Policy Making
18. International policies during the 1980s

Like any other macroeconomic policy, one cannot conduct a monetary policy in the modern world without regard for the foreign sector. The "U.S." interest rate is a case in point. In the middle and late 1980s the Federal Reserve was prevented by foreign response from lowering the U.S. interest rate. Deficits on its current account had made the U.S. heavily dependent on the supply of foreign financial capital. The U.S. interest rate was in effect the world interest rate--over which even the mighty Federal Reserve Board had limited influence. An open market operation that looks large when measured in strictly American terms may dwindle to insignificance in the markets of the entire investing world. British, Japanese, Middle-Eastern, and indeed American saving will go where the interest rate is best. In consequence the rate in New York is tied to the world.

The U.S. government and the Federal Reserve in particular are concerned also with the exchange rate of the dollar. In principle the value of the dollar can move wherever the international currency market takes it. A fluctuating exchange rate gives back the power over U.S. affairs that the Fed loses to international markets, because it unlinks American prices and interest rates from their bondage to world prices and interest rates. Under fluctuating rates a dollar today is not the same in terms of Swiss francs or Japanese yen as it will be tomorrow. So the United States is on its own, so to speak. It can have its own interest rate, earned on dollar-denominated assets.

The trouble with this pleasant-sounding result is that the value of the dollar is itself a target of policy. American exporters of food processing equipment or lumber complain bitterly if the dollar is allowed to rise in value, since a higher dollar relative to francs or yen will price American goods out of world markets. But likewise importers of shirts or televisions complain when the dollar is allowed to fall. A stable dollar is usually a safe political compromise. Making it stable, however, to repeat, takes the ability to influence the interest rate or inflation out of the hands of policymakers. It is a case of the Tinbergen rule: you need as many instruments as you have policies; attempting a policy of stable exchange rates will make the policy of, say, a low real rate of interest impossible to achieve. If you try to get the low interest rates by loosening up on the money supply, under fixed exchange rates the money just goes abroad.

For example, in 1985 the U.S. authorities decided to step in and bring about a lowering of the dollar exchange rate. At the time U.S. interest rates were very high and attracted a large pool of foreign financial capital. The results were a strong dollar (because of the heavy demand for dollars), increasing interest rates in other countries (because they demanded the financial capital, too), and persistently large U.S. trade deficits (because the strong dollar was good for U.S. imports and bad for exports). After an international agreement in 1985 the dollar came down in value. So did the interest rates, and the U.S. trade deficit decreased some.