gross domestic product government borrowing wasleaving little capital for private enterprises, and the cost offinancing government debt was spiraling out of control.Rampant inflation was putting pressure on the Turkishcurrency, the lira, which at time was pegged in value to a basketof other currencies.Realizing that it needed to drastically reform its economy, theTurkish government sat down with the IMF in late1999 towork out a recovery program, adopted in January 2000.As with most IMF programs, the focus was on bringing downthe inflation rate, stabilizing the value of the Turkish currency,and restructuring the economy to reduce government debt. TheTurkish government committed itself to reducing governmentdebt by taking a number of steps. These included an acceleratedprivatization program, using the proceeds to pay down debt;

the reduction of agricultural subsidies; reform to make it moredifficult for people to qualify for public pension programs; andtax increases. The government also agreed to rein in the growthin the money supply to better control inflation. To limit thepossibility of speculative attacks on the Turkish currency in theforeign exchange markets, the Turkish government and IMFannounced that Turkey would peg- the value of the lira againsta basket of currencies and de throughout 2000, bringing thetotal devaluation for the year to 25 percent. To ease the pain, theIMF agreed to provide the Turkish government with $5 billionin loans that could be used to support the value of the lira.Initially the program seemed to be working. Inflation fell to 35percent in 200b, while the economy grew by 6 percent. By theendof2000, however, the program was in trouble. Burdenedwith nonperforming loans, a number of Turkish banks faceddefault and had been taken into public ownership by thegovernment. When a criminal fraud investigation uncoveredevidence that several of these banks had been pressured bypoliticians into providing loans at below market interest rates,foreign in vestors, worried that more banks might be involved,started to pull their money out of Turkey. This sent the Turkishstock market into a tailspin and put enormous the pressure onthe Turkish lira. Sensing that the government might be forcedto devalue the lira at a faster rate than planned, traders in theforeign exchange market started to sell the lira short, while theflow of foreign capital out of Turkey increased to a flood, whichput even more pressure on the lira. The government raisedTurkish overnight interbank lending rates to as high as 1,950percent to try to stem the outflow of capital, but it was clearthat Turkey alone could not halt the flow.The IMF stepped once more into the breach, December 6, 2000,announcing a quickly arranged $7.5 billion loan program for thecountry. In return for the loan, the IMF required the Turkishgovernment to close 10 insolvent banks, speed up itsprivatization plans (which had once more stalled), and cap anypay increases for government workers. The IMF also reportedlyurged the Turkish government to let its currency float freely inthe foreign exchange markets, but the government refused,arguing that the result would be a rapid devaluation in the lira,which would raise import prices and fuel price inflation. Thegovernment insisted that reducing inflation should be its firstpriority.This plan started to come apart in February 2001. A surge ininflation and a rapid slowdown in economic growth once morespooked foreign investors. Into this explosive mix wadedTurkey’s prime minister-and president, who engaged in a highlypublic argument about economic policy and political corruption.This triggered a rapid outflow of capital. The governmentraised the overnight interbank lending rate to 7,500 percent totry to persuade foreigners to leave their money in the country,but to no avail. Realizing that it would be unable to keep the

LESSON 23THE FOREIGN-EXCHANGE MARKET

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lira within its planned monthly devaluation range withoutraising interest rates to absurd levels or seriously depleting thecountry’s foreign exchange reserves, on February 23, 2001, theTurkish government decided to let the lira float freely. The liraimmediately dropped 50 percent in value against the U.S. dollar,but ended the day down some 28 percent.Over the next two months, the Turkish economy continued toweaken as a global economic slowdown affected the nation.Inflation stayed high, and progress at reforming the country’seconomy remained bogged down by political considerations. Byearly April the lira had fallen 40 percent against the dollar sinceFebruary 23, and the country was teetering on the brink of aneconomic meltdown. For the third time in 18 months, the IMFstepped in, arranging for another $8 billion in Loans. Oncemore, the IMF insisted that the Turkish government accelerateprivatization, close insolvent banks, deregulate its market, andcut government spending. Critics of the IMF, however, claimedthis “austerity program” would only slow the Turkish economyand make matters worse, not better. These critics advocated amix of sound monetary policy and tax cuts to boost Turkey’seconomic growth. .Sources: P. Blustein, “Turkish Crisis Weakens the, Case forIntervention,” Washington Post, March 2, 2001, p. E1; H.Pope, “Can Turkey Finally Mend Its Economy?” Wall StreetJournal, May 22,2001, p. A18; “Turkish Bath,” Wall StreetJournal, February 23,2001, p. A14; E. McBride, “Turkey-FingersCrossed,” The Economist, June 10, 2000, p. $$16-$$17; and“Turkey and the IMF,” The Economist, December 9, 2000, pp.81-82.The international monetary system refers to the institutionalarrangements that countries adopt to govern exchange rates. Weassumed the foreign exchange market was the primary institu-tion for determining exchange rates and the impersonal marketforces of demand and supply determined the relative value ofany two currencies (i.e., their exchange rate). Furthermore, weexplained that the demand and supply of currencies is influ-enced by their respective countries’ relative inflation rates andinterest rates. When the foreign exchange market determines therelative value of a currency, we say that the country is adhering toa floating exchange rate regime. The world’s four major tradingcurrencies-the US. dollar, the European Union’s euro, theJapanese yen, and the British pound-are all free to float againsteach other. Thus, their exchange rates are determined by marketforces and fluctuate against each other on a day-to-day, if notminute-to-minute, basis. However, the exchange rates of manycurrencies are not determined by the free play of market forces;other institutional arrangements are adopted.In the opening case, for example, we learned that until recently,the value of the Turkish lira was pegged to a basket of curren-cies. Many of the world’s smaller nations peg their currencies,primarily to the dollar or the euro. A pegged exchange ratemeans the value of the currency is fixed relative to a referencecurrency, such as the U.S. dollar, and then the exchange ratebetween that currency and other currencies is determined by thereference currency exchange rate. Thus, Belize pegs its currency tothe dollar, and the exchange rate between the Belizean currency

and the euro is determined by the U.S. dollar/euro exchangerate.Other countries, while not adopting a formal pegged rate, try tohold the value of their currency within some range against animportant reference currency such as the U.S. dollar. This isoften referred to as a dirty float. It is a float because in theory,the value of the currency is determined by market forces, but itis a ditty float (as opposed to a clean float) because the centralbank of a country will intervene in the foreign exchange marketto try to maintain the value of its currency if it depreciates toorapidly against an important reference currency.Still other countries have operated with a fixed exchange ratesystem, in which the values of a set of currencies are fixedagainst each other at some mutually agreed on exchange rate.Before the introduction of the euro in 2000, several memberstates of the European Union operated with fixed exchangerates within the context of the European Monetary System(EMS). For a quarter of a century after World War II, theworld’s major industrial nations participated in a fixed exchangerate system. Although this system collapsed in 1973, some stillargue that the world should attempt to reimpose it.Pegged exchange rates, dirty floats, and fixed exchange ratesystems all require some degree of government intervention inthe foreign exchange market to maintain the value of a currency.A currency may come under pressure when there are significanteconomic problems in the nation. In the case of Turkey, forexample, these included high inflation, excessive governmentdebt, and a crisis in the banking system. A government can tryto maintain the value of its currency by using foreign currencyheld in reserve (foreign exchange reserves) to buy its currency inthe market, thereby increasing demand for the currency andraising its price: Thus, as the Turkish lira began to depreciaterapidly in late 2000, the Turkish central bank entered the foreignexchange market, using foreign currency it held in reserve, suchas U.S. dollars, Japanese yen, and euros, to purchase lira in anattempt to halt the depreciation in the exchange rate. However,since governments may not have sufficient foreign exchangereserves to defend the value of their currency, they sometimescall on a powerful multinational institution, the InternationalMonetary Fund (IMF), for loans to help them do this. TheIMF is another important player in the international monetarysystem. As we saw in the opening case, the IMF does notsimply lend money to a country in trouble. In exchange for theloan, it requires that the government adopt policies designed tocorrect whatever economic problems caused the depreciation inthe nation’s currency. Thus, the IMF insisted that. Turkey takesteps to reduce its inflation rate, and government debt and toresolve problems in the country’s banking system.

The Bretton Woods SystemIn 1944, at the height of World War II, representatives from 44countries met at Bretton Woods, New Hampshire, to design anew international monetary system. With the collapse of thegold standard and the Great Depression of the 1930s fresh intheir minds, these statesmen were determined to build anenduring economic order that would facilitate postwar eco-nomic growth. There was general consensus that fixed exchangerates were desirable. In addition, the conference participants

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Twanted to avoid the senseless competitive devaluations of the1930s, and they recognized that the gold standard would notassure this. The major problem with the gold standard aspreviously constituted was ‘that no’ multinational institutioncould stop countries from engaging in competitive devalua-tions.The agreement reached at Bretton Woods established twomultinational institutions the International Monetary Fund(IMF) and the World Bank. The task of the IMF would be tomaintain order in the international monetary system and thatof the World Bank would be to promote general economicdevelopment. The Bretton Woods agreement also called for asystem of fixed exchange rates that would be policed by theIMP. Under the agreement, all countries were to fix the value oftheir currency in terms of gold but were not required toexchange their currencies for gold. Only the dollar remainedconvertible into gold-at a price of $35 per ounce. Each countrydecided what it wanted its exchange rate to be vis-à-vis thedollar and then calculated the gold par value of the currencybased on that selected dollar exchange rate. All participatingcountries agreed to try to maintain the value of their currencieswithin 1 percent of the Par value by buying or selling currencies(or gold) as needed. For example, if foreign exchange dealerswere selling more of a country’s currency than they demanded,the government of that country would intervene in the foreignexchange markets, buying its currency in an attempt to increasedemand and maintain its gold par value.Another aspect of the BrettonWoods agreement was a commit-ment not to use devaluation as a weapon of competitive tradepolicy. However, if a currency became too weak to defend, adevaluation of up to 10 percent would be allowed without anyformal approval by the IMP. Barger devaluations required IMFapproval.

The Role of the IMFThe IMF Articles of Agreement were heavily influenced by theworldwide financial collapse, competitive devaluations, tradewars; high unemployment, hyperinflation in Germany andelsewhere, and general economic disintegration that occurredbetween the two world wars. The aim of the Bretton Woodsagreement, of which the IMF was the main custodian, was totry to avoid a repetition of that chaos through a combinationof discipline and flexibility.

DisciplineA fixed exchange rate regime imposes discipline in two ways.First, the need to maintain a fixed exchange rate puts a brake-on competitive devaluations and brings stability to the worldtrade environment. Second, a fixed exchange rate regimeimposes monetary discipline on countries, thereby curtailingprice inflation. For example, consider what would happenunder a fixed exchange rate regime if Great Britain rapidlyincreased its money supply by printing pounds. The increase inmoney supply would lead to price inflation. Given fixedexchange rates, inflation would make British goodsuncompetitive in world markets, while the prices of importswould become more attractive in Great Britain. The resultwould be a widening trade deficit in Great Britain, with thecountry importing more than it exports. To correct this trade

imbalance under a fixed exchange rate regime, Great Britainwould be required to restrict the rate of growth in its moneysupply to bring price inflation back under control. Thus, fixedexchange rates are seen as a mechanism for controlling inflationand imposing economic discipline on countries.

FlexibilityAlthough monetary discipline was a central objective of theBretton Woods agreement, it was recognized that a rigid policyof fixed exchange rates would be too inflexible. It wouldprobably break down just as the gold standard had. In somecases, a country’s attempts to reduce its money supply growthand correct a persistent balance-of-payments deficit could forcethe country into recession and create high unemployment. Thearchitects of the Bretton Woods-agreement wanted to avoidhigh unemployment, so they built limited flexibility into thesystem. Two major features of the IMF Articles of Agreementfostered this flexibility: IMF lending facilities and adjustableparities.The lMF stood ready to lend foreign currencies to members totide them over during short periods of balance-of-paymentsdeficits, when a rapid tightening of monetary or fiscal policywould hurt domestic employment. A pool of gold andcurrencies contributed by IMF members provided the resourcesfor these lending operations. A persistent balance-of-paymentsdeficit can lead to a depletion of a country’s reserves of foreigncurrency, forcing it to devalue its currency. By providing deficit-laden countries with short-term foreign currency loans, IMFfunds would buy time for countries to bring down theirinflation rates and reduce their balance-of-payments deficits. Thebelief was that such loans would reduce pressures for devalua-tion and allow for a more orderly and less painful adjustment.Countries were to be allowed to borrow a limited amount fromthe IMF without adhering to any specific agreements. However,extensive drawings from IMF funds would require a country toagree to increasingly stringent IMF supervision of itsmacroeconomics policies. Heavy borrowers from the IMF mustagree to monetary and fiscal conditions set down by the IMF,which typically included IMF-mandated targets on domesticmoney supply growth, exchange rate policy, tax policy, govern-ment spending, and so on.The system of adjustable parities allowed for the devaluationof a country’s currency by more than 10 percent if the IMFagreed that a country’s balance of payments was in “fundamen-tal disequilibrium.” The term fundamental disequilibrium wasnot defined in the IMF’s Articles of Agreement, but it wasintended to apply to countries that had suffered permanentadverse shifts in the demand for their products. Withoutdevaluation, such a country would experience high unemploy-ment and a persistent trade deficit until the domestic price levelhad fallen far enough to restore a balance-of payments equilib-rium. The belief was that devaluation could help sidestep apainful adjustment process in such circumstances.

The Role of the World BankThe official name for the World Bank is the International Bankfor Reconstruction and Development (IBRD). When theBretton Woods participants established the World Bank, the

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need to reconstruct the war-tom economies of Europe wasforemost in their minds. The bank’s initial mission was to helpfinance the building of Europe’s economy by providing lowinterest loans. As it turned out, the World Bank was overshad-owed in this role by the Marshall Plan, under which the UnitedStates lent money directly to European nations to help themrebuild. So the bank turned its attention to “development” andbegan lending money to Third World nations. In the 1950s, thebank concentrated on public sector projects. Power stations,road building, and other transportation investments were muchin favor. During the 1960s, the bank also began to lend heavilyin support of agriculture, education, population control, andurban development.The bank lends money under two schemes. Under the IBRDscheme, money is raised through bond sales in the internationalcapital market. Borrowers pay what the bank calls a market rateof interest-the bank’s cost of funds plus a margin for expenses.This “market” rate is lower than commercial banks’ market rate.Under the IBRD scheme, the bank offers low- interest loans torisky customers whose credit rating is often poor.A second scheme is overseen by the International DevelopmentAgency (IDA), an arm of the bank created in 1960. Resources tofund IDA loans are raised through subscriptions from wealthymembers such as the United States, Japan, and Germany. IDAloans go only tq the poorest countries. (In 1991, those weredefined as countries with annual incomes per capita of less than$580.) Borrowers have 50 years to repay at an interest rate of 1percent a year:

The Collapse of the Fixed Exchange Rate SystemThe system of fixed exchange rates established at BrettonWoods worked well until the late 1960s, when it, began toshow signs’ of strain. The system finally collapsed in 1973, andsince then we have had a managed-float system. To understandwhy the system collapsed, one must appreciate the special roleof the U.S. dollar in the system. As the only currency that couldbe converted into gold, and as the currency that served as thereference point for all others, the, dollar occupied a central placein the system. Any pressure on the dollar to devalue couldwreak havoc with the system, and that is what occurred.Most economists- trace the breakup of the fixed exchange ratesystem to the U.S. macroeconomic policy package of 1965-1968.To finance both the Vietnam conflict and his welfare programs,President Johnson backed an increase in U.S. governmentspending that was not financed by an increase in taxes. Instead,it was financed by an increase in the money supply, which led toa rise in price inflation from less than 4,percent in 1966 to closeto 9 percent by 1968. At the same time, the rise in governmentspending had stimulated the economy, with more money intheir pockets, people spent more-particularly on imports-andthe U.S. trade balance began to deteriorate.The increase in inflation and the worsening of the U.S. foreigntrade position gave rise to speculation in the foreign exchangemarket that the dollar would be devalued. Things came to ahead in the spring of 1971 when U.S. trade figures showed thatfor the first time since 1945, the United States was importingmore than it was exporting. This set off massive purchases of

German deutsche marks in the foreign exchange market byspeculators who guessed that the mark would be revaluedagainst the dollar. On a single day, May 4, 1971, the Bundesbank(Germany’s central bank) ‘had to buy $1 billion to hold thedollar/deutsche mark exchange rate at its fixed exchange rategiven the great demand for deutsche marks. On the morning ofMay 5, the Bundesbank purchased another $1 billion during thefirst hour of foreign exchange trading! At that point, theBundesbank faced the inevitable and allowed its currency tofloat.In the weeks following the decision to float the deutsche mark,the foreign exchange market became increasingly convinced thatthe dollar would have to be devalued. However, devaluation ofthe dollar was no’ easy matter. Under the Bretton ‘Woodsprovisions, any other-country could change its exchange ratesagainst all currencies simply by fixing its dollar rate at a newlevel. But as the key currency in the system, the dollar could bedevalued only if all countries agreed to simultaneously revalueagainst the dollar. And many countries did not want this,because it would make their products more expensive relative toU.S. products.To force the issue, President Nixon announced in August 1971that the dollar was no longer convertible into gold. He alsoannounced that a new io percent tax on imports would remainin effect until U.S. trading partners agreed to revalue theircurrencies against the dollar. This brought the trading partnersto the bargaining table, and in December 1971 an agreementwas reached to devalue the dollar by about 8 percent againstforeign currencies. The import tax was then removed.The problem was not solved, however. The U.S. balance-of-payments position continued to deteriorate throughout 1972,while the nation’s money supply continued to expand at aninflationary rate. Speculation continued to grow that the dollarwas still overvalued and that a second devaluation would benecessary. In anticipation, foreign exchange dealers beganconverting dollars to deutsche marks and other currencies. Aftera massive wave of speculation in February 1972, which culmi-nated with European central banks spending $3.6 billion onMarch 1 to try to prevent their currencies from appreciatingagainst the dollar, the foreign exchange market was closed.When the foreign exchange market reopened March 19, thecurrencies of Japan and most European countries were floatingagainst the dollar, although many developing countriescontinued to peg their currency to the dollar, and many do tothis day. At that time, the switch to a floating system wasviewed as a temporary response to unmanageable speculation inthe foreign exchange market. But it is now 30 years since theBretton Woods system of fixed exchange rates collapsed, andthe temporary solution looks permanent. .The Bretton Woods system had an Achilles’ heel; The systemcould not work if its key currency, the U.S. dollar, was underspeculative attack. The Bretton Woods system could work onlyas long as the U.5; inflation rate remained low and the UnitedStates did not run a balance-of-payments deficit. Once thesethings occurred, the system soon became strained toe thebreaking point.

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TEvolution to Floating Exchange RateThe IMF’s system was initially one of fixed exchange rates.Because the U.S. dollar was the cornerstone of the internationalmonetary system, its value remained constant with respect tovalue of gold. Other countries could change the value of theircurrency against gold and the dollar, but the value of the dollarremained fixed.On August 15,1971, president Richard Nixon announced thatthe United States would turing of the international monetarysystem. The resulting Smithsonian Agreement of December1971 had several important aspects:An 8-percent devaluation of the dollar (an official drop in thevalue of the dollar against gold)A revaluation of some other currencies (an official increase inthe value of each currency against gold)A widening of exchange-rate flexibility (from 1 percent to 2.25percent on either side of par value)This effort did not last, however. World currency marketsremained unsteady during 1972, and the dollar was devaluedagain by 10 percent in early 1973(the year of the Arab oilembargo and the start of fast-rising oil prices and globalinflation). Major currencies began to float (i.e., each one reliedon the market to determine its value) against each other insteadof relying on the Smithsonian Agreement.Because the Bretton Woods Agreement was based on a systemof fixed exchange rates and par values, the IMF had to changeits rules to accommodate floating exchange rates. The JamaicaAgreement of 1976 amended the original rules to eliminate theconcept of parity can occur on an individual country basis aswell as on an overall system basis. Let’s see how this works.

The Floating Exchange Rate RegimeThe floating exchange rate regime that followed the collapse ofthe fixed exchange rate system was formalized in January 1976when IMF members met in Jamaica and agreed to the rules forthe international monetary system that are in place today.

The Jamaica AgreementThe Jamaica meeting revised the IMF’s Articles of Agreementto reflect the new reality foreign exchange rate. The mainelements of the Jamaica agreement include the following:1. Floating rates were declared acceptable. The IMF members

were permitted to enter the foreign exchange market to evenout “unwarranted” speculative fluctuations.

2. Gold was abandoned as a reserve asset. The IMF returned itsgold reserves to members at the current market price, placingthe proceeds in a trust fund to help poor nations. IMFmembers were permitted to sell their own gold reserves atthe market price.

3. Total annual IMF quotas the amount member countriescontribute to the IMF were increased to $ 41 billion. (Sincethen they have been increased to $300 billion while themembership of the IMF has been expanded to include 183countries.) Non-oil-exporting, less developed countries weregiven greater access to IMF funds.

After Jamaica, the IMF continued its role of helping countriescope with macroeconomic and exchange rate problems, albeitwithin the context of a radically different exchange rate regime.

The Case for Fixed Exchange RatesThe case for fixed exchange rates rests on arguments aboutmonetary discipline, speculation, uncertainty, and the lack ofconnection between the balance and exchange rates.

Monetary DisciplineWe have already discussed the nature of monetary disciplineinherent in a fixed exchange rate a fixed exchange rate parityensures that government do not expand their money suppliesat inflationary rates. While advocates of floating rates argue thateach country should be allowed to choose its own inflation rate(the monetary autonomy argument), advocates of fixed ratesargue that governments all too rapidly, causing unacceptablyhigh price inflation. A fixed exchange rate regime will ensurethat this does not occur.

SpeculationCritics if a floating exchange rate regime also argue that specula-tion can cause fluctuations in exchange rates. They point to thedollar’s rapid rise and fall during the tuitions in exchange rates.They point to the dollar’s rapid rise and fall during the 1980s,which they claim had nothing to do with comparative inflationrates and the U.S. trade deficit, but everything to do withspeculation. They argue that when foreign exchange dealers see acurrency depreciating, they tend to sell the currency in theexpectation of future depreciation, regardless of the currency’slonger-term prospects. As more traders jump on the band-wagon, the expectations of depreciation are realized. Suchdestabilizing speculation tends to accentuate the fluctuationaround the exchange rate’s long-run value. It can damage acountry’s economy by distorting export and import process.Thus, advocates of a fixed exchange rate regime argue that sucha system will limit the destabilizing effects of speculation.

UncertaintySpeculation also adds to the uncertainty surrounding futurecurrency movements that characterizes floating exchange rateregimes. The unpredictability of exchange rate movement in thepost-Bretton Woods era has made business planning difficultand it makes exporting, importing and foreign investment riskyactivities. Given a volatile exchange rate, international businessesdo not know how to react to the change-and often they do notreact. Why change plans for exporting, importing, or foreigninvestment after 6 percent fall in the dollar this month, whenthe dollar may rise 6 percent next month? This uncertainty,according to the critics, dampens the growth of internationaltrade and investment. They argue that a fixed exchange rate, byeliminating such uncertainty, promotes the growth of interna-tional trade and investment. Advocates of a floating systemreply that the forward exchange market insure against the riskassociated with exchange rate fluctuations, so the adverse impactof uncertainty on the growth of international trade andinvestment has been overstated.

Trade Balance AdjustmentThose in favor of floating exchange rates argue that floatingrates help adjust trade imbalances. Critics question the closeness

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of the link between the exchange rate and the trade balances.They claim trade deficits are determined by the balance betweensavings and investment in a country, not by the external valueof its currency. They argue that depreciation in a currency willlead to inflation (due to the resulting increase in import prices).This inflation will wipe put any apparent gains in cost competi-tiveness that come from currency depreciation. In other world, adepreciating exchange rate will not boost export and reduceimports, as advocates of floating rates claim; it will simplyboost price inflation. In support of this argument, those whofavor floating rates point out that the 40 percent drop in thevalue of the dollar between 1985 and 1988 did not correct theU.S. trade deficit. In reply, advocates of a floating exchange rateregime argue that between 1985 and 1992, the U.S. trade deficitfell from over $160 billion to about $70 billion, and theyattribute this in part to the decline in the value of the dollar.

Exchange-Rate Regimes, and of 2001Exchange rates can be either fixed or pegged to another currencyunder vary narrow fluctuations (exchange arrangement with noseparate legal tender currency board arrangements or otherconventional fixed peg arrangements), pegged to somethingelse with a wider band of fluctuation (pegged exchange rateswith in horizontal bands), and floating, (crawling pegs,exchange rates within crawling bands, managed floating, orindependently floating).Regimes Number of CountriesExchange arrangements with no separate legal tender 40Currency board arrangements 8Other conventional fixed peg arrangements 41Pegged exchange rates within horizontal bands 5Crawling pegs 4Exchange rates within horizontal bands 6Managed floating with no pronounced path for exchange rate

42Independently floating 40Total 186Exchange arrangements with no separate legal tender: Thecurrency of another country circulates as the sole legal tender, orthe number belongs to a monetary of currency union in whichthe members of the union share the same legal tender. Anexample would be the countries in the euro area.Currency Board arrangements: A Monetary regime based onan implicit legislative commitment to exchange domesticcurrency for a specified foreign currency at a fixed exchange rate,combined with restrictions on the issuing authority to ensurethe fulfillment of its legal obligation. Two examples would beBosnia and Hong Kong.Other conventional peg arrangements: The country pegs itscurrency (formal or de facto) at a fixed rate to a major currency ora basket of currencies in which the exchange rate fluctuateswithin a narrow margin of at most 1/21 percent around acentral rate. For example, China pegs its currency to the U.S.dollar.

Pegged exchange rates within horizontal bands: The valueof the currency is maintained within margins of fluctuationaround a formal or de facto fixed peg that are wider than 1/21percent around a central rate. Many countries that used to beconsidered managed gloating are in this category because theybasically peg their currency to something else. An examplewould be Denmark in the new Exchange Rate Mechanism inEurope, a country that was not part of the euro group in 2002,yet was still linking itself to the euro as much as possible but ata wider degree of flexibility.Crawling pages: The currency is adjusted periodically in smallamounts at a fixed, preannounce rate or in response to changesin selective quantitative indicators, costa Rica and Bolivia are twoexamples.Exchange rates within crawling bands: The currency ismaintained within certain fluctuation margins around acentr5al rate that is adjusted periodically at a fixedpreannounced rate or in response to changes in selectivequantitative indicators. Romania, Israel, and Uruguay arethree examples.Managed floating with no pronounced path for theexchange rate: The monetary authority influences the move-ments of the exchange rate by actively intervening in theforeign-exchange market without specifying, or recommitting toa preannounced path for the exchange rate. India andAzerbaijan are examples.Independent floating: The exchange rate is market deter-mined, with any foreign-exchange intervention aimed atmoderating the rate of change and preventing undue fluctua-tion in the exchange rate rather than at establishing a level for it.Canada, the United States, and Mexico are three examples ofcountries in this category.Source: International Monetary Fund, “International FinancialStatistics” (November 1999): 2-3; and Andrea Bubula and inciOtker-Robe, “The Evolution of Exchange Rate Regimes Since1990: Evidence form de Facto Policies,” IMF Working page,(September 2002): http://www.imf.org/external/pubs/ft/wp/2002/wp02155.pdf.