The Adjustment Mechanism: Theory and Problems

Large deficits, persistent swings in real exchange rates, and sharply increased volatility of month-to-month exchange rate movements have alerted the policy community to the need to do something. Financing of imbalances at times seems too ample, at other times too scarce. Real exchange rates seem to be dominated by the news of the day rather than the productivity of the decade. Disagreement prevails on what is expected of a well-functioning international monetary system. Should it sustain a pattern of purchasing power parity (PPP) exchange rates or of balanced current accounts? provide open-ended financing or force maximum adjustment? equalize inflation across countries or maximize independence? And if the system performs poorly, what are appropriate directions of reform? These are the questions in today’s debate on the international monetary system. Not surprisingly, no unanimity exists, but it is significant that policymakers are inclining toward a resumption of actively managed exchange rate targets while academic opinion is sharply divided between agnostics and activists. This paper reviews some of the conceptual and empirical issues involved in the debate. Activists believe that there should be a comprehensive, actively managed system of policy coordination. Agnostics do not have much enthusiasm for exchange-rate-oriented monetary policy and do not believe that fiscal coordination is always desirable or ever practicable. Agnostics share with activists the belief that asset markets can grossly misprice exchange rates and, after encouraging a major departure from equilibrium rates, suddenly lose faith and strand the world economy in