Developments in the foreign exchange markets for most of the major currencies over the 18 months ending in March 1980 were quite different from those of the preceding two years. Chart 1 shows how the change in the tone of exchange markets, while closely related to developments involving the U.S. dollar, also involved important shifts in relationships among other major currencies. Each index plotted in the chart provides a composite measurement of the value of the specified currency in terms of the other major currencies.
The U.S. dollar, which depreciated by roughly 15 per cent in effective terms from September 1977 to October 1978, recouped about half of that decline over the ensuing 18 months. Broadly parallel depreciations of the Canadian dollar and the Italian lira were also arrested in late 1978, although neither of these two currencies has appreciated as much as the U.S. dollar since that time. A much more marked break with earlier trends is evident for the Japanese yen, for which three fourths of an appreciation of some 40 percentage points from late 1976 to October 1978 was reversed over the ensuing year and a half, despite large-scale intervention by the Bank of Japan in support of the yen. One of the significant factors in the depreciation of the yen—the latest round of oil price increases—had the opposite effect on the pound sterling. That currency, after a fairly steady development during 1977 and 1978, appreciated strongly during 1979 and early 1980, despite a very high domestic inflation rate in the United Kingdom. Only in the cases of the French franc and the deutsche mark can it be said that earlier trends—roughly flat for the French franc and moderately rising for the deutsche mark—were sustained over the later period as well.
1Effective exchange rates 2
Shifts in the pattern of external current account balances among the major industrial countries are shown in Chart 2. Broadly speaking, balances of countries in that group, except the United States, shifted toward reduced deficits or increased surpluses from 1976 to mid-1978. These shifts had as their principal counterpart a large deterioration in the U.S.
current account balance, and the result was a pattern of marked imbalances by early 1978. In the latter part of 1978 and 1979, however, partly because of the reversion of the U.S. current account toward balance and partly because of the increase in oil import bills, the external accounts of most major industrial countries shifted toward balance or, in the cases of the Federal Republic of Germany, Japan, and the United Kingdom, into significant deficits. The only exception to this pattern was Canada, where the current account balance has remained steadily in deficit by amounts equivalent to roughly 2 per cent of gross national product (GNP).
2Payments balances on current account, including official transfers 1
1 Seasonally adjusted, annual rates.
The improvement in the pattern of current account balances, which began in 1978 and continued in 1979, is partly attributable to the exchange rate changes—notably the depreciation of the dollar and the appreciation of the yen evident in Chart 1—set in motion by the earlier deterioration in the pattern of current account balance. At least equally important, however, were concurrent changes among the various countries in relative rates of expansion of domestic demand in real terms. Whereas the growth of real domestic demand in the United States had been some 4 percentage points higher than the average for other major industrial countries during 1977, the opposite was true during 1979. This succession of contrasts in the respective growth rates of domestic demand was a major factor behind both the initial widening of imbalances in the current accounts of these countries and the subsequent improvement in the pattern of balances.
Other, more specific, factors also played a role. For Japan, the degree of both the initial increase in the surplus and the later swing into substantial deficit was due partly to the initially perverse “J-curve” effects of exchange rate changes. For the United Kingdom, on the other hand, the current account balance moved into deficit from 1978 to 1979, despite a substantial improvement in the balance on oil transactions, depressed economic conditions, and the appreciation of the pound sterling. This appreciation, which was linked primarily to the prospects for North Sea oil and to the restrictive financial policies of the authorities, has led to a significant deterioration in the balance on non-oil transactions.
Exchange rate developments are significantly influenced by capital account transactions; these, in turn, are critically affected by interest rates. The gradual escalation of interest rates from the low levels of 1977 or early 1978 to the new peaks reached in virtually every country in March of this year is evident in the data in Chart 3. Also evident is the impact of the measures announced by the U.S. monetary authorities in late October 1978, early October 1979, and mid-March 1980.
Exchange rate relationships are affected most directly, at least in the short run, by the relative yields obtainable on various types of money-market paper in each country Careful comparison of Charts 1 and 3 points up the following key relationships: (1) the turnaround in the U.S. dollar in November 1978, as well as its strengthening in late 1979 and early 1980, coincided with sharp advances in yields on U.S. dollar-denominated assets; (2) conversely, the weakness of the yen and the capital outflows experienced by Japan during 1979 and early 1980 went hand in hand with an unusually wide yield spread against yen-denominated assets; and (3) the appreciation of the pound sterling since the beginning of 1978, while a composite reflection of many factors, has coincided with a widening interest-rate spread, which averaged 4 to 5 percentage points against other major industrial countries during 1979, in favor of sterling-denominated assets.
Differentials in rates of inflation exert a significant impact on exchange rates, particularly over the medium or longer term. Because exchange rates tend over time to gravitate toward a set of rate relationships that would equalize prices for tradable goods and services, it is not a coincidence that the country (the Federal Republic of Germany) that has had the lowest rate of inflation as measured by the consumer price indices (shown in Chart 4) has also had the most steadily appreciating exchange rate. Nevertheless, as the recent data for Japan and the United Kingdom show, deviations from purchasing power parity can sometimes prove substantial. (See also Chart 6.)
There tends to be a rough correspondence between the inflation differentials evident in Chart 4 and the corresponding interest differentials implicit in Chart 3. This correspondence—which is most easily discerned for the Federal Republic of Germany, Italy, Japan, and the United States—is rooted in the tendency of competitive market interest rates to gravitate toward levels (inclusive of “inflation premia”) that equate the “real returns” on corresponding types of investments in different countries.
1 Average of three months ending in the month indicated over (ha preceding three months; seasonally adjusted, annual rates.
2 Excluded from the figures plotted is the estimated increase in U.K. consumer prices associated with the increase approximately 33/4 per cent in value added tax (VAT) rates in that country effective June 18, 1979.
3 Average for the seven major industrial countries.
In the past several years there has been an increasing public interest in rates of monetary expansion as independent determinants of exchange rates. However, the effects of differential rates of monetary expansion (or contraction) are evident not directly in spot exchange rate changes but through a complex chain of intermediate transmission mechanisms, which involve such factors as changes in the income velocity of money, interest rate differentials, and price expectations.
There are a few instances, such as the recent Japanese experience, in which relative rates of monetary expansion appear to have been closely followed by major changes in effective exchange rates. Even in these instances, however, other factors have influenced changes in exchange rates. A notable feature of Chart 5 is the number of countries reporting an acceleration of growth in narrowly-defined stocks of money (M-1) in 1978 and subsequent deceleration during 1979. The general shift toward slower monetary expansion during 1979 was indicative of a widespread emphasis on monetary policy as the key tool used in the major industrial countries to combat inflation.
The indices plotted in Chart 6 are indices of relative costs and prices adjusted for exchange rate changes; they can be regarded as indices of “real exchange rates.” These series relate only to the manufacturing sector, where competition among industrial countries is most direct and pervasive. A rise in one of these indices denotes a loss of competitiveness; a decrease denotes an improvement.
Indices of the type shown in Chart 6 are particularly useful in assessments of the impact of past exchange rate changes and domestic price changes on a country’s competitive position vis-à-vis its trading partners. Key points to note are (1) changes in real exchange rates over the 1970s have often been large, in some cases—notably the United States—they have been quite persistent; (2) large recent changes in real exchange rates for the United Kingdom and Japan reflect changes in nominal effective exchange rates that exacerbate the effect of inflation on the competitive positions of these two countries (Charts 1 and 3); and (3) at the end of 1970s the competitive position of the United States and Canada was stronger, and that of the United Kingdom and, to a lesser extent, the Federal Republic of Germany was weaker than at any time during the decade.
6Major industrial countries: relative costs and prices of manufactures, adjusted for exchange rate changes1
1 Indexes of the type shown here are frequently referred lo as indicators of real effective exchange rates.
2 Annual deflators for gross domestic product originating in manufacturing with quarterly interpolation and extrapolations (beyond the latest available data) based on wholesale price date for raw materials and manufactures.
3 Hourly compensation divided by potential “output per manhour.”