L.c. l‘—i. 13/3 2 ‘Q?-)-_ # “/0? 6 Report No. 86-109 E N O L O N G E R PROPERTY 0 F O L I N LIBRARY Washington itmiversitv u.s. MONETARY POLICY, THE ECONOMY AND THE FOREIGN EXCHANGE VALUE on THE DOLLAR, 1960-1986 Government Publications Unit AUG O4-B94 by 0 Washington University Libraries Helen J. Scott St‘ Louis’ MO 63130 Specialist in Money and Banking Economics Division August 25, 1986 CONGRESSIONAL RESEARCH Universit of Missouri-Columbia ll illlllllllllilllllllll Illllil lllilililiil 0‘ CONGRESS i 010-103940540 The Congressional Research Service works exclusively for the Congress, conducting research, analyzing legislation, and providing information at the request of committees, Mem- bers, and their staffs. » i “flee makes such research available, without parti- , -as, in many forms including studies, reports, compila- s, giats, and background briefings. Upon request, CRS g jifciom, r_' ees in analyzing legislative proposals and 'i list, an 5.-in’assessing the possible effects of these proposals 55 . alternatives. The Service’s senior specialists and figtibjiéict analysts are also available for personal consultations .*"i‘"n their respective fields of expertise. ABSTRACT Relationships between U.S. monetary policy and the foreign exchange value of the dollar since the early 1960s are examined in this report. Coverage includes monetary policy under fixed exchange rates in the 19605 and early 1970s, as well as the dollar's depreciation later in the decade. The appreciation of the dollar if: the early 1980s and its recent decline are examined in relation to current monetary policy. CRS-v CONTENTS ABSTRACT BACKGROUND . . . . . . . . . . . THE BRETTON WOODS PERIOD . . . . The First-Half of the Sixties -~ The Domestic Economy . International Considerations Conflict Between Domestic and Balance of Payments Problems The Second Half of the Sixties -- The Conflict The Early Seventies . . . . The Breakdown of Bretton woods . . THE DOLLAR FLOATS . . . . . . . . "Managed" Floating . . . . . Monetary Policy under Fixed Rates Monetary Policy Under Floating Rates The 1973-76 U.S. Economy Following 1977-80 The Depreciating Dollar -- Intervention 1977-1978 . . . Intervention in 1979 . . . . Monetary Policy in 1979 . . Intervention in 1980 . . . . Monetary Policy in the Early 1980s Floa The 1981-1984 Nonintervention Policy Macroeconomic Policies . . . Intervention -- 1985-1986 . CONCLUSION . . . . . . . . . . . t. Continues U.S. MONETARY POLICY, THE ECONOMY AND THE FOREIGN EXCHANGE VALUE OF THE DOLLAR, 1960-1986 Attention Inn; been focused recently (N1 the role cfi? monetary policy in determining the foreign exchange value of the dollar. Paul Volcker, the Chairman of the Federal Reserve Board, has, during the past few years, expressed his reluctance to see the dollar fall too swiftly. The Secretary of the Treasury, James Baker, however, according to newspaper reports, would welcome a weaker dollar. Each, of course, is looking at the problem from a different perspective. The Federal Reserve, although not opposed to a declining dollar, believes that the dollar should not fall too fast. A swiftly falling dollar would undermine confidence in time United States, causing higher interest and inflation rates. (hi the other hand, Treasury Secretary Baker, never advocating that the dollar should fall precipitously, believes tiuu; a declining dollar would encourage exports and discourage imports. Lately, although both.tflu2 Fed and the Treasury have shifted emphasis slightly to the role of foreign economies in stimulating U.S. exports, the role of monetary policy is still a key element in affecting the foreign exchange value of the dollar. The postwar history of the dollar, under, first, fixed and, then, floating rates, illustrates attempts by the monetary authorities to manage the relationship of the dollar to foreign currencies. Relationships between monetary policy and value of the dollar from the fixed foreign exchange rates of Bretton Woods to the floating rates of the 1970s and 1980s are examined in this report. BACKGROUND Monetary policy (uni affect the foreign exchange value (H? the dollar in two ways: One, the Fed can expand or contract the money supply which might affect the dollar through changes in interest rates or prices, or, two, the Department of the Treasury and the Federal Reserve can intervene jointly and directly affect the dollar by buying or selling currency in the foreign exchange market. Legally, the ffreasury-initiates intervention ill the foreign exchange market, and the Federal Reserve carries out the decision. In practice, a decision to intervene is arrived at jointly after consultation between both the Federal Reserve and tin: Treasury. while the Treasury has the authority to decide when to intervene, the Federal Reserve, as an independent agent of Congress, can indirectly affect the foreign exchange value of the dollar by expanding or contracting the money supply. CRS-2 An expansion of the money Supply by the Federal Reserve would probably take place Ix) lower interest rates in 21 slack etonomy. These lower interest rates should lower the demand of foreign investors for U.S. securities. A lower demand for U.S. securities would reduce the price of dollars in foreign exchange markets, which, if everything else remained constant, would encourage exports. l] A greatly simplified example of the way the Fed and the Treasury would intervene tun, say, bring down tflmz price of time dollar in foreign exchange markets would be for (Juan to buy jointly foreign currencies or securities for dollars. This operation would expand the domestic money supply if the Federal Reserve created new money to purchase foreign currency. Such an expansion might be in conflict with current domestic monetary policy. The existing policy oftJm2Government is, therefore, to "sterilize" its intervention operations by offsetting the newly created money by selling securities from its portfolio. when the Fed sells Government securities to a Government bond dealer, the dealer writes a check to the Fed. The Fed collects its money from the bank by reducing the reserves the bank keeps with it. A contraction in a bank's reserves reduces its ability to expand its deposits. This, in turn, reduces the money supply, which, presumably, offsets the increased flow of dollars from the intervention operation. If the monetary authorities wishad to raise the value of the dollar in foreign exchange markets, the Fed and the Treasury would buy dollars (sell foreign currencies cn- securities froni their holdings (Hf foreign reserve assets%. A sale of reserve assets (purchase of dollars) by the Federal Reserve would contract the money supply, causing disruptions iii the domestic economy. In tins situation, the Fed would offset its sale of foreign reserve assets (purchase of dollars) by buying U.S. Treasury securities, thereby replacing the reserves that were sold and balancing the contractive effects of its sale of foreign reserve assets. THE BRETTON WOODS PERIOD The Bretton Woods Agreement, signed at Brettmn woods, New Hampshire, in 1944, by 45 countries, including the United States, established 21 system Cd? fixed exchange rates ;hi terms cm? the U.S. dollar which was convertible into gold. The International Monetary Fund (IMF) was also established at this time to facilitate trade by increashug the exchangeability of currencies among itx; member subscribers. 3/ l] Johnson, Ivan C. and William W. Roberts. Money and Banking: A Market-oriented approach, 2d ed., Chicago, The Dryden Press, 1985. p. 61-62. _2_/ Spero, Herbert. Money and Banking. New York, Barnes & Noble, Inc., 1962. p. 38. CRS~3 The First-Half of the Sixties -- The Domestic Economy Confidence in the credit of the United States was unquestioned in the early post-World War II years; foreigners eagerly acquired U.S. dollars, which were a claim on the gold stock of the U.S. Government. But as aid from, and exports to, the United States expanded, the supply of dollars around the world became excessive. Faith in the dollar shrank, and holders began to redeem their dollars for gold. Up until the late 1950s, the loss of gold to the United States was not necessarily considered undesirable as it aided the recovery in international trade by distributing reserve assets to other countries, thus providing them with an international medium of exchange. The Federal Reserve, worried about inflation at home, began to tighten up on the money supply toward the end of the 1950s. At the end of the decade, interest rates were comparatively high and unemployment was rising. As the 1960s began, and a new Administration took office, unemployment replaced inflation as the number one domestic economic worry. Money suppLy, consisting (Hf currency, demand deposits, and time deposits -- (Ml) -- jumped from practically no growth in 1960 to 2.9 percent in 1961. International Considerations Besides the domestic economy, the United States in 1961 became concerned about the decline in the country's gold stock which had fallen by about 20 percent -- from $22.8 billion to $18.0 billion-- from 1958 to 1961. 1/ The substantial loss of gold within such a short space of time, reflecting increasing deficits in the balance of payments account, worried the Administration. As the economy turned down in 1960 and 1961, American short-term interest rates dropped below those abroad, complicating the gold outflow problem. Foreign- owned short-term dollar balances began to be converted into gold and transferred out of the country. 3/ The International Monetary Fund (IMF), created in 1944, pursuant to the Bretton Woods agreement, fixed the par value of the currencies of its 45-nation signatories in terms of the U.S. dollar which was convertible into gold. The par value of a nation's currency was to be used in all irmernational trade and financial transactions. IMF members deposited a specified amount of their own currencies and gold with the IMF. This deposit could be exchanged for the currency of any other IMF nmmber with whidn a country had 21 deficit in. its balance of payments account (i.e.,its exports of goods and services plus foreign capital inflows were less than imports and outflows). Devaluation of a country's currency (reducing its par value), arising from balance of payments deficits, was Ix) be undertaken only ii? a Q] Council of Economic Advisers. Economic Report of the President. January 1962. Washington, U.S. CPO, 1962. p. 151. 3/ Kreps, Clifton H., Jr. Money, Banking and Monetary Policy. New York, The Ronald Press Company, 1962. p. 556. CRS-4 country's currency, due to ea fundamental change, fell out (If line with other currencies. A country with a temporary balance of payments deficit could bring its currency into line by buying up the excess supply of its currency, either with its deposit at the IMf or with its foreign reserves (initially gold or U.S. dollars). Nations with a chronic deficit that had exhausted their foreign reserves were left with no choice but to contract their imports, expand exports, and attract .financial investments from abroad. This could nean tightening up on the money supply to curb inflation and to raise real rates of interest (nominal rates minus expected inflation), which, in turn, could mean lower incomes and rising unemployment. Q] If the United States had wished to reduce the excess supply of dollars, it would have had to do so by selling gold for dollars, since gold constituted the major portion of its official reserves at that time. (See chart 1.) The goal of the Federal Reserve in that period was, however, to conserve gold, not sell it. Devaluation was not a viable alternative as the par value of the dollar could only be changed by the President of the United States with the approval of Congress. Economists with the advantage of 20- 20 hindsight have suggested that the United States should have had greater freedom to devalue. A lower value of the dollar would have bought fewer foreign goods and the outflow of dollars to the foreign exchange market would not have been so great. §_/ This would have permitted the monetary authorities to pursue a domestic policy less hampered by considerations of balance of payments deficits. Besidesljualegal barrier to devaluation, however, there was another argument against the United States pursuing such a program. A reduced value for the dollar would have meant that those countries that held dollars (and did not convert them to gold) would have suffered a loss as their holdings would be worth less in terms of other currencies. Conflict Between Domestic and Balance of Payments Problems Thus, in the early 1960s, the U.S. monetary authorities faced the dilemma of expanding the money supply to stimulate domestic demand, or restricting growth to stem the outflow of dollars. U In other words, §/ Ritter, Laurence S. and William L. Silber. Principles of Moneyg Banking, and Fflnancial Markets, 2d ed., New York, Ronald Press, 1977. p. 486, 487, 500. Q] Johnson and Roberts, Money & Banking. p. 573. 7/ The United States did not intervene in the foreign exchange markets to any significant degree at this time as the dollar was the currency against which all currencies were measured, and intervention which would have caused the dollar to depreciate would have been offset by appreciation of other currencies. Emum>m a>ucuca ~qx¢teu mzu we vLc:»c>oc go tuccm .u¢LL:om CRS-5 mam. omm. mum. cum. mmm_ com. mam. . omm_. m __:__:______:_ _ _ _ _ _ _ _ _4 _Il_ _ _ _ _.|._# _ _ _.l_ __ _ _ J _ _ _ W IIIIII II/I lllll .«I_aI._r/ruwxl, ii 505 Boo 2:: A 5 ./// A 1/ . /If 9 TI l...l 111 2/x. ,, 21.) T; 4$mm=.._ .m .3 _ 2.25 CRS-6 the Fed luui to decide between conducting monetary policy tx> lower interest rates :hi order In) encourage domestic expansion, cu‘ raise interest rates to alleviate the balance of payments deficits. To solve this dilemma, the Federal Reserve compromised with a program called, "Operation Twist." This program was designed to put upward pressure (H1 short-term rates and downward pressure on long rates. The higher short-term rates would attract capital from abroad, while the lower long rates would presumably encourage domestic investment. The operation was less than a resounding success. At the same time the Ihul was trying lx) raise short-tenn rates, the Treasury was borrowing long-term, thus raising rates in the long end of the market. Furthermore, the assumption of "Operation Twist" that interest rates in short- and long-tenn markets are not related 11; open to question. §/ The outflow of capital continued to plague the country during the early 1960s as Japan and European countries borrowed heavily in the U.S. capital markets. with few exceptions, U.S. money and capital markets were much better developed and freer from restrictions than those abroad. Interest rates at that time were also low in comparison with rates in foreign countries. Consequently, foreigners seeking capital looked tx> U.S. financial markets, while interest- sensitive funds moved abroad in search of higher yields. 9_/ Multi- national companies with their direct investment abroad also contributed to the outflow of capital. The Fed's approach during the first half of the 1960stx>the sluggish growth in the economy was slow and deliberate as it first attempted to make "Operation Twist" a success. Money supply grew at an average annual rate of 3.5 percent from 1960 to 1965. Interest rates edged up from an average of nearly 3.0 percent in 1960 to almost 4.0 percent in 1965. Unemployment remained in the neighborhood of 5.0 percent until 1965, when the stimulus of the 1964 tax cut brought it down to 4.1 percent. The restrained growth followed by the Fed was probably undertaken partially in response to the balance of payments problem. This restraint might also have been responsible for the low 2.0 annual rate of inflation over the same period, as measured by the gross national product (GNP) implicit price deflator. Despite this rather restrained approach tolnonetary policy,cnmflows of capital in the early 1960s continued, precipitating the passage of the Interest Equalization Tax (IET) in July 1963. The IET was designed to equalize borrowing rates in the United States with those in foreign countries by taxing purchases by Americans of security issues of developed nations. The following excerpt from the 1966 Economic Report of the Fkesident illustrates the Administration's reasons for the IET which it felt would free the Federal Reserve from pursuing an overly restrictive monetary policy that would damage domestic exports: §/ Johnson and Roberts, Money and Banking, p. 574. 9/ Council of Economic Advisers. Economic Report ofIflm:President, 1966. Washington, U.S. Govt. Print. Off., 1966. p. 165. CRS-7 The volume of capital outflows likely to occur in the absence of any measures to moderate them would clearly be inconsistent with equilibrium iii our external payments. Given that private capital outflows must be contained, the selective measures currently in use seem, for the present, an essential component CH? our policy. Compared with reliance solely on restrictive general monetary measures that might conceivably hold down capital flows to the same extent, the selective credit techniques have time obvious advantage of allowing monetary policy to respond to the needs for domestic credit, as well as to affect the 5-10 percent (H? total credit that flows abroad. The Federal Reserve program, moreover, gives priority to export financing, which would be squeezed undereihighly restrictive monetary policy. By increasing the cost of borrowing in the U.S., the IET contains its own escape valve: countries in need of new U.S. capital issues are still free to enter our markets; the less urgent needs are screened out. 10] The Second Half of the Sixties -- The Conflict Continues Despite the restraint imposed 137 the Federal Reserve znul the IET, the balance of payments problem persisted into the second half of the 19603. From 1960 to 1965, the United States lost about $4.8 billion of its foreign reserves, consisting mainly of gold. Voluntary credit controls on outflows of bank capital were put into effect in 1965 znui mandatory controls (M1 direct investment abroad became effective in 1968. Compared with the first half of the 1960s, monetary policy in the second half turned more accommodative (as well as more volatile) as time war in Vietnam escalated and demands on the economy grew. From 1965 to 1970, M1 grew at an annual rate of 5.1 percent, which, although not excessive by 1986 standards, was high for that period. Ml growth dropped to 2.8 percent in 1966, bringing on ea "credit crunch," which prompted the Fed to expand the money supply in 1967 and 1968 by over 6.0 percent, only to draw in the reins to 4.0 percent in 1969. (See chart 2.) Inflation also began to rear its head and the implicit price deflator rose by 3.3 percent -- excessive as compared with the first half's 2.0 percent. The average rate on 3-month Treasury bills also rose -- to about 5.0 percent. During the latter half of the 1960s, the Fed seemed to be driven more lnr events ill the domestic economy than ix: the international financial sphere. Fiscal policy was also employed in the second half of the 1960s to alleviate some of both external and domestic problems. Mandatory controls (Ml direct foreign investment helped stem the outflow of capital, as American businesses obtained foreign capital for their investments abroad. Thus the Fed was able to pursue a slightly more accommodative policy than might otherwise have been possible. However, a need for the Fed to tighten arose when the economy grew in response to expansive fiscal and it own periodic 1 / Ibid., p. 168. CRS-8 - 2Em>m mkmmmm émmofl mI._. mo mmozE>oo .._O om.En5m G202 N Hmm m_>$mn._m ._oo .._o omm:mummom amumvmm osu mo muo:um>oU mo vumom uouusom $9 89 39 S2 82 82 $2 89 o l.::_::_::E.I_ _ _ J # _ _ \(/K...) Auk/lull)/..(...f....lIl|l V I , ,»1 ozam >m$mm_m .m .3 « guano CRS-12 foreign central banks in mid-August held $35 billion, while gold in the U.S. Treasury amounted to only $10 billion. 11/ As in the 1960s, the Federal Reserve, along with the Treasury, probably did not find it feasible in 1971 to intervene to buy dollars in the foreign exchange market. The foreign reserves of the United States consisted almost entirely of gold. (See chart 1.) Special Drawing Rights (SDRS), which increased borrowing power at the IMF, had come into existence only in 1970, and therefore added very little to U.S. foreign reserve assets. (See chart 4.) The Federal Reserve did arrange to absorb some dollars with foreign currencies purchased through temporary swap lines of credit with other central banks in the first half of 1971, but the depletion of foreign reserve assets, tflubugh conversion of dollars into gold, nevertheless, became overwhelming by August. On August 15, 1971, the Nixon Administration inaugurated its "New Economic Policy," under which fiscal and monetary steps were taken to reduce both unemployment and inflation. ihi an effort to deal with the problem of the glut of dollars in the world, a temporary,fee was placed on imports, and the gold window was closed to foreign central banks, with their large holdings of dollars. Without convertibility to gold, the dollar began to float in terms of several major currencies. This meant that the fixed ratio between the dollar and these major currencies was no longer in force. It meant that the price of the dollar fell in terms of other currencies. For example, ea British pound that might have bought $2.00 before floating, would have bought $3.00 after floating. W Conversely, for example,a1dollar that could be exchanged, for one- half a British pound before the gold window was closed, would command only one-third of a pound after it was closed. Thus, the demand and supply for the dollar in terms of, say, the British pound would determine the dollar's price in pounds. (Actually, in December 1971, the British pound had risen by 4.5 percent to $2.53 from approximately $2.42 [fixed price] in March 1971.) Under Bretton Woods,‘ the exchange value of the dollar in relation to the pound could fluctuate only between $2.42 and $2.38 and,did not vary as demand and supply for the dollar changed with imports and exports and the inflow and outflow (H3 capital. The higher price for the dollar aided in reducing the pressure on the reserve assets of the United States, but for the first time since 1959 theme was a deficit in the current account of the balance of payments accounts. 5 The Federal Reserve in the last two quarters of 1971, reduced the growth in the money supply. This, along with wage and price controls, probably helped to hold the inflation rate in check and aided in improving the real rate of interest, thus putting some brake on the outflow of capital. fi/ Ritter and Silber. Principles of Money, Banking and Financial Markets, 2d ed. p. 490. CRS-13 The Breakdown of Bretton Woods The immediate issue facing governments after August 15, 1971, was a realignment of exchange rates, especially a readjustment of the U.S. dollar relative to the other major currencies. The Smithsonian Accord which was signed on December 18, 1971, and which set the stage for the more extended task of designing a new order for international monetary cooperation dealt with the issue of realignment on a temporary basis. The Smithsonian Accord devalued the dollar by raising the price of gold from $35.00 to $38.00 21 fine ounce. (One dollar would buy one-thirty-fifth of an ounce of gold before the price was raised, and only one-thirty-eighth after devaluation -- a drop in the value of the dollar relative to gold of almost 8.0 percent.) The Accord revalued the Japanese yen and the west German mark in terms of gold, effectively increasing their exchange rates in terms of the dollar by 16.9 and 13.6 percent, respectively. France and Great Britain agreed Ix) hohd to their previous par values, which resulted in an increase of 8.6 and 11.6 percent of time franc and pound, respectively, against the dollar. 12/ In 1972, as confidence in international relationships was restored wwith the realignment of exchange rates, foreign private investors began to invest in the United States, which reduced capital outflow zuul pressure West Germanyg there would berunautomatic adjustment of the exchange rate to reflect this imbalance. lg] Other countries that were running a deficit with West Germany would be forced sooner or later to adjust their balances by exchanging gold, dollars, or in this case, marks, for the deficit they were incurring. with the United States, things were different. The dollar was a reserve currency which could be used by other countries to satisfy their own balance of payments deficits. Therefore, up to a point, most countries were willing to hold the dollars they had acquired in 13/ Kreinin, Mordechai. International Economics. New York, Harcourt Brace Jovanovich, Inc., 4th ed., 1983. p. 177-180. l§/ Foreign reserve assets consist of varying amount of gold, IMF deposits, and SDRs and other reserve currencies. (See charts 1 and 4.) lg/ The par value of a Nation's currency was to be changed only within specified limits except when there was a fundamental change that caused a Nation's currency Ix) be out cm? line with other currencies. CRS-15 selling tx) the United States, or dollars which they purchased with their own reserves to maintain the fixed ratio of their currency with the dollar. The United States could, therefore, run up deficits for a long period of time without being called upon to exchange foreign exchange reserves for the accumulated dollars of a trading partner. "Managed" Floating The flcmting rate system that succeeded Bretton Woods was :1 "managed" or "dirty" float system. Countries were not constrained by the IMF, which survived the breakdown of Bretton Woods, from intervening in foreign exchange markets to stabilize their exchange rates. Thus, there was never a chance for freely floating rates to be tested. Under floating rates, discipline presumably would be imposed through the exchange value of the dollar. However, tin: dollar remained a reserve currency (foreign countries still required dollars for intervention purposes as the float was a "managed" or "dirty" float) and thus 21 certain amount of the demand for the dollar was uninfluenced by imbalances in trade or capital flows. The dollar is also used as an} international transaction currency. For example, Middle East oil is priced in dollars and payment from a country such as west Germany would be in dollars. Countries that depended on exports to generate domestic income immervened in foreign exchange markets ill order tn) keep their currency from appreciating so that the price of their exports, in terms of dollars, would not rise. Since the United States market was the largest market in the world for foreign goods and since dollars received in exchange for these goods were often in surplus supply, foreign central banks usually bought dollars when they intervened in iforeign exchange markets. A large supply of dollars relative to other currencies would cause the dollar to depreciate, thereby making other currencies more expensive. Therefore, as intervention was not prohibited under floating rates and as the dollar continued to be a key currency, and the United States a large importer, the floating rate system adopted after 1973 was not radically different from the fixed rates of Bretton woods. The United States with its large domestic economy has until recently been concerned only sporadically about foreign trade or commerce. It intervened moderately in the early 1970s, but except under unusual circumstances as in the 1978-80 period, described below, and contrary to what most other countries did, the United States, has not, as a matter of policy, intervened ill foreign exchange markets to stabilize the dollar. 11/ 11/ McKinnon, Ronald I. An International Standard for Monetary Stabilization. Washington, Instituue for International Economics. Cambridge, MIT Press, 1984. p. 4. CRS-16 Monetary Policy under Fixed Rates Floating rates were hailed as a way of freeing the Fed of balance of payments considerations and permitting it 11) concentrate on managing the domestic economy. 1§/ Many economists have felt that the U.S. economy of the early 1960s would have performed better if the Fed had not been attempting to stimulate economic growth while, at the same time, trying to solve the gold and balance of payments problems. 12/ The Fed was also criticized for spending too much time and effort on "Operation Twist," the program designed to reduce the outflow of gold, while boosting investment in the United States. At that particular time, in the early 1960s, with M1 growing at an annual rate of only 3.5 percent, inflation below 1.5 percent, and the unemployment rate nearing the 6 percent mark, the Fed might have been able to speed up growth in the money supply, without doing too much damage to the balance of payments. During the latter half of the 1960s, however, as the Vietnam War heated up, monetary policy was concerned more with the domestic economy than with the balance of payments deficit. Control of the money supply in this period was also secondary to fiscal policy as a means of managing the economy. The following from the Economic Report of the President in 1968 confirms the role assigned Ix) monetary policy: After a hard look at the alternatives, it has been and remains the conviction of both the Administration and the Federal Reserve System that the nation should depend on fiscal policy, not monetary policy, to carry the main burden of the additional restraint on the growth of demand that now appears necessary, Q9/9 9 9 H Although economists saw floating rates as affording more freedom to the United States in its conduct of monetary policy, many economists also saw the rest of the world benefiting as the United States would no longer export inflation. A major criticism of fixed rates was that a country could not insulate itself from the domestic economic policies of its trading partners. In the case of the United States, critics held that the United States had flooded the world with dollars, especially in the latter Bretton Woods years from 1970 to 1972. These dollars could be used by other Countries as reserves to expand their money supply. Thus, the United States exported the inflationary bias inherent in the over-expansion of its money supply in the late 1960s and early 1970s. From 1966 to 1972, M1 expanded on an annual basis by over 6.0 percent, which compares with a rate of only about 4.0 percent in the preceding 6 years. 1§/ Johnson and Roberts, Money and Banking, p. 576. 12/ Ritter anni Silber. Principles of Money, Banking, and Financial Markets. p. 528, 529. 22/ Council of Economic Advisers. Economic Report of the President. January 1968. Washington, U.S. Govt. Print. Off., 1968. p. 84-85. CRS-l7 Monetary Policy Under Floating Rates While the switch from fixed to floating rates afforded the Fed some small additional freedom to pursue independent domestic stabilization policies, this new freedom was far from unlimited. with fixed rates, the dollar's value, relative tx> other currencies van; guaranteed. lmbalances with other countries in trade or capital were reflected in the balance of payments accounts vdlii these countries. These countries could ckmmnd that the United States redeem its dollar <flfligations with gold cn- other foreign reserve assets. Under floating rates, monetary policy through its effect on prices §£/ and interest rates also influences the value of time dollar. If? an expansionary monetary policy is expected to result in inflation, the dollar will probably depreciate, effectively reducing line price of the dollar ll] terms (M? foreign currencies, thereby encouraging exports as foreigners obtain more dollars in exchange for their currencies when they buy American goods. If, however, prices of U.S. goods also rise, again due to inflation, then the price advantage of the lower dollar could be wiped out. with interest rates, the effect could be more immediate. A Since the advent of floating rates, the stock of foreign currency within a country is thought of as an asset on which a return is expected. Currency is usually converted into an instrument on which a return is earned. As interest rates on capital investments are linked to foreign exchange values, a change in monetary policy, or even an expected change in monetary policy, can affect interest rates and exchange values almost instantaneously. Therefore, if monetary policy is, for example, expansionary or is expected to be expansionary, and nominal interest rates do not reflect an adequate premium for inflation expectations, relative tx> expectations for rwxfl. rates in the rest of the vnnld, capital will flow out of the country which could adversely affect capital investment. gg/ The 1973-76 U.S. Economy Following Floating Rates Although the United States escaped some of the consequences of its expansionary monetary policy during the late Bretton Woods period as «dollars “remained abroad, the country did run: escape forever. Prices rose by 6.5 percent in 1973, while the dollar, as measured by the Federal Reserve Board's Trade-Weighted Index of the Dollar, (1973=lO0) fell by almost 10 percent. (See charts 55 and 6.) In addition, time Organization cm? Petrolemn Exporting Countries (OPEC) placed an embargo on the sale of oil to the United States in October 1973 and subsequently raised prices by 400 percent. As OPEC prices its 21/ Pigott, Charles. The Influence of Real Factors on Exchange Rates. Economic Review. Federal Reserve Bank (H? San. Francisco, Fall 1981. p.37. 23/ Cooper, Richard N. Recent History of World Monetary Problems. In Agmon, Tamir, Robert C. Hawkins and Richard M. Levich. The Future of the International Monetary System. Lexington, Lexington Books, 1984. p. 19. CRS-18 mommzzoo .._O game .m.: momsom mi: :9 — 2.? «R: _.\.m_. E2 83 mom. . fl « q . V. BE 82 _ moz<:o _._o E5. 4<:zz< mO.~<.E.u.._Q moan. :o_._n_2_ n_ZO m 52mm 9 NF CRS-19 mt: sm:m>mm>Emmm ._oo ...o omzom momaom E? if mt: NB. E: E2 82 82 om: I1 -«L- ON moz>:mg$E m<._._oo .._o m3<> moz<:8a zomEo.._ ® ,Em m_>mmmmm 258... m1» .._O mmozE>oo .8 92cm momaom $2 mm? 59 cm? 22 4 q 4 mt: .\.\.m— 39 . _ 4 mm? 4 _ CE ».E%m Ezoz m ,.E respond consistently favorably to the Fed's anti-inflation policy. The Fed, in announcing in October 1979 that it would base monetarygxflicy on growth in the money supply and not on the stabilizaticni of interest rates, followed the monetarists' doctrine which at that time was perceived to be anti-inflationary. Because it took on the monetarists' coloration, the Fed had hoped to send a message to the financial markets that its policy would bring the inflation rate down. §1/ The dollar recovered some in the first quarter of 1980, but retreated in the following two quarters as monetary policy eased. It was not until the fourth quarter of 1980 when monetary policy decelerated from an annual rate in the third quarter of almost 16.0 percent to about 11.0 percent that the dollar's value began again to improve. Monetary policy tightened in 1981 and in the first half of 1982, with the result that interest rates moved to new heights and the dollar strengthened against all major currencies. The period from late 1980 to mid-1982 was marked by high real interest rates, which, although volatile, seemed to be the driving force behind the rise in the dollar which grew at an annual rate of over 15 percent during this period. (See chart 8.) As the 1980s progressed, the Fed followed various degrees of tightness. Its restrictive monetary policy of 1981-82 is usually cited as being responsible for the economic slump that lasted for nearly a year from the end of 1981 to the third quarter of 1982. After easing in late 1982 and for most of 1983, the Fed tightened again in 1984, causing some slowdown in the economy. with a tight, as opposed to an easy, monetary policy, during most of the early 1980s, inflation fell, while real interest rates remained high. (See chart 9.) Because of the stability of the U.S. political system, as well as the liquidity and size of the U.S. capital markets, these high real interest rates in the United States were a powerful magnet for investors worldwide. In addition, poor economic growth in Europe and low interest rates in Japan helped to keep the U.S. dollar strong through this period. As the dollar grew in strength through the early 1980s, imports became cheap as importers' profits from selling goods in the United States rose when the dollar became more valuable in terms of importers’ currency. As the return to importers rose, they could afford to charge less than American manufacturers for the same product. At the same time, American exporters, being paid in foreign currencies, received less in terms of dollars and therefore were at a disadvantage when selling abroad. The economic slowdown in Europe during most of the early 1980s also hurt American exports. In this way the strong §1/ For 21 discussion (Hf monetarism see: U.S. Library of Congress. Congressional Research Service. Monetarist and Keynesian worlds -- what's the Difference? Report No. 84-181E by Helen J. Scott. Washington, 1984. p. 5-17. CRS-26 33$“ mmm_ 2Em>m m>mmmmE ._<~m8.._ mI._. .._O mmozmm_>oo .._o am>..ma moz/«:83 zom_mo.._ m em__ m ..§<:o m_oz<:o ..._O m:. draw additional capital inflows from abroad. The reduction in net exports implies 21 weaker stimulus from fiscal policy. . . because the extra job-creating impact of additional government (or reduced taxes) is partly offset by reduced employment in industries that produce exports or compete with imports. 4Q/ In the past three and a half years, [1981 through July 1984] the U.S. first experienced a significant contraction ha money growth, and then rapid fiscal expansion. The monetary restriction was accompanied by rising interest rates and was quickly followed by a contraction. This contraction was deep and prolonged in spite of the fiscal stimulus that was forthcoming. These events suggest a very powerful monetary policy that was operating over the business cycle. ‘At the same time, the effect of fiscal policy seems to have been weak. Interest rates would seem at first to have been pushed up by §2/ Wallich, Henry (L International auui Domestic Aspects of Monetary LPolicy. Speech given upon receiving the [Hstinguished Achievement Award of the Money Marketeers of New York University, May 28, 1985. p. 13. 49/ U.S. Library of Congress. Congressional Research Service. Jane Cravelle and (L. Thomas Woodward. U.S. Economic Policy in an International Context. p. 18. CRS-31 monetary restriction and then, as money growth loosened, were held up by fiscal stimulus. 31/ ' The tax cuts, proposed and passed by Congress in 1981, were expected in 1982 to stimulate the flagging.economy that followed the Fed's anti-inflation policy of 1981 and 1982. This fiscal stimulus created 21 huge deficit in 1982. with the Fed not nmnetizing the debt, as it held fast to its anti-inflation policy, real interest rates rose, attracting capital from abroad. Economists such as Robert Mundell of Cblumbia University (1971) §2/ and Martin Feldstein of Harvard (1980) 33/ had advocated such a combined approach of tight monetary, and relaxed fiscal, policy. Mundell had recommended a policy mix of tight money to control inflation and tax cuts to spur real growth. He pointed out that if exchange rates were floating such a policy mix would raise the value of the dollar. Feldstein felt that high interest rates would reduce inflation and discourage housing expenditures, while a program of tax incentives for business would raise investment spending. Intervention -- 1985-1986 Although a free-market non-interventionist policy approach to the determination of the exchange value of the dollar is the ideal strived for by most administrations 55/, there are times when markets may be perceived to be disorderly, or may, at times, be seen as damaging to the economy. This was the case in early 1985 as the consistent rise in the dollar was seen as damaging export and import- competing industries. Throughout 1985, despite double-digit growth rates in the money supply, the inflation rate fell -- from 4.1 percent of the GNP deflator in 1984 to 3.3 percent in 1985. Short-term interest rates, as measured by the Treasury bill rate, dropped by two percentage points (see chart 10), while long rates, measured by 10-year Treasuries fell by almost the same amount. The yield curve flattened during the year as short-term interest rates fell steeply in the first month of the year, while long rates had a large part of their run-up in the last quarter. 31/ Ibid. p. 24 3g/ Mundell, Robert. The Dollar and the Policy Mix: 1971. Essay in International Finance, no. 87, Princeton University, 1971. In Blinder, Alan. The Policy Mix: Lessons from time Recent Past. Paper presented at tflua 33rd Annual Conference on the Ekonomic Outlook, University of Michigan, Nov. 22, 1985. p.5. 1_+__3_/ Feldstein, Martin. Tax Rules and the Mismanagement of Monetary Policy. American Economic Review, May 1980. p. 182-186. In Blinder, Alan. The Policy Mix. p. 5. fifi/ See Council of Economic Advisers. Economic Report of the President. Washington, U.S. Govt. Print. Off., 1978. p. 125 CRS-32 sm:m>m m>EBm .558... m_..:. ...o mmozE>oo .5 92cm momaom £9 £9 _ mm? mm? d , % E3 . cm? 4 32 mt: R2 32 J 4 W Am_m the Honorable Walter E. Fauntroy, Chairman, Subcommittee (nu Domestim: Monetary Policy, Committee (N1 Banking, Finance and Urban Affairs, from Paul A. Volcker, Chairman of the Board of Governors of the Federal Reserve System. Washington, November 6, 1985. F 31/ Board of Governors of the Federal Reserve System. Monetary Policy Report to the Congress. Washington, February 19, 1986. p. 11. CRS-35 year. 38/ It was generally assumed after this testimony that the Fed had been watching the slide in the dollar with some concern, although it appeared that the Treasury would have welcomed a weak dollar to stimulate U.S. exports. §9/ The Federal Reserve Board's Index of the dollar's value showed the dollar continuing to slide through the early months of 1986. At the end of June, the dollar was down to 112.10 or 9.3 percent below its 1985 year-end closing level cfi? 123.62. The dollar's fall in early 1986 might have been prompted initially by a concerted effort on the part of the United States, West Germany and Japan to lower interest rates. Despite the Chairman's testimony an; the Monetary Policy Hearings in February, the Fed cut the discount rate three times from March through mid-July. Its first reduction on March 7 to 7.0 percent was followed on the same day by discount rate cuts Eur west Germany and Japan. However, there were signs that for the West Germans and the .Japanese tflue dollar" might. have dropped too fast. Only Japan (not west Germany) followed the United States in the second 1986-discount rate cut on April 21. The third.«discount rate cum; by the Federal Reserve became effective on July 11, 1986. As of the end of July, there had been no follow-up cuts by either Japan or West Germany. The discount rates of these two countries, however, were 3.0 and 3.5 percent, respectively, at the end of July, considerably below the U.S. discount rate of 6.0 percent. Declines ix: short-tenn money market rates if) early 1986 were generally ix: line with these cuts. Again, as iii the fourth quarter of 1985, short-term interest rates fell at a slower rate than long-term bonds, further flattening the yield curve during the first half of the year. In July 1986, when the Chairman of the Federal Reserve Board again testified before Congress on the conduct of monetary policy, he seemed to be less concerned about a precipitous drop in the dollar. a (The dollar had fallen by 6.0 percent in the five-month period since his last. testimonyu) Chairman Volcker emphasized that the LLS. economy would not improve until the trade deficit had declined and he noted that: To make an intelligent forecast for the Unites States now, you have to have some sense of what the prospects are in the rest of the world. That's a new kind of world for us to be living in, but we are living in it. §Q/ 38/ U.S. Congress. House. Committee on Banking, Finance and Urban Affairs. Hearing on Conduct of Monetary Policy, 99th Cong., 2d Sess., February 19, 1986. Washington, US. Govt. Print. Off., 1986. p. 154. - 32/ Klott, Gary. Dollar Hits Low Again Vs. the Yen. New York Times, April 29, 1986. p. D1. §Q/ U.S. Congress. Senate Committee on Banking, Housing, and Urban Affairs. Hearing on Federal Reserve's Second Monetary Policy Report for 1986. 99th Cong., 2d Sess. July 24, 1986. In Berry, John M. Volcker Spurns Pleas to Cut Rates Further. The Washington CRS-36 Coordination of policies among industrial nations was agreed to at the 7-nation Economic Summit talks held in Tokyo in May 1986. The United States, Japan, and the major European industrial democracies agreed informally to a plan proposed by Treasury Secretary, James Baker, to coordinate economic policies in an effort to ensure fair valuation of their currencies. §l/ The cooperation exhibited by the G-5 countries in their 1985 intervention efforts and their early 1986 interest-rate reduction operations probably set the stage for unrealistic expectations for the 7-nation loosely drawn coordination agreement. Since coordination of domestic economic policies is, at best, a long-term very ambitious goal, expectations of immediate success of the plan were probably too optimistic. Since the Tokyo summit, only the United States, through a reduction in its discount rate in July, has acted directly to stimulate a sluggish economy. The following excerpt from a Washington Post article of Saturday, August 9, 1986, illustrates, in Secretary Baker's words, not only the importance of coordination, but also how difficult it is to achieve. They had their own good reasons as to why they [west Germany and Japan] didn't want to join us in an interest- rate reduction the last time, and as to why they think that what they're doing economically is sufficient for their domestic economic purposes. we're going to continue to point out that the United States has carried a large portion of the load for the last 43, 44 months in terms of the world economy. We are not going to lecture them about how they should run: their business any more than we would expect them to lecture us. But we will make good-faith suggestions about the importance of their growing more, just as they make suggestions to us about getting our fiscal deficits down. And we accept those suggestions in good faith. I think they will accept our suggestions that they find ways to generate more internal growth. CONCLUSION while intervention and domestic monetary policy may affect the international value of the dollar in the short run, broader policies are needed to effect a more lasting change. Under fixed rates, the United States in conjunction with members of line IMF, ultimately, devalued the dollar in discrete steps by raising the price of gold. During the 1970s, under floating rates, most economists concede that it was the inflationary bias in the U.S. money Supply and the low real rates of interest in this country that caused time dollar to Post, July 24, 1986. p. El. §l/ Lewis, Paul. 7 Nations Seeking Stable Currency. New York, The New York Times, May 6, 1986. p. A1, A13. ~ CRS-37 deteriorate. Monetary policy was effective in correcting this situation in the early 1980s. After a substantial rise in the dollar, fiscal policy, with its large deficits which created ea shortfall if! the Nation's savings, necessitated high real rates to attract capital from abroad, in the period from 1982 through early 1985. One contributing factor to the high real rates was the low inflation rate made possible by the high volume of imports that competed successfully with American goods. Therefore, unlike the 1970s when monetary policy was responsible for“ the declhfing dollar which eventually was remedied by an tight monetary policy, it now appears that it was not only monetary policy, but IJM: combination (Mi monetary euui fiscal policy’ that kept the dollar high during the period from 1982 to through early 1985. Although intervention and monetary policy may have combined to reduce the value of the dollar in 1985 and the first half of 1986, this lower value of the dollar, so far, has not improved our trade deficit. Secretary Baker and Chairman Volcker both think that this condition could be corrected if other countries, notably Japan and West Germany, stimulated their economies. Chairman Volcker, however, has acknowledged in past congressional testimony that the large fiscal deficits of the U.S. Government has necessitated keeping real interest rates high in order to attract the necessary capital from abroad. And as alluded to by Secretary Baker, other countries also believe that we should reduce our budget deficit if we wish to reduce deficits in our balance of payments account. The conclusion would therefore seem to be that disruptive exchange rates are probably the result, not the cause, of a country's economic problems. Intervention and manipulating the money supply to change exchange rates seem to work for only a short while. The fundamental policies of a country and how these policies mesh with those of other countries may be the long-term solution tx) trade deficits and balance of payments problems. hjs/af/hjs/sem LIBRARY OF WASHINGTON UNIVERSITY 37. LOUIS - M0.