Case For Flexible Exchange Rates Research Articles

The Case for Flexible Exchange Rates in 1953 and 1969: Friedman versus Johnson

AbstractDuring the years of the Bretton Woods system, Milton Friedman and Harry Johnson, respectively, authored two of the most influential articles on exchange‐rate systems. Friedman's article, “The Case for Flexible Exchange Rates,” was published in 1953. Johnson's article, published 16 years later, carried the almost identical title—“The Case for Flexible Exchange Rates, 1969.” While both articles achieved classic status in the 1970s and the 1980s, Johnson's essay appears to have surpassed Friedman's essay in stature in the view of some economists. This paper provides a comparison of the arguments in favor of flexible rates and against fixed rates presented by Friedman and Johnson. I conclude that Friedman's essay presaged all of the major arguments made in Johnson's essay while excluding several major misses made by Johnson. Nevertheless, there were pragmatic reasons why Johnson's essay became more influential.

Harry Johnson's “Case for flexible exchange rates”—50 years later

AbstractFifty years ago, Harry G. Johnson published “The Case for Flexible Exchange Rates, 1969”, its title echoing Milton Friedman's classic essay of the early 1950s. Though somewhat overlooked today, Johnson's reprise was an important element in the late 1960s debate over the future of the international monetary system. The present paper has three objectives. The first is to lay out the historical context in which Johnson's “Case” was written and read. The second is to examine Johnson's main points and see how they stand up to nearly five decades of experience with floating exchange rates since the end of the Bretton Woods system. The third is to review the most recent academic critiques of exchange‐rate flexibility and ask how fatal they are to Johnson's basic argument. I conclude that the essential case for exchange‐rate flexibility still stands strong.

Harry Johnson's "case for flexible exchange rates"—50 years later

Fifty years ago, Harry G. Johnson published “The Case for Flexible Exchange Rates, 1969,” its title echoing Milton Friedman’s classic essay of 1953. Though somewhat overlooked today, Johnson’s reprise was an important element in the late 1960s debate over the future of the international monetary system. The present paper has three objectives. The first is to lay out the historical context in which Johnson’s “Case” was written and read. The second is to examine Johnson’s main points and see how they stand up to nearly five decades of experience with floating exchange rates since the end of the Bretton Woods system. The third is to review the most recent academic critiques of exchange rate flexibility and ask how fatal they are to Johnson’s basic argument. I conclude that the essential case for exchange rate flexibility still stands strong.

Milton Friedman and Exchange Rates in Developing Countries

Milton Friedman’s famous 1953 essay, “The case for flexible exchange rates,” deals entirely with advanced nations. An interesting question is what Friedman thought about exchange rate and monetary regimes in emerging economies. In this paper I investigate how his views on the subject evolved through time. I analyze speeches, articles, and interviews. I examine his archives for correspondence and unpublished manuscripts. I show that for him flexible rates were a second best solution for middle income and poor nations. I also analyze Friedman’s role in Chile’s failed attempt, during the Pinochet regime, at using a fixed exchange rate to stabilize the economy and eliminate inflation.

Milton Friedman and the Case for Flexible Exchange Rates and Monetary Rules

Milton Friedman was a strong proponent of flexible exchange rates accompanied by a domestic monetary rule. He believed that such a combination would deliver superior economic performance and would also be more consistent with democratic principles than a regime based on fixed exchange rates and discretionary monetary policy. John Taylor’s recent proposal of a rules-based international monetary system –- based on flexible exchange rates and a Taylor rule for each country - is very much in that spirit and represents a modern rendition of Friedman’s views. Under both the Friedman and Taylor proposals, instead of policy coordination among countries there would be policy harmonization.

Comment on “Price Stability and the Case for Flexible Exchange Rates”

Comment on “Price Stability and the Case for Flexible Exchange Rates”

Price Stability and the Case for Flexible Exchange Rates

We revisit Friedman’s case for flexible exchange rates in a small open economy with several distortions and rigidities and a variety of domestic and external shocks. We find that, for external shocks, the flexible exchange rate regime outperforms the fixed regime independent of the source of domestic nominal rigidities provided that the monetary authorities pursue a policy of strict inflation targeting. For domestic supply shocks, a joint policy of a flexible exchange rate and strict inflation targeting fares well when the main source of nominal rigidities is in the domestic goods markets, but not if rigidities arise in the labor markets.

Reflections on Milton Friedman's contributions to open economy money/macro

Friedman's central contributions to open economy macroeconomics are contained in his essay “The Case for Flexible Exchange Rates.” The paper describes equilibrium in an open economy in terms of the flow market for domestic currency, and so presents the basic elements of The Monetary Approach to the Balance of Payments, which Mundell and Johnson developed later in the decade. An application of the argument includes the first definitive statement of the criteria which one finds in the literature on Optimum Currency Areas. The essay's model, in a better specified, more modern form, reappears in A Monetary History (with Anna Schwartz), where it serves as a basis for detailed analysis of particular episodes and as a framework for empirical work which continues to this day.

Openness and the case for flexible exchange rates

Models of stabilization in open economy traditionally emphasize the role of exchange rates as a substitute for nominal price flexibility in fostering relative price adjustment. This view has been recently criticized on the ground that, to the extent that prices are sticky in local currency, the exchange rate does not play the stabilizing role envisioned by the received wisdom. An important question is whether, for this very reason, stabilization policies should limit exchange rate movements, or even eliminate them altogether. In this paper, I re-assess this issue by extending the [Corsetti Giancarlo, and Paolo Pesenti. 2001. Welfare and Macroeconomic Interdependence. Quarterly Journal of Economics 116 (2), 421–446.] model to allow for home bias in consumption—so that I can exploit the advantages of closed-form solutions. While this extension leaves most properties of the model unaffected, home bias implies that the real exchange rate in an efficient equilibrium is not constant, but fluctuates with the terms of trade. The weight that monetary authorities optimally place on stabilizing domestic marginal costs is increasing in home bias: with asymmetric shocks, fixed exchange rates are incompatible with efficient monetary rules. Yet, the adverse welfare consequences of exchange rate movements constrain the optimal intensity of monetary responses to domestic shocks. Openness matters: in our specification each country produces an equal share of the world value added; the lower the import content of consumption, the higher the exchange rate volatility implied by optimal stabilization rules. In relatively closed economy, optimal monetary rules tend to converge, regardless of the nature of nominal rigidities in the exports market.

Price Rigidity and the Selection of the Exchange Rate Regime

We evaluate and qualify Friedman's, 1953, “case for flexible exchange rates” in the presence of sticky prices in a two country model. We find that a flexible regime performs indeed better when the degree of nominal price rigidity is high while a bilateral peg does better when prices are fairly flexible. This result obtains independent of whether monetary policy is activistic or not and is mostly due to the negative relationship between employment and productivity shocks when prices are relatively sluggish (Gali, 1999). A unilateral peg tends to produce the lowest level of world welfare but it sometimes represents the best monetary arrangement for the pegger.

Unknown Friedman: The Contribution of Great Monetarist to the Fall of Bretton Woods

In 1973, the US Treasury Secretary informed the IMF that the United States had moved from system of fixed exchange rates to flexible exchange rates. The fall of the Bretton Woods system became the culmination of the campaign led by M. Friedman during the previous quarter of a century. This publication studies the process by which Friedman's case for flexible exchange rates was transformed from economic "heresy" to the majority academic opinion. The primary focus of the paper is political economy of organization and developing of the intellectual and political forces which undermined the Bretton Woods system.

Revisiting the case for flexible exchange rates in North America

This paper provides econometric and qualitative evidence that flexible exchange rate regimes have played important roles in stabilising the Canadian and Mexican economies in the face of asymmetric shocks, nominal rigidities, and limited international labour and capital mobility. Empirical evidence from Canada and from the more recent period in Mexico (1995—present) is organised around three propositions: one, the economies of Canada, Mexico, and the United States often experience large asymmetric shocks and the correlation between their business cycles is relatively low; two, exchange rates in Canada and Mexico are primarily driven by macroeconomic fundamentals and adjust appropriately to large asymmetric shocks, which are often caused by commodity price movements; and, three, flexible exchange rates facilitate adjustment to shocks in the underlying fundamentals.

International Risk-Sharing and the Exchange Rate: Re-Evaluating the Case for Flexible Exchange Rates

A classic argument for flexible exchange rates is that the exchange rate plays a ‘shock-absorber’ role in an open economy vulnerable to country-specific shocks. This paper presents a sharp counter-example to this argument within a very conventional open economy model. Countries are subject to unpredictable shocks to world demand for their goods. Efficient adjustment is prevented, both by sticky nominal wages and by the absence of a market for hedging consumption risk internationally. A flexible exchange rate policy acts perfectly as a ‘shock-absorber’, fully stabilizing output and replicating the flexible wage outcome. Despite this, a policy that fixes the exchange rate may be welfare superior, even though fixed exchange rates cause output to deviate from the flexible wage outcome. Moreover, an optimal monetary rule in this environment would always dampen exchange rate movements, and may even be a fixed exchange rate.

Fewer Monies, Better Monies

In the aftermath of emerging market crises from Russia to Asia and Latin America, there is a quest for better monetary arrangements that are more crisis-proof. Fixed rates are out, flexible rates are in with a policy focus on inflation targeting. But there is, of course, the alternative of abolishing exchange rates all together. This paper revisits the issue of dollarization or currency boards to review what arguments in the debate stand up. The case for flexible exchange rates emphasizes the need for a tool to accomplish relative price adjustment. This paper argues that in an intertemporal perspective most shocks require financing in the capital market rather than adjustment. Moreover, countries frequently do not use their flexible rate to play a cyclical role and, as a result, only a pay a premium for the option to depreciate but do not take advantage of the flexibility; on the contrary, they engineer systematic overvaluation in the context of inflation targeting.

Local-currency pricing and the choice of exchange-rate regime

Feldstein (1992, The Economist 19–22; 1997, Journal of Economic Perspectives 11, 23–42) invokes Friedman's (1953, Essays in Positive Economics. Chicago University Press, Chicago, pp. 157–203) classic case for flexible exchange rates to argue that the single currency of the European Monetary Union will hinder adjustments that might have occurred through real exchange rate movements under a more flexible exchange rate system. The extent of local-currency pricing among European countries undermines this view. The prices that consumers pay for imported goods are not much influenced by changes in nominal exchange rates in the short run. The channels for adjustment through relative price changes are considerably narrowed when local-currency pricing predominates. New evidence is presented that reaffirms the predominance of local-currency pricing for consumer prices in Europe. The optimum currency area analysis is reexamined in a Mundell–Fleming framework with local-currency pricing.

Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility

This paper develops a welfare-based model of monetary policy in an open economy. We examine the optimal monetary policy under commitment, focusing on the nature of price adjustment in determining policy. We investigate the implications of these policies for exchange-rate flexibility. The traditional approach maintains that exchange-rate flexibility is desirable in the presence of real country-specific shocks that require adjustment in relative prices. However, in the light of empirical evidence on nominal price response to exchange-rate changes—specifically, that there appears to be a large degree of localcurrency pricing (LCP) in industrialized countries—the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of LCP, we find that the optimal monetary policy leads to a fixed exchange rate, even in the presence of country-specific shocks. This is true whether monetary policy is chosen cooperatively or non-cooperatively among countries. To what extent does independent monetary policy in an open economy require flexibility of the nominal exchange rate? The modern case for flexible exchange rates goes back to Friedman (1953). Real country-specific productivity or demand shocks require adjustment of relative price levels between countries. If nominal prices adjusted quickly, Friedman argues, the choice of exchange-rate regime would be irrelevant because the relative price adjustment could be achieved by nominal price changes: If internal prices were as flexible as exchange rates, it would make little economic difference whether adjustments were brought about by changes in exchange rates or by equivalent changes in internal prices. But this condition is clearly not fulfilled. The exchange rate is potentially flexible in the absence of administrative action to freeze it. At least in the modern world, internal prices are highly inflexible.

Price flexiblity and output volatility: the case for flexible exchange rates

This paper uses descriptive statistics and regression analyses to examine the relationship between exchange rate variability and output volatility in developed countries based on 1961 to 1984 data. The result indicate that a flexible exchange rate system is associated with less, not more, dispersion in output growth across industrialized countries despite a more turbulent global environment. Also, countries which have more exchange rate volatility experience less output volatility. The relationship appears not to be spurious. The results are consistent with the idea that an increase in price flexibility does not destabilize output.

What Remains of the Case for Flexible Exchange Rates? (Invited Lecture)

In the 1950s and 1960s, there was much support among academic economists for abandoning the Bretton Woods System in favour of a system of flexible exchange rates. Such proposals had their opponents, of course, some of whom, for example Robert Triffin (l960), believed that, if anything. the Bretton Woods System granted too much, rather than too little, scope to individual national governments to vary their exchange rates. Nevertheless, at that time, the weight of professional opinion was against them, and when exchange rate flexibility was adopted in the 1970s, economists by and large welcomed it. This change in policy regime was not, however, the outcome of reforms undertaken in the light of academic arguments; although these did have some influence in some places, not least the United Kingdom.' Nevertheless, the single most important factor leading to the demise of the Bretton Woods System was not the acceptance of any academic arguments about how to make the international monetary system function more’ smoothly. It was something much more down to earth, namely the unwillingness of certain governments, notably that of West Germany, to accept the balance of payments and hence domestic inflationary consequences of United States fiscal and monetary policies associated with the Vietnam War.

Protectionism and the case for flexible exchange rates: A reexamination

This paper reexamines the arguments by early proponents that flexible exchange rates would lessen the incentives for protectionism and also permit countries to pursue independent monetary policies. We argue that there is a basic inconsistency between these two arguments; the pursuit of independent monetary policy can lead to situations which involve very strong pressures on policy-makers to engage in protection. A theoretical analysis supporting our argument is developed, and some circumstantial evidence is presented.

The case for flexible exchange rates

In the first part of the article the author shows that the double objective of the return to convertibility and the liberalisation of imports cannot be reached unless exchange rates are allowed to move. In the second and third parts he treats the longer run aspect of the problem, giving exhaustive analysis of possible methods of dealing with a deficit in the balance of payments. This is done first by discussing the disadvantages of the various alternative ways that may be adopted under the system of fixed exchange rates, and second by showing that a policy of fluctuating rates is superior to these methods. In the fourth part the suggestion for combining the policy of flexible rates with establishment of stabilisation funds is discussed. In concluding the author points to the possibility of adopting in the early stages a system of “limited flexibility” under which exchange rates would be allowed to fluctuate between limits that were well defined but considerably wider than those which prevail at present. JEL: E42, F31, F32