Exchange rates targets.

• Author: Obstfeld, Maurice

When massive speculative attacks shattered the system of fixed exchange rates among industrial countries in early 1973, policymakers viewed the shift to generalized floating rates as a tactical retreat. Nearly 19 years later, however, most industrial countries' exchange rates continue to float against the U.S. dollar. Nonetheless, in the past decade the world economy has evolved in the direction of more limited exchange rate flexibility.

The group of countries participating in the exchange rate mechanism (ERM) of the European Monetary System has expanded since the system's inception in 1979, and the original adjustable-peg regime has given way to one in which realignments increasingly are avoided. Developing countries, as well as the transforming economies of the former Soviet bloc, have used stable external exchange rates both as anti-inflationary anchors and as a conduit for importing informative signals from world markets about relative prices. Finally, during the late 1980s the main industrial countries intervened heavily against the dollar in foreign exchange markets, and in some periods targeted the dollar exchange rates of major currencies.

Academic economic research has mirrored and, it is fair to say, encouraged the movement toward more deliberate exchange rate management. In the late 1960s and early 1970s, a significant school of academic opinion favored abandoning the Bretton Woods adjustable peg system in favor of floating rates determined by the market; the system's final collapse in February 1973 initially appeared to vindicate that view. The subsequent performance of the world economy revealed, however, that floating exchange rates were not the panacea that their early advocates had promised. It remains widely accepted that some economic disturbances require exchange rate adjustment. But it is also recognized that floating rates can move sharply and in ways that bear no close short-term relationship to international costs; they do not prevent persistent departures from current account balance; their movements redistribute income domestically, creating political pressures inimical to free trade; and they may present governments with harmful macroeconomic incentives.

My research has focused on several aspects of exchange rate targeting. One set of studies has addressed the problem of imperfect government credibility under managed exchange rates. A second examines the theory of exchange rate target zones and regime switches under uncertainty. A final area of research concerns the role of official foreign exchange intervention in pursuit of exchange rate targets. I now summarize some of this work, along with some related studies by other NBER researchers.

Credibility and Exchange Rate Management: The Case of Europe

When the eight original members of the European ERM began to peg their mutual exchange rates in March 1979, relatively few observers would have bet heavily on the system's survival. Annual inflation rates at that time ranged from 2.7 percent in Germany to 12.1 percent in Italy, and the looming prospects of recession and higher oil prices augured poorly for the future of ERMs. Indeed, the first phase of ERM history was rather turbulent, punctuated by periodic speculative crises. To date, there have been 11 substantive realignments of intra-ERM exchange rates.(1)

The last ERM alignment--that of the French franc in January 1987--apparently inaugurated a new phase marked by startling successes. Since then, exchange rates have remained stable, even though France and Italy have dismantled their remaining...