Exchange Rates since 1973

Since March 1973, exchange rates have become much more volatile and less predictable than they were between 1945 and 1973.⁴ This volatility has been partly due to a number of unexpected shocks to the world monetary system, including:

1. The oil crisis in 1971, when the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of oil. The harmful effect of this on the US inflation rate and trade position resulted in a further decline in the value of the dollar.

2. The loss of confidence in the dollar that followed the rise of US inflation in 1977 and 1978.

3. The oil crisis of 1979, when OPEC once again increased the price of oil dramatically--this time it was doubled.

4. The unexpected rise in the dollar between 1980 and 1985, despite a deteriorating balance-of-payments picture.

5. The rapid fall of the US dollar against the Japanese yen and German deutsche mark between 1985 and 1987, and against the yen between 1993 and 1995.

6. The partial collapse of the European Monetary System in 1992.

7. The 1997 Asian currency crisis, when the Asian currencies of several countries, including South Korea, Indonesia, Malaysia, and Thailand, lost between 50 percent and 80 percent of their value against the US dollar in a few months.

Figure 10.1 summarizes the volatility of four major currencies--the German mark, Japanese yen, British pound, and US dollar--from 1970 to 1998. The Morgan Guaranty Index, the basis for Figure 10.1, represents the exchange rate of each of these currencies against a weighted basket of the currencies of 19 industrial countries (the index was set equal to 100 in 1990). All four currencies have been quite volatile over the period. The index value of the Japanese yen, for example, has ranged from a low of 44 in 1970 to a high of 170 in June 1995. Similarly, the US dollar index has been as low as 89.3 in 1995 and as high as 158 in 1985.

Perhaps the most interesting phenomena in Figure 10.1 are the rapid rise in the value of the dollar between 1980 and 1985 and its subsequent fall between 1985 and 1988, and the similar rise and fall in the value of the Japanese yen between 1990 and 1998. We will briefly discuss the rise and fall of the dollar, since this tells us something about how the international monetary system has operated in recent years. The rise and recent fall of the yen are profiled in the accompanying Country Focus.⁵

The rise in the value of the dollar between 1980 and 1985 is particularly interesting because it occurred when the United States was running a large and growing trade deficit, importing substantially more than it exported. Conventional wisdom would suggest that the increased supply of dollars in the foreign exchange market as a result of the deficit should lead to a reduction in the value of the dollar, but it increased in value. Why? A number of favorable factors temporarily overcame the unfavorable effect of a trade deficit. Strong economic growth in the United States attracted heavy inflows of capital from foreign investors seeking high returns on capital assets. High