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December 1986

The Dollar Exchange Rate and International Monetary Cooperation

by Ronald I. McKinnon

The author holds that that unless there is a move toward greater international monetary policy coordination, sharp exchange rate fluctuations are inevitable. The basis for this position is the fact that under a floating exchange rate regime, governments are not required to follow common monetary policies, a condition that generally characterizes a fixed exchange rate regime. Because of this, investors seeking the best investment must continually guess which of the many fiat currencies to hold. Thus, is such a world, the author argues, large swings in exchange rates will occur because the speculative forces that would restore equilibrium to the exchange rate market are weakened in a world of nonaligned national monetary policies. The exchange rate fluctuations give rise to protectionist pressures that supporters argue will protect domestic industry and insulate domestic prices. To avoid this chain of events, the author argues that a stable international monetary system is required to assure free trade of goods and services. In his analysis, the main participants of such a new order would be the Federal Reserve, the Bank of Japan, and the Bundesbank. To achieve exchange rate stability, the author suggests that these three monetary authorities establish a four-point program that, among other things, coordinates their domestic monetary policies along with explicit intervention in markets to achieve certain target exchange rates.