ESSAYS IN INTERNATIONAL FINANCE

ESSAYS IN INTERNATIONAL FINANCE are published bythe International Finance Section of the Department ofEconomics of Princeton University. The Section sponsorsthis series of publications, but the opinions expressed arethose of the authors. The Section welcomes the submissionof manuscripts for publication in this and its other series.Please see the Notice to Contributors at the back of thisEssay.

The author of this Essay, Paul Krugman, is Class of 1941Professor of Economics at the Massachusetts Institute ofTechnology. His publications include Rethinking Interna-tional Trade (1990), The Age of Diminished Expectations(1990), and Currencies and Crises (1992). This Essay waspresented as the Frank D. Graham Memorial Lecture onApril 16, 1993, and concluded a conference on the interna-tional monetary system sponsored by the InternationalFinance Section to celebrate the fiftieth anniversary ofEssays in International Finance. A complete list of GrahamMemorial Lecturers is given at the end of this volume.

PETER B. KENEN, DirectorInternational Finance Section

INTERNATIONAL FINANCE SECTIONEDITORIAL STAFF

Peter B. Kenen, DirectorMargaret B. Riccardi, EditorLillian Spais, Editorial Aide

Lalitha H. Chandra, Subscriptions and Orders

Library of Congress Cataloging-in-Publication Data

Krugman, Paul.What do we need to know about the international monetary system? / Paul Krugman.p. cm. — (Essays in international finance, ISSN 0071-142X ; no. 190)Includes bibliographical references.ISBN 0-88165-097-8 (pbk.) : $8.001. International finance. 2. Foreign exchange. 3. Monetary unions. I. Title.

II. Series.HG3881.K778 1993332′.042—dc20 93-9099

CIP

Copyright © 1993 by International Finance Section, Department of Economics, PrincetonUniversity.

All rights reserved. Except for brief quotations embodied in critical articles and reviews,no part of this publication may be reproduced in any form or by any means, includingphotocopy, without written permission from the publisher.

Printed in the United States of America by Princeton University Printing Services atPrinceton, New Jersey

International Standard Serial Number: 0071-142XInternational Standard Book Number: 0-88165-097-8Library of Congress Catalog Card Number: 93-9099

CONTENTS

1 INTRODUCTION 1

2 SILVER LININGS IN A EUROPEAN CLOUD 1

3 WHAT I THINK WE KNOW 4Linkage Problem 1: Trade Theory 9Linkage Problem 2: Intertemporal Analysis 13Linkage Problem 3: Rational Expectations 15

4 WHAT WE NEED TO KNOW 18

REFERENCES 23

FIGURES

1 U.S. Unemployment and Inflation-Rate Change 7

2 U.S. Exchange-Rate Indices 8

3 Rates of Export Growth 9

WHAT DO WE NEED TO KNOW ABOUT THEINTERNATIONAL MONETARY SYSTEM?

1 Introduction

Frank Graham is today best known for his work in the pure, that is,nonmonetary, theory of international trade. His most famous paper issurely “Some Aspects of Protection Further Considered” (Graham1923). This paper anticipated many of the themes that I and othershave pursued under the unfortunate name of the “new trade theory,”and it did so with such insight that reading it makes one wonderwhether the rest of us were necessary.

Yet Graham knew that trade takes place in a monetary world, and,unlike many real-trade theorists, he did not retreat from confrontingthe messier and less secure terrain of international monetary affairs. Itis surely appropriate that, at a conference honoring the fiftieth anniver-sary of Essays in International Finance, I should commend to youEssay No. 2, Graham’s (1943) thoughtful discussion of the troubledchoice between fixed and floating exchange rates—an issue that I shallargue remains at the heart of what we need to know in internationalmonetary economics.

It is especially fitting for me to refer to the great Graham traditionin international economics, for I shall have a lot to say during thislecture about the virtues of traditional insights and approaches tointernational monetary economics. I shall not merely celebrate thepast, however, but shall begin with a very recent event: the crisis thatgripped the European Monetary System (EMS) only eight months ago,in September 1992.

2 Silver Linings in a European Cloud

A few days after a massive speculative attack forced the United Kingdomto pull the pound out of the Exchange Rate Mechanism (ERM) of theEMS, Chancellor of the Exchequer Norman Lamont denied that theevents represented a policy defeat. He claimed that he had alwaysregarded the defense of a fixed parity as a mistake (although, right upto the day of the debacle, he had asserted Britain’s absolute commitmentto the ERM), and he went so far as to say that, after the pound was freedfrom its peg to the mark, he had been “singing in the bath” with relief.

1

I don’t know whether the chancellor was actually singing in the bathor whether he was doing so more than usual. I can say, however, that,in late September of 1992, I myself was feeling pretty cheerful. Not thatI wished the EMS harm; but the way the events of Black Septemberunfolded encouraged me in my belief that we international macro-economists do in fact know a thing or two.

It is a slightly shameful but true observation that economists inter-ested in policy find themselves pleasantly stimulated by economiccrisis, just as professional military men are somewhat cheered by theprospect of war. This is particularly true when the events are dramaticwithout being too threatening in a personal sense: I have never seen asmany happy people at the National Bureau of Economic Research as Idid during the first few days after the 1987 stock market crash. Thereis extra satisfaction when the crisis is one that you and your friendsthink you understand, and to be around when a crisis that you havepredicted actually comes to pass is very heaven.

The ERM crisis of September was one that many of us thought weunderstood quite well indeed, and one that at least some of us hadpredicted well in advance. (For the record: I wrote a column in U.S.News and World Report in February 1991, predicting that the fiscalconsequences of German reunification would create strains on theEMS and force a realignment; of course I won’t tell you about all thecrises I predicted that didn’t materialize). The story of the rise andpartial fall of the EMS is deeply satisfying to tell, because it fits so wellinto the standard, workhorse models that most of us use to discussinternational macroeconomic policy. The whole episode seems like akind of textbook exercise designed to lead the student through theworkings of a basic model of exchange rates, interest rates, and policyinterdependence. (Indeed, I can guarantee that for a while, at least,the troubles of the EMS will be viewed as precisely such a textbookcase; after all, Obstfeld and I [1991] write the textbook!)

The events of September, then, confirmed me in the view that wedo, in fact, know quite a lot about the international monetary system.To be sure, our quantitative accuracy is limited. But, in a basic sense,we do know how monetary and fiscal policy work in open economies,and we know how they are transmitted internationally under fixed andfloating exchange rates. This knowledge was enough to enable us topredict correctly that the combination of fiscal expansion and tightmoney in Europe’s key currency nation would create a recession in therest of the continent. And we knew enough about the behavior ofexchange markets to anticipate correctly that the breakdown of the

2

system under these strains would be attended by massive speculativeattacks (a point that gives me extra pleasure, for I have some personalintellectual property rights in such attacks).

So the policy debacle of 1992 was intellectually reassuring. I wascertainly not the only economist who, behind his serious expressions ofconcern, was thinking “Ha! Told you so!.” And yet, even the intellectualsatisfaction was not unalloyed. We may know a lot about the interna-tional monetary system, but we cannot rest easy with that knowledge.Indeed, hardly anyone is pleased with the state of our field.

One reason for our discontent is that the standard model that sonicely explains the ERM crisis works better in practice than it does intheory. It is essentially a slightly updated version of the Mundell-Fleming model, which is rooted in the kind of old-fashioned, ad hocmacroeconomics that nobody respects anymore. It is a short-run modelthat has never been clearly linked to the long-run stories we use toexplain both trade and capital flows. And it is ugly. In StephenWeinberg’s book, Dreams of a Final Theory (1992), Weinberg assertsthat theories should be beautiful, and that a theory is beautiful if itseems “inevitable,” that is, if none of its assumptions can be changedwithout compromising its entire conceptual basis. By this measure, thestandard model of international macroeconomics is exceedingly homely.It involves a set of plausible, but by no means overwhelmingly compel-ling, assumptions; indeed, some key parameters of the model do notseem to be tied down by any deep economic logic. It is better to use anugly model that seems to work than to insist on beautiful falsehoods, butmodified Mundell-Fleming does not comfort the economist’s soul.

Worse yet, the standard model leaves some crucial questions unan-swered. We understand pretty well what Britain gained by droppingout of the ERM. We can even hope to make a rough quantitativeestimate of the value of the monetary autonomy obtained by abandon-ing the fixed parity. But what did Britain lose by letting its rate float?What would it be worth to Europe if, despite the odds, the MaastrichtTreaty were somehow to succeed in producing a unified Europeancurrency? We have some suggestive phrases—reduced transactioncosts, improvement in the quality of the unit of account—to describewhat we think are the benefits of fixed rates and common currencies.We even have a loose-jointed theory of optimum currency areas thatstresses the tension between these hypothesized benefits of fixity andthe more measurable costs of lost monetary autonomy. What we do nothave, however, is anything we can properly call a model of the benefitsof fixed rates and common currencies.

3

This is an unsatisfactory situation. I would suggest that the issue ofoptimum currency areas, or, more broadly, that of choosing an ex-change regime, should be regarded as the central intellectual questionof international monetary economics. We have formulated this questionwell enough to agree that it is a matter of trading off macroeconomicflexibility against microeconomic efficiency. Unfortunately, we are notcompletely happy with the way we model the macroeconomic side, andwe have no way at all at present to model the microeconomics.

I shall eventually argue in this lecture that developing some kind ofmodel of the microeconomics of international money ought to be ourtop research priority. Most of the lecture, however, will be spent on adifferent issue: that of defining what it is that we actually do know aboutthe international monetary system. Unfortunately, macroeconomics ingeneral and international economics in particular is a field marked bydeep ideological divisions and much mutual incomprehension. It ishard to hold on to the things that we actually do know, let aloneexpand our territory. My initial task will therefore be to try to make amap, to sketch out the border between what I think we know and whatI am sure we do not know about the international monetary system.

3 What I Think We Know

In a recent essay (1991), I used the term “Mass. Ave. model” to de-scribe the slightly updated version of the Mundell-Fleming model thatis the workhorse of international-policy analysis. Let me use a differentterm here and call it “modified-Mundell-Fleming,” or “MMF” forshort. (I guess that’s pronounced “mmph.”) A typical version of MMFlooks something like the following:

First, we assume a Keynesian demand-side determination of output,in which real output y (in terms of some composite domestic good) isthe sum of domestic absorption A and net exports NX:

where i is the interest rate and π is the expected rate of inflation.

(1)y A(y, i π) NX ,

We also assume a standard LM curve:

where M is the money supply and P the domestic price level.

(2)M/P L(y, i) ,

Prices are assumed to be sticky. In the original Mundell-Flemingmodel, they were simply taken as given; in the MMF model, inflationis determined by the difference between real output and the “natural”

4

level yN, and on the expected inflation rate π:

and expected inflation is assumed to adjust only slowly in response to

(3)PP

φ(y y N) π ,

actual inflation:

All of this is just standard early 1970s macroeconomics. The specifi-

(4)π λ

PP

π .

cally international side of the model comes in the determination of netexports and the exchange rate. We assume export and import equationsthat depend on incomes and relative prices, so that the net-exportequation looks something like this:

where y* is foreign output, E is the exchange rate, and P* is the foreign

(5)NX NX(y, y , EP /P) ,

price level.In the original Mundell-Fleming model, international arbitrage was

assumed to equalize interest rates. In MMF, we need something that isnot so obviously untrue. A typical assumption is that markets expectthe real exchange rate to revert toward some “normal” level, eE, andthat they set the expected return on domestic and foreign interest-bearing assets as equal:

I am not going to do anything with these equations. I put them here

(6)i i π π γ

ln(e E) ln

EPP

.

just to give some concreteness to what I mean when I talk about thestandard model of international macroeconomics. I think it is fair to saythat something like this model underlies most informed policy discussionof exchange rates, macroeconomic interdependence, balance-of-pay-ments adjustment, and so on.

Of course, each of us would like to make a few changes in thedetails. The aggregate-demand equation is far too simple: all sorts ofother factors should be included as determinants of expenditure. TheLM curve is nastier than I have written it, especially given the problemof defining a useful monetary aggregate. The net-export equationdefinitely needs some lagged effects for the real exchange rate, and it

5

should probably be so constructed as to yield a J-curve. Some peoplewould want to include risk premia in the exchange-rate equation, so asto allow some scope for the effectiveness of sterilized intervention. Morebroadly, the assumption of perfect capital mobility is questionable. AsObstfeld (1993) points out in his paper for this conference, there aresubstantial questions about the degree of long-run capital mobility evenfor advanced countries. Dooley’s (1993) paper is a reminder that manydeveloping countries were simply shut out of international capitalmarkets for a decade. These are all, however, technical adjustments;they do not challenge the fundamental conceptual basis of the model.

There are many economists—although few of them actually engagedin making policy recommendations—who would challenge the funda-mental conception. Indeed, a substantial number of economists regardthe MMF model as pure nonsense. I shall get to those criticisms in alittle while. First, however, I want to spend some time pointing outthat the most controversial aspects of the MMF model have actuallyheld up rather well in the face of recent experience.

In terms of the philosophical underpinnings, the most troublesomeaspect of the MMF model has nothing to do with international eco-nomics. It is the assumption of gradual price adjustment. Indeed, bythe early 1980s, after years of relentless criticism from Lucas and hisfollowers, it had become inadvisable to write down anything like myequations (3) and (4) in a paper intended for a refereed journal. Yetthis old-fashioned, ad hoc approach to aggregate supply has in factfared rather well in the face of the actual experience of price behaviorsince 1980. We can see this in two ways.

First, “adaptive-expectations” Phillips curves do not do badly infitting the actual interplay between the business cycle and inflation.Figure 1 shows a crude illustration of this point. It compares the U.S.rate of unemployment on an annual basis with the change in theinflation rate (measured by the GDP deflator) since 1973. The relationis far from perfect—I could no doubt do much better by playing withlag structures and demographically corrected unemployment rates—buttwo things are unmistakable: there is a negative correlation betweenthe rate of unemployment and the change in the inflation rate, and theslope is not all that steep. That is, the picture is broadly consistent withthe idea that there is a fairly flat short-run tradeoff between inflationand unemployment, but a vertical tradeoff in the long run. The impor-tant point is that this picture, some version of which has been appear-ing in textbooks since the late 1970s, still looks pretty good after allthese years.

6

has been apparent at least since Ricardo’s time: there is no room inRicardo’s model, or certainly in the formalization of that model byJohn Stuart Mill, for the kind of price movements envisioned inHume’s story of balance-of-payments adjustment. Robert Mundelldeveloped his macro analysis of exchange-rate regimes only a few yearsafter making major contributions to real-trade theory; yet the twoanalyses seem to be referring to completely different worlds.

In fact, I can think of only one well-known paper that seriously triesto build a bridge between international trade and international money:the Ricardian model of Dornbusch, Fischer, and Samuelson (1977).That paper struck me like a bolt of lightning when I first read it—itseemed to me to legitimize international macroeconomics and to makesense of some of its characteristic assumptions in a way that had notbeen possible before. Not everyone appreciates what these threeaccomplished, however, so let me review briefly their argument, beforeI talk about what is missing.

The Dornbusch-Fischer-Samuelson approach envisages a world inwhich each country has only a single factor of production, which it canuse to produce a large number of traded goods and perhaps a range ofnontraded goods as well. It begins with a pure, static, real-trade model.With a little ad hockery, however—simply assuming domestic nominalexpenditure proportional to the domestic money supply—the modelbecomes dynamic and monetary. With a little more ad hockery—assuming rigid nominal wages—the model becomes Keynesian as well.

The model immediately suggests answers to several major historicaldebates in international economics; indeed, it suggests that they are allreally about the same thing. It offers a startlingly neat solution to theKeynes-Ohlin debate over the transfer problem: Ohlin is right inprinciple, but Keynes is right in practice if a large fraction of expendi-ture falls on nontraded goods. The model also offers a quick integrationof trade theory with Hume’s adjustment mechanism: allowing money toflow automatically generates a specie-flow mechanism; if nontradedgoods are important, this then becomes a price-specie-flow mechanismin which a trade deficit is associated with an unusually high relativewage rate and domestic price level. In other words, the question ofwhether the price component of Hume’s story is essential is the sameas the answer to the transfer problem. Finally, when we turn to devalua-tion, we see that the debate between the absorption and elasticityapproaches comes down to the same thing: relative price changes are anessential part of the adjustment process if, and only if, conventionalwisdom on the transfer problem is right.

10

The model also shows that the conventional wisdom that exchange-rate adjustment helps reconcile balance-of-payments targets withemployment targets is justified in the presence of sticky nominal wages.In so doing, it basically integrates Ricardo’s trade theory not only withHume’s earlier monetary story, but with the external-and-internal-balance stories that Swan (1963), Johnson (1958), and others put at theheart of international macro analysis 140 years later.

All of this is wonderful. I have used what I learned from Dornbusch,Fischer, and Samuelson as an underpinning for a lot of work and,indeed, for some serious policy arguments. With its remarkable encap-sulation of 200 years of thought into 17 pages of text, it is one of myfavorite papers.

There is only one problem. Nobody thinks that the Ricardian modelis an adequate representation of the forces driving international trade.And, unfortunately, the integration of trade and monetary theoryachieved by Dornbusch, Fischer, and Samuelson does not easily surviveintroduction of a more complex trade model. To see the problem, letus simply imagine replacing the Ricardian setting with a standard two-factor model of trade and see what happens to the results.

In the Ricardian model, introducing nontraded goods is enough to giveus the conventional presumption on the transfer problem. If country Atransfers income to country B, the transfer will raise the demand fornontraded goods in B and lower it in A, even if they have the sameexpenditure patterns on the margin. Because nontraded goods areproduced with domestic labor, the effect is to shift world relative demandfor the two countries’ labor, and thus to push up B’s relative wage rate.This shift in the double-factorial terms of trade will produce a corre-sponding change in just about any measure of the real exchange rate.

It is easy to show, however, that, in a two-or-more-factor world, thisneed not happen. Suppose, for example, that there are two traded goodsand one nontraded good, produced with two factors. And suppose thateach country produces at least some of both traded goods. A transferwill then lead to a complicated reshuffle of resources within eachcountry, with the nontraded sector releasing resources to traded-goodsproduction in one country and absorbing them in the other, generatingRybczinski effects all over the place. If technologies and tastes are thesame, however, the end result of the shuffle will be to allow the worldto accommodate the shift in the location of consumption of nontradedgoods without any change in relative prices or factor returns. Thesimple association of a large nontraded sector with a Keynesian view onthe transfer problem is broken.

11

Worse yet, when there are multiple factors of production, onecannot introduce a Keynesian story about unemployment simply byassuming a rigid nominal wage rate. Fixed wage rates in two-factormodels do weird things, leading to abrupt changes in specializationwhen the relative wage rates shift a little. Obviously, that doesn’thappen in practice, and the reason why is clear: steel mills cannot beturned into textile mills over the course of a few months. What welearn, however, is that, once we try to get the realistic tradeoff betweeninternal and external balance into anything more complex than aRicardian model, we are immediately faced with the need to get into alot of messy stuff. We cannot just assume sticky wages; we need tostart worrying about things like the dynamic adjustment of sector-specific capital stocks. The simplicity of both the Mundell-Flemingmodel and the Dornbusch-Fischer-Samuelson model seems to getburied under a welter of detail.

How, as economists, do we deal with the glaring inconsistencybetween the models we use to think about macroeconomic and tradeissues? One answer is simply to specialize: many trade economistsprofess a total lack of understanding of, or faith in, macroeconomicanalysis, and many macroeconomists simply lack interest in trade. Theworld wants answers, however, and some of us try to keep abreast inboth areas. How do we manage the cognitive dissonance? We do solargely, I believe, by telling ourselves that the MMF model is a short-run story, whereas modern trade theory is a long-run story. In fact,however, nobody other than Dornbusch, Fischer, and Samuelson hassucceeded in making anything like MMF emerge as the short run of along-run model.

Matters get even worse when we introduce the concerns of the “newtrade theory,” increasing returns and imperfect competition. I havepersonally made a small stab at integrating monetary factors into a new-trade-theory model (Krugman 1987), using a framework shamelesslyplagiarized from Dornbusch, Fischer, and Samuelson. That exercisesuggested that, in a world of increasing returns, we may not even beable to assume that the long run is exempt from monetary influences:a large short-run overvaluation or undervaluation may permanentlychange the pattern of dynamic comparative advantage.

What I have argued, then, is that there is a glaring lack of consistencybetween the stories we tell about international trade and the way thatwe model trading economies when we want to talk about macroeconom-ics. One reaction to this inconsistency would be to dismiss the macroanalysis. After all, the trade stories have coherent microeconomic bases,

12

and the MMF model does not. That is not, however, my reaction. Thefact is that the MMF analysis seems to be extremely useful—it appearsto work in practice much better than it ought to work in the light oftrade theory. The question is why.

So here is a research challenge: let us try to build a link between thetrade analysis that works in theory and the macro analysis that seems towork in practice.

Linkage Problem 2: Intertemporal Analysis

A number of years ago, when I was on the staff of the Council ofEconomic Advisers, I found myself obliged to defend the CEA free-trade position in a meeting in which most people were much moresenior than I. Among them was the then U.S. trade representative. Atone point, I tried to emphasize the domestic origins of the U.S. tradedeficit by referring to the point that the trade balance equals thedifference between domestic saving and domestic investment. AmbassadorBrock was polite. “That’s an interesting theory,” he said.

Of course, the identity X − M = S − I is not a theory. It is one of thefew things in international economics about which we are absolutelysure. So one might think that an “intertemporal” approach to thebalance of payments, one that treats current accounts as the outcomeof long-run savings and investment decisions, would be at the core ofthe way we do open-economy macroeconomics. And we all invoke suchan approach, at least informally, when we try to discuss enduringpatterns in international capital flows, such as the persistent current-account surpluses of Japan and pre-reunification West Germany. Thereis also a growing formal literature on international economic modelsbased on intertemporal optimization models. This is nicely surveyed byRazin (1993).

What seems striking to me, however, is that there has been verylittle contact between the world of more or less practical policy analysisand the intertemporal approach. If anyone has tried to discuss thetravails of the EMS in terms of intertemporal optimization, I am notaware of it.

Why do we seem unable to make any use of these models? It couldbe that the policy-relevant types are simply too old-fashioned to bewilling to use modern analysis—but I don’t think that’s a fair judgment.The real reason, I think, is that the intertemporal approach doesn’t seemto accord with what we think we know about what actually happens.

Let me start at the shallow end. The thing I find most striking aboutthe predictions from intertemporal maximizing models is how compli-

13

cated they are compared with the fairly simple stories told by theMMF model. Suppose I ask how an extra percentage point of U.S.economic growth next year will affect U.S. trade. Even a very simpleintertemporal model will respond with a request for more information.Is the shock temporary or permanent? Is the shock in traded or non-traded goods? Or what about the relation between the trade balanceand the real exchange rate? The answer again seems to depend on avariety of questions about the source and persistence of shocks. Thepeculiar thing is that, although things are complicated and messy intheory, they are fairly simple in practice: the trade equations describedby Hooper and Marquez (1993), equations that work rather well, tell usthat 1 percent on U.S. GDP means imports rise by 2 percent; 10percent on the real exchange rate means net exports decline by 1percent of GDP—end of story. It is hard to sell a practical policyeconomist on a theoretical framework that seems to require her tothrow away simple tools that have proved useful and to replace themwith complicated ones that seem to give no answers at all.

A deeper problem with the intertemporal approach is that it may berigorous but wrong. It assumes that people have a very high degree ofrationality about the effects of shocks on their future income, to adegree that one can reasonably argue would actually require irrationalexpenditures of resources on gathering and processing information.

Consider, for example, what the intertemporal approach says aboutone of the issues surrounding the troubles of the EMS. Should Germanyhave tried to finance the rebuilding of the East with higher taxes ratherthan accept large fiscal deficits? Many economists believe that, with adifferent fiscal stance by Germany, the strains that led to Black Wednes-day could have been avoided. According to the standard intertemporalapproach, however, it would have made no difference. Robert Barrobecame famous for arguing that long-lived households should decide ontheir consumption based on what they expect the government to spend,not on the particular time path of the taxes it plans to collect to pay forthat spending.

The point, of course, is that this story requires that ordinary WestGerman households sit down over their evening meal and estimate theimpact of likely subsidies to the East on their future tax liabilities. Isthis plausible? Would the improvement in expected utility from doingso actually be worth the time and effort for the typical German family?I doubt it. Surely it is far more likely that people use reasonable, butnot hyperrational, rules of thumb to decide on their consumption, rulesthat are not likely to provide an automatic offset to changes in taxes

14

unmatched by changes in spending plans.We might note as an aside that many intertemporal models make the

high rationality required seem more plausible by assuming an ergodicstructure of recurrent random shocks. The idea is that, through longexperience, households develop rules of thumb that approximateoptimal behavior given the shocks they typically face. Unfortunately,the times when we really need our models are when atypical shockscome along; German reunification is not something that happens on aregular basis.

Finally, let me note the obvious point that the MMF model focusescrucially on the role of sluggish price adjustment, and that this focusseems to be correct. The intertemporal models currently available,however, are full-employment models in which there is no natural wayto introduce the nominal rigidities that remain so critical to under-standing the real issues that confront us.

Yet one cannot simply dismiss an intertemporal approach as useless.The present is linked to the future by saving and investment; what wedo now matters for what we expect to happen in the future, and viceversa. We cannot ultimately rest easy with any short-run model that isnot at least approximately embedded in some kind of intertemporalframework. The MMF model, once again, does not meet that criterion;it respects the accounting identities, but that’s about it.

So here is another research challenge: let us try to build an inter-temporal approach in which the balance of payments is determined byforward-looking (if not necessarily hyperrational) saving and investmentdecisions, yet which remains able to discuss the kind of issue that theMMF model seems to handle acceptably.

Linkage Problem 3: Rational Expectations

During the 1970s, the rational-expectations revolution swept all beforeit in macroeconomics. It became completely unacceptable in politecircles to make ad hoc assumptions about expectations or dynamicadjustment processes. Everything, from asset pricing to aggregatesupply, was supposed to be grounded in rational behavior, albeit in thepresence of incomplete information. At the core of the revolution waswhat we may call the Lucas Project, the effort to build business-cycletheory on maximizing microfoundations.

The initial effect of this revolution was exhilarating; its eventualeffect was devastating. Traditional Keynesian macroeconomics was, as amatter of theory, completely vanquished, as were the various ad hocmodels of asset markets that had been common ingredients of macro

15

analysis up to that point. The ramshackle, ad hoc intellectual structuresof the 1950s and 60s were ruthlessly cleared away, making room for theerection of a new structure to be based on secure microfoundations.Unfortunately, that structure never got built.

The fact is that the Lucas Project succeeded in destroying the oldregime but failed to create a workable new macroeconomics. The effortto explain the business cycle in terms of rational confusion over whichshocks were nominal and which were real was, in the end, a failure:economic agents have too much information, and business cycles aretoo persistent. The true believers in equilibrium business cycles shiftedto real-business-cycle theory (to which the intertemporal models of thebalance of payments are related), while most theorists simply abandonedthe subject of business cycles altogether. Meanwhile, forecasts andpolicy assessments had to be made. So, practical economists continuedto use the old-fashioned models, like Cuban drivers stranded by theU.S. embargo doing the best they can with lovingly maintained 1959Chevys.

The theoretical devastation wreaked by the rational-expectationsrevolution was perhaps most severe in international macroeconomics,for two reasons:

First, in international even more than domestic economics, theevidence for some kind of nominal rigidity is overwhelming. Domesticmacroeconomists can point to the lack of clear correlation between anyparticular monetary aggregate and real output and deny that nominalvariables have real effects; or they can claim that such correlation asthere is represents reverse causation from real shocks to an endoge-nous Federal Reserve. International macroeconomists must face up tomuch stronger evidence, the nearly perfect correlation between nominaland real exchange rates in industrial countries since 1980. There are afew who try to make the reverse causation argument—but they mustthen confront the question of why the “real” shocks seem to change somuch when the nominal regime shifts. Real exchange rates were farmore volatile after 1973 than before; the formation of the EMS wasassociated with a sharp reduction in real-exchange-rate movement withinthe currency bloc. An extremist might dismiss even this evidence on thegrounds that the changes in exchange-rate regime were endogenous.This is certainly true: physicists tell us that only a few basic constantsare truly exogenous, and the rest is all quantum mechanics. But, asEichengreen (1993) shows, the factors determining changes in exchangeregime are far too subtle to produce such a raw, striking correlation.And one must, in the end, also confront such facts as the change in

16

Ireland’s real-exchange-rate behavior from close correlation with theUnited Kingdom before its entry into the ERM to close correlation withGermany afterward. I personally think that the effort to explain away theapparent real effects of nominal shocks is silly, even if one restrictsoneself to domestic evidence. Once one confronts international evidence,however, it becomes an act of almost pathological denial.

The problem, of course, is that Lucas made us all painfully aware thatwe lack good microfoundations for assuming any sort of nominalrigidities. This leaves international macroeconomics with a painfuldilemma: to write a macroeconomic model with sticky prices is profes-sionally dangerous, but to write one without such rigidities is empiricallyridiculous. The result is a considerable degree of intellectual paralysis.

The situation is made worse by the second problem of internationalmacroeconomics: the apparent failure of rational expectations even inthe place where one might hope it would work, international assetmarkets.

For a number of years, there was a sort of academic industry thatfocused on testing the speculative efficiency of the forward exchangerate. A few early papers claimed to confirm that the forward rate wasan efficient predictor of the subsequent change in the exchange rate(or more accurately, failed to reject the null hypothesis that it was anefficient predictor). Since the crucial paper by Hansen and Hodrick(1980), however, it has been obvious that this is not the case. Indeed,if anything, the correlation is negative. Now, this need not imply arejection of efficiency if there are risk premia, especially shiftingones—although nobody thought large shifting risk premia were likely tobe important until the devastating failure of simple efficiency ideasbecame apparent. In the end, however, it just won’t wash. Taylor’s(1993) paper summarizes the huge and dispiriting literature on foreign-exchange-market efficiency: after more than a decade of work, it seemsclear that nobody has found any reasonable way to “save” the specula-tive-efficiency hypothesis within the data. This is devastating in itsimpact on our research. What we know how to model are efficientmarkets; what we apparently confront are inefficient ones. Nor can we,in international macroeconomics, tacitly put speculative behavior onone side. Under floating exchange rates, the role of market expecta-tions is crucial to every aspect of policy analysis.

What practical policy analysts do, of course, is apply ad hoc rulesabout expectation formation, like the rule embedded in equation (6) inmy exposition of the MMF. These rules are clearly wrong as a fulldescription of how markets behave, yet they contain enough truth to

17

give some guidance, and they at least allow the model to be completed.This kind of brutal expediency, however, encourages the slightly disrep-utable reputation that international macroeconomics has among smartyoung economists.

In my last two linkage discussions, I have suggested that there is roomfor some research on trying to put what we think we know aboutinternational monetary economics together with what we think we knowabout related fields. Here, I have no such optimistic suggestion. It seemsto me that macroeconomics is in a terrible state independent of itsinternational aspects. Until we find some resolution of its difficulties,which I suspect will involve facing up to deep issues such as the role ofbounded rationality, there is little that can be done on the internationalfront. Perhaps a slender bridge can be constructed between internationalmacroeconomics and “new Keynesian” macroeconomics à la Mankiw(1991, 1992), but I guess I wouldn’t expect more from that than a bit ofrationalization for continuing to use the MMF model.

4 What We Need to Know

Up to this point, I have described a series of problems with the MMFmodel of international macroeconomics. I have pointed out that it is anad hoc model that is poorly linked with the models that we use toexplain international trade, even though an open macroeconomy isnecessarily also a trading economy. I have pointed out further that theMMF model does not link up at all well with our best models of savingand investment decisions, even though it is a basic identity that thecurrent account equals the savings-investment balance. And I havepointed out that the MMF model, along with virtually all relevantshort-run macroeconomics, has been intellectually stranded by the waythe rational-expectations macroeconomics first vanquished Keynesianism,then collapsed in the face of its own internal contradictions.

And yet, despite all of these problems, when it comes to makingsense of the international monetary system, the macroeconomic side isnot the biggest obstacle. The MMF model is crude, ad hoc, and inhuge need of improvement. Nonetheless, it is a workable guide. If youask me what will happen if, say, Mexico emulates Argentina and adoptsa “currency-board” system that pegs the peso to the dollar; if you askme what will happen if France gives up the franc fort, or Germanydecides to slash public spending; if you ask what the consequenceshave been of Canada’s determination to achieve price stability, I think,in all of these cases, I know how to answer—and maybe even to

18

produce a rough quantitative assessment—using something along thelines of the MMF model.

But now, suppose you ask me some related questions, to whichpolicymakers would very much like to know the answers. What will bethe impact on European trade and, beyond that, on the efficiency ofthe European economy if the European Community (EC) actuallyadopts a common currency? What will be the effect on North Americantrade if Canada and Mexico permanently peg their currencies to theU.S. dollar? I can talk a good game on these questions when pressed,but I know, even if my listeners do not, that I do not have a modelnearly as well developed as the MMF model to back up my assertions.What I have is only a set of nice words, backed by vague images. Inparticular, I have no real way of quantifying the forces to which I canallude. To put it briefly, we have a workable, if not beautiful, model ofinternational macroeconomics; we have no real model of the microeco-nomics of international money.

The same is, of course, true for domestic macroeconomics. The truthis that there is no even halfway adequate model of the microeconomicsof money, at least in the sense of a model that addresses the issues thateveryone thinks really matter. The case in point is the welfare costs ofinflation: existing models only let us get at the “shoe-leather” costs thatarise from the use of non-interest-bearing money as a medium ofexchange. These costs are small at anything short of hyperinflation.Most economists who worry about the issue believe, however, that themain costs of inflation lie, not in the degraded role of money as mediumof exchange, but in its damaged role as unit of account—for which wehave no model.

Nonetheless, in domestic macroeconomics, we do not usually findthat our microeconomic ignorance is crucial. The consensus that thereis no long-run tradeoff between unemployment and inflation, but thatthe short-run tradeoff is quite flat, has allowed the emergence of apolicy consensus that inflation should be kept at its current fairly lowlevels, but that it is not worth a costly push to full price stability. Toput it another way, the central issues in domestic monetary policy donot, at present, seem to require reaching a judgment about the micro-economic side of the equation. (Strictly, this is true only for advancedcountries with low inflation. The relation between inflation and long-run growth is much more central for the kind of stabilization problemsdiscussed by Bruno [1993]).

In international monetary affairs, however, I think it is fair to saythat the central, canonical issue is that of choosing an exchange regime.

19

Of course, there are always problems of policy management within anexchange regime: Chancellor Lamont still needs all the advice he canget, and better open-economy macro models remain essential to manyreal policy issues, such as the coordination problems discussed byBryant (1993). Still, the big issues involve fundamental regime choice.Should Mexico contemplate devaluation to restore some of its industrialcompetitiveness, or should it lock in its gains against inflation bypermanently pegging to the dollar (or even adopting the dollar as itscurrency)? Should Sweden (Poland? Slovakia?) join EMU, if such athing happens? These are all questions that are, in effect, variants ofthe optimum-currency-area problem.

Now, Mundell (1961), McKinnon (1963), and Kenen (1969) gave usa very nice intellectual structure for thinking about the problem ofdefining an optimum currency area. In all cases, we think of a countryas asking whether it prefers the macroeconomic independence thatcomes with an independent currency and perhaps a floating rate, orwhether it prefers the microeconomic benefits of stable rates andperhaps a common currency. We have a fairly good idea of what themacroeconomic tradeoff is: we know that fixed rates cost least whentrade is large, when labor mobility is high, when shocks are symmetric,and when there are compensating fiscal transfers. Knowing this, weguess that some index based on these criteria will indicate when and ifa country should join a currency area.

In fact, however, we know almost nothing about the other side ofthe comparison. To repeat: what we say about the microeconomics is amatter of metaphor and slogans rather than worked-out models. I amsure that a common European currency would save the transactionexpenses now incurred in changing currencies—London and Pariscould get by with far fewer foreign-exchange kiosks. Beyond that, wereally don’t know. Does confusion over fluctuation in units of accountsignificantly inhibit the ability of European businessmen to reachmutually beneficial deals? To the extent that it does, how large are thecosts? I don’t think we even have an idea of the order of magnitude.

Of course, we must make judgments anyway. I would identify threedifferent strategies that have been used to try to deal with, or perhapsto paper over, our almost total ignorance about the crucial microeco-nomic tradeoffs involved in the formation of monetary areas.

First, we seem to be able to resolve the issue in many cases bypointing to overriding political concerns, often involving seigniorage,that force monetary areas to coincide with nations. Goodhart (1993)makes this point effectively, and it is surely often valid. Yet I cannot

20

help noticing the relief with which economists seize upon discussionsof seigniorage as a way to avoid the really difficult issues. After all,seigniorage is something we understand; we slip away from the opti-mum-currency-area argument into a discussion of inflation taxes withsomething like the attitude of a man changing from his business shoesinto a pair of comfortable old slippers. Unfortunately, comfortable as wemay be with this kind of argument, it will only sometimes be enough.

Second, quite a few economists have tried to assert that there are nomacroeconomic benefits to independent currencies, so we don’t have toworry about how big the microeconomic costs are. This line of argu-ment usually rests on rational-expectations macroeconomics, whichseems to suggest that highly visible nominal policies like currencydepreciation should have, at most, very transitory real effects. Indeed,with some time-consistency stories thrown in, one may argue that acountry with a propensity to inflationary policies is actually better offpegging its currency to a more disciplined partner, because this com-mitment will gain it credibility that actually improves the ex posttradeoff between inflation and unemployment. If fixed rates are amacroeconomic plus, then any microeconomic gains are icing on thecake; our ignorance about their size doesn’t matter for policy purposes.

Unfortunately, this neat solution to our conundrum is just too neat.There was a time when it seemed reasonably plausible for non-GermanEurope: as long as the United Kingdom, Italy, and even France werepreoccupied with regaining credibility in their fight against inflation,one could argue that pegging to the mark was an unambiguous good.But that was a special contingent circumstance. In the world of 1993,when inflation is nobody’s top priority and recession is a big problem,when the vices of German fiscal policy have upstaged the virtues ofGerman monetary policy, it becomes clear that the old-fashioned viewthat pegging one’s currency will impose macroeconomic costs is onceagain the sensible one. For most of 1992, no European policymakerwas willing to say as much, but, despite their protestations that theywould never contemplate abandoning the ERM, it was obvious toeveryone, speculators especially, that the non-tradeoff view was nolonger viable. This is not to say that arguments about credibility maynot be useful in their place, as in Rodrik’s (1993) discussion of theproblems of sequencing of reform. We are kidding ourselves, however,if we think that they can settle the optimum-currency-area problem.

Finally, we often try to deal with our microeconomic ignorance byleaning on analogies. In particular, the Great Analogy of internationalmonetary discussion in the late 1980s and early 1990s has turned out to

21

be between potential currency blocs and the United States. Initially,this analogy was used to justify Europe’s lunge toward monetary union.After all, the United States is a continent-sized monetary union thatworks pretty well, so why shouldn’t the same be true for the EC?Subsequent research has driven home just how different Europe is fromthe United States on at least two of the dimensions of the optimum-currency-area argument—labor mobility and fiscal integration—and thecomparison with the United States is now mostly used as a critique ofmonetary union.

The U.S.-Europe comparison is a useful intellectual strategy. It hasled to a lot of very interesting economic research and has clearly raisedthe tone of the discussion of international monetary reform. I haveused it as an effective debating tool myself. Yet it is clear if we arehonest with ourselves that it is a bit of an intellectual scam. We cancompare Europe (or the North American Free Trade Area, or anyother proposed currency bloc) with the United States. But we have noreason to suppose that the United States defines an optimum currencyarea. Conceivably, the United States would be better off with a half-dozen regional currencies. Equally conceivably, the hidden microeco-nomic benefits of a common currency are so overwhelming in theUnited States that Europe should follow suit even though the macro-economic costs would be much greater. We just don’t know. It is notthat there are conflicts among the estimates. There are simply noestimates at all. At this point, you may ask me how I propose to remedythis gap. The short answer is that I don’t know. All I can do is assertthat, if there is one crucial priority in international monetary economics,it is putting some analytical flesh on the microeconomic side of theoptimum-currency-area argument.

This lecture is entitled “What Do We Need to Know About the Inter-national Monetary System?.” Much of it, however, has dealt with thingsI would like to know. I would like to know how the macro model thatI more or less believe can be reconciled with the trade models that Ialso more or less believe. I would like to know how to build a bridgebetween an intertemporal story about savings and investment and thatmacroeconomic model. And I would very much like to be able to rebuilda macro structure that I can believe in the desolation that rationalexpectations left behind. For many purposes, however, including thegiving of policy advice, the existing macro model is good enough to servefor the time being. What we need to know is how to evaluate themicroeconomics of international monetary systems. Until we can do that,we are making policy advice by the seat of our pants.

22

References

Bruno, Michael, “Inflation and Growth in an Integrated Approach,” paperpresented at the Conference on The International Monetary System,honoring the fiftieth anniversary of Essays in International Finance, Prince-ton, N.J., April 15-16, 1993; forthcoming in Peter B. Kenen, ed., Under-standing Interdependence: The Macroeconomics of the Open Economy,Princeton, N.J., Princeton University Press, 1994.

Bryant, Ralph, “International Cooperation for National MacroeconomicPolicies: Where Do We Stand?,” paper presented at the Conference on TheInternational Monetary System, honoring the fiftieth anniversary of Essaysin International Finance, Princeton, N.J., April 15-16, 1993; forthcoming inPeter B. Kenen, ed., Understanding Interdependence: The Macroeconomicsof the Open Economy, Princeton, N.J., Princeton University Press, 1994.

Dooley, Michael, “A Retrospective on the Debt Crisis,” paper presented at theConference on The International Monetary System, honoring the fiftiethanniversary of Essays in International Finance, Princeton, N.J., April 15-16,1993; forthcoming in Peter B. Kenen, ed., Understanding Interdependence:The Macroeconomics of the Open Economy, Princeton, N.J., PrincetonUniversity Press, 1994.

Dornbusch, Rudiger, Fischer, Stanley, and Samuelson, Paul, “ComparativeAdvantage, Trade, and Payments in a Ricardian Model with a Continuum ofGoods,” The American Economic Review, 67 (December 1977), pp. 823-839.

Eichengreen, Barry, “The Endogeneity of Exchange-Rate Regimes,” paperpresented at the Conference on The International Monetary System,honoring the fiftieth anniversary of Essays in International Finance, Prince-ton, N.J., April 15-16, 1993; forthcoming in Peter B. Kenen, ed., Under-standing Interdependence: The Macroeconomics of the Open Economy,Princeton, N.J., Princeton University Press, 1994.

Goodhart, Charles, “The Political Economy of Monetary Union,” paperpresented at the Conference on The International Monetary System,honoring the fiftieth anniversary of Essays in International Finance; forth-coming in Peter B. Kenen, ed., Understanding Interdependence: TheMacroeconomics of the Open Economy, Princeton, N.J., Princeton UniversityPress, 1994.

Graham, Frank D., “Some Aspects of Protection Further Considered,” TheQuarterly Journal of Economics, 37 (February 1923), pp. 199-227.

———, Fundamentals of International Monetary Policy, Essays in InternationalFinance No. 2, Princeton, N.J., Princeton University, International FinanceSection, Autumn 1943.

Hansen, Lars Peter, and Hodrick, Robert, “Forward Exchange Rates asOptimal Predictors of Future Spot Rates: An Econometric Analysis,” TheJournal of Political Economy, 88 (October 1980), pp. 829-853.

23

Hooper, Peter, and Jaime Marquez, “Exchange Rates, Prices, and ExternalAdjustment,” paper presented at the Conference on The InternationalMonetary System, honoring the fiftieth anniversary of Essays in Internation-al Finance, Princeton, N.J., April 15-16, 1993; forthcoming in Peter B.Kenen, ed., Understanding Interdependence: The Macroeconomics of theOpen Economy, Princeton, N.J., Princeton University Press, 1994.

Johnson, Harry, “Towards a General Theory of the Balance of Payments,” inHarry Johnson, International Trade and Economic Growth, New York, Allenand Unwin, 1958.

Kenen, Peter B., “The Theory of Optimum Currency Areas: An EclecticView,” in Robert A. Mundell and Alexander K. Swoboda, eds., MonetaryProblems of the International Economy, Chicago, University of ChicagoPress, 1969, pp. 41-60; reprinted in Peter B. Kenen, Essays in InternationalEconomics, Princeton, N.J., Princeton University Press, 1980, pp. 163-182.

———, The International Economy, 2nd ed., Englewood Cliffs, N.J., Prentice-Hall, 1989; 3rd ed., Cambridge and New York, Cambridge University Press,forthcoming 1994.

Krugman, Paul, “The Narrow Moving Band, the Dutch Disease, and theCompetitive Consequences of Mrs. Thatcher: Notes on Trade in thePresence of Dynamic Scale Economies,” Journal of Development Econom-ics, 27 (October 1987), pp. 41-55.

———, Rethinking International Trade, Cambridge, Mass., MIT Press, 1990.———, The Age of Diminishing Expectations, Cambridge, Mass., MIT Press,

1990.———, Currencies and Crises, Cambridge, Mass., MIT Press, 1992.Krugman, Paul, and Maurice Obstfeld, International Economics: Theory and

Policy, 2nd ed., New York, Harper Collins, 1991.———, Has the Adjustment Process Worked?, Washington, D.C., Institute for

International Economics, 1991.Mankiw, N. Gregory, Macroeconomics, New York, Worth, 1992.Mankiw, N. Gregory, and David Romer, eds., New Keynesian Economics,

Cambridge, Mass., MIT Press, 1991.McKinnon, Ronald I., “Optimum Currency Areas,” The American Economic

Review, 53 (September 1963), pp. 717-724.Mundell, Robert A., “A Theory of Optimum Currency Areas,” The American

Economic Review, 51 (September 1961), pp. 657-664.Obstfeld, Maurice, “International Capital Mobility in the 1990s,” paper

presented at the Conference on The International Monetary System,honoring the fiftieth anniversary of Essays in International Finance; forth-coming in Peter B. Kenen, ed., Understanding Interdependence: TheMacroeconomics of the Open Economy, Princeton, N.J., Princeton UniversityPress, 1994.

Razin, Assaf, “The Dynamic-Optimizing Approach to the Current Account:Theory and Evidence,” paper presented at the Conference on The Interna-tional Monetary System, honoring the fiftieth anniversary of Essays in

24

International Finance, Princeton, N.J., April 15-16, 1993; forthcoming inPeter B. Kenen, ed., Understanding Interdependence: The Macroeconomicsof the Open Economy, Princeton, N.J., Princeton University Press, 1994.

Rodrik, Dani, “Trade Liberalization in Disinflation,” paper presented at theConference on The International Monetary System, honoring the fiftiethanniversary of Essays in International Finance, Princeton, N.J., April 15-16,1993; forthcoming in Peter B. Kenen, ed., Understanding Interdependence:The Macroeconomics of the Open Economy, Princeton, N.J., PrincetonUniversity Press, 1994.

Swan, Trevor, “Longer-Run Problems of the Balance of Payments,” in HeinzW. Arndt and W. Max Corden, eds., The Australian Economy: A Volume ofReadings, Melbourne, Cheshire Press, 1963.

Taylor, Mark, “Exchange-Rate Behavior Under Alternative Exchange-RateArrangements,” paper presented at the Conference on The InternationalMonetary System, honoring the fiftieth anniversary of Essays in InternationalFinance, Princeton, N.J., April 15-16, 1993; forthcoming in Peter B. Kenen,ed., Understanding Interdependence: The Macroeconomics of the OpenEconomy, Princeton, N.J., Princeton University Press, 1994.

Weinberg, Stephen, Dreams of a Final Theory, New York, Pantheon, 1992.

25

FRANK D. GRAHAM MEMORIAL LECTURERS

1950–1951 Milton Friedman1951–1952 James E. Meade1952–1953 Sir Dennis Robertson1953–1954 Paul A. Samuelson1955–1956 Gottfried Haberler1956–1957 Ragnar Nurkse1957–1958 Albert O. Hirschman1959–1960 Robert Triffin1960–1961 Jacob Viner1961–1962 Don Patinkin1962–1963 Friedrich A. Lutz (Essay 41)1963–1964 Tibor Scitovsky (Essay 49)1964–1965 Sir John Hicks1965–1966 Robert A. Mundell1966–1967 Jagdish N. Bhagwati (Special Paper 8)1967–1968 Arnold C. Harberger1968–1969 Harry G. Johnson1969–1970 Richard N. Cooper (Essay 86)1970–1971 W. Max Corden (Essay 93)1971–1972 Richard E. Caves (Special Paper 10)1972–1973 Paul A. Volcker1973–1974 J. Marcus Fleming (Essay 107)1974–1975 Anne O. Krueger (Study 40)1975–1976 Ronald W. Jones (Special Paper 12)1976–1977 Ronald I. McKinnon (Essay 125)1977–1978 Charles P. Kindleberger (Essay 129)1978–1979 Bertil Ohlin (Essay 134)1979–1980 Bela Balassa (Essay 141)1980–1981 Marina von Neumann Whitman (Essay 143)1981–1982 Robert E. Baldwin (Essay 150)1983–1984 Stephen Marris (Essay 155)1984–1985 Rudiger Dornbusch (Essay 165)1986–1987 Jacob A. Frenkel (Study 63)1987–1988 Ronald Findlay (Essay 177)1988–1989 Michael Bruno (Essay 183)1988–1989 Elhanan Helpman (Special Paper 16)1989–1990 Michael L. Mussa (Essay 179)1990-1991 Toyoo Gyohten1991-1992 Stanley Fischer1992-1993 Paul Krugman (Essay 190)

27

PUBLICATIONS OF THEINTERNATIONAL FINANCE SECTION

Notice to Contributors

The International Finance Section publishes papers in four series: ESSAYS IN INTER-NATIONAL FINANCE, PRINCETON STUDIES IN INTERNATIONAL FINANCE, and SPECIALPAPERS IN INTERNATIONAL ECONOMICS contain new work not published elsewhere.REPRINTS IN INTERNATIONAL FINANCE reproduce journal articles previously pub-lished by Princeton faculty members associated with the Section. The Sectionwelcomes the submission of manuscripts for publication under the followingguidelines:

ESSAYS are meant to disseminate new views about international financial mattersand should be accessible to well-informed nonspecialists as well as to professionaleconomists. Technical terms, tables, and charts should be used sparingly; mathemat-ics should be avoided.

STUDIES are devoted to new research on international finance, with preferencegiven to empirical work. They should be comparable in originality and technicalproficiency to papers published in leading economic journals. They should be ofmedium length, longer than a journal article but shorter than a book.

SPECIAL PAPERS are surveys of research on particular topics and should besuitable for use in undergraduate courses. They may be concerned with internationaltrade as well as international finance. They should also be of medium length.

Manuscripts should be submitted in triplicate, typed single sided and doublespaced throughout on 8½ by 11 white bond paper. Publication can be expedited ifmanuscripts are computer keyboarded in WordPerfect 5.1 or a compatible program.Additional instructions and a style guide are available from the Section.

How to Obtain Publications

The Section’s publications are distributed free of charge to college, university, andpublic libraries and to nongovernmental, nonprofit research institutions. Eligibleinstitutions may ask to be placed on the Section’s permanent mailing list.

Individuals and institutions not qualifying for free distribution may receive allpublications for the calendar year for a subscription fee of $35.00. Late subscriberswill receive all back issues for the year during which they subscribe. Subscribersshould notify the Section promptly of any change in address, giving the old addressas well as the new.

Publications may be ordered individually, with payment made in advance. ESSAYSand REPRINTS cost $8.00 each; STUDIES and SPECIAL PAPERS cost $11.00. Anadditional $1.25 should be sent for postage and handling within the United States,Canada, and Mexico; $1.50 should be added for surface delivery outside the region.

All payments must be made in U.S. dollars. Subscription fees and charges forsingle issues will be waived for organizations and individuals in countries whereforeign-exchange regulations prohibit dollar payments.

Please address all correspondence, submissions, and orders to:

International Finance SectionDepartment of Economics, Fisher HallPrinceton UniversityPrinceton, New Jersey 08544-1021

29

List of Recent Publications

A complete list of publications may be obtained from the International FinanceSection.

ESSAYS IN INTERNATIONAL FINANCE

157. Wilfred J. Ethier and Richard C. Marston, eds., with Charles P. Kindleberger,Jack Guttentag, Richard Herring, Henry C. Wallich, Dale W. Henderson, andRandall Hinshaw, International Financial Markets and Capital Movements: ASymposium in Honor of Arthur I. Bloomfield. (September 1985)

158. Charles E. Dumas, The Effects of Government Deficits: A ComparativeAnalysis of Crowding Out. (October 1985)

159. Jeffrey A. Frankel, Six Possible Meanings of “Overvaluation”: The 1981-85Dollar. (December 1985)

160. Stanley W. Black, Learning from Adversity: Policy Responses to Two OilShocks. (December 1985)

161. Alexis Rieffel, The Role of the Paris Club in Managing Debt Problems.(December 1985)

162. Stephen E. Haynes, Michael M. Hutchison, and Raymond F. Mikesell,Japanese Financial Policies and the U.S. Trade Deficit. (April 1986)

163. Arminio Fraga, German Reparations and Brazilian Debt: A ComparativeStudy. (July 1986)

164. Jack M. Guttentag and Richard J. Herring, Disaster Myopia in InternationalBanking. (September 1986)

165. Rudiger Dornbusch, Inflation, Exchange Rates, and Stabilization. (October1986)

166. John Spraos, IMF Conditionality: Ineffectual, Inefficient, Mistargeted. (De-cember 1986)

167. Rainer Stefano Masera, An Increasing Role for the ECU: A Character inSearch of a Script. (June 1987)

168. Paul Mosley, Conditionality as Bargaining Process: Structural-AdjustmentLending, 1980-86. (October 1987)

169. Paul A. Volcker, Ralph C. Bryant, Leonhard Gleske, Gottfried Haberler,Alexandre Lamfalussy, Shijuro Ogata, Jesús Silva-Herzog, Ross M. Starr,James Tobin, and Robert Triffin, International Monetary Cooperation: Essaysin Honor of Henry C. Wallich. (December 1987)

170. Shafiqul Islam, The Dollar and the Policy-Performance-Confidence Mix. (July1988)

171. James M. Boughton, The Monetary Approach to Exchange Rates: What NowRemains? (October 1988)

172. Jack M. Guttentag and Richard M. Herring, Accounting for Losses OnSovereign Debt: Implications for New Lending. (May 1989)

173. Benjamin J. Cohen, Developing-Country Debt: A Middle Way. (May 1989)174. Jeffrey D. Sachs, New Approaches to the Latin American Debt Crisis. (July 1989)175. C. David Finch, The IMF: The Record and the Prospect. (September 1989)176. Graham Bird, Loan-loss Provisions and Third-World Debt. (November 1989)

30

177. Ronald Findlay, The “Triangular Trade” and the Atlantic Economy of theEighteenth Century: A Simple General-Equilibrium Model. (March 1990)

178. Alberto Giovannini, The Transition to European Monetary Union. (November1990)

179. Michael L. Mussa, Exchange Rates in Theory and in Reality. (December 1990)180. Warren L. Coats, Jr., Reinhard W. Furstenberg, and Peter Isard, The SDR

System and the Issue of Resource Transfers. (December 1990)181. George S. Tavlas, On the International Use of Currencies: The Case of the

Deutsche Mark. (March 1991)182. Tommaso Padoa-Schioppa, ed., with Michael Emerson, Kumiharu Shigehara,

and Richard Portes, Europe After 1992: Three Essays. (May 1991)183. Michael Bruno, High Inflation and the Nominal Anchors of an Open Economy.

(June 1991)184. Jacques J. Polak, The Changing Nature of IMF Conditionality. (September 1991)185. Ethan B. Kapstein, Supervising International Banks: Origins and Implications

of the Basle Accord. (December 1991)186. Alessandro Giustiniani, Francesco Papadia, and Daniela Porciani, Growth and

Catch-Up in Central and Eastern Europe: Macroeconomic Effects on WesternCountries. (April 1992)

187. Michele Fratianni, Jürgen von Hagen, and Christopher Waller, The MaastrichtWay to EMU. (June 1992)

188. Pierre-Richard Agénor, Parallel Currency Markets in Developing Countries:Theory, Evidence, and Policy Implications. (November 1992)

189. Beatriz Armendariz de Aghion and John Williamson, The G-7’s Joint-and-SeveralBlunder. (April 1993)

190. Paul Krugman, What Do We Need to Know About the International MonetarySystem?. (July 1993)

PRINCETON STUDIES IN INTERNATIONAL FINANCE

55. Marsha R. Shelburn, Rules for Regulating Intervention Under a Managed Float.(December 1984)

56. Paul De Grauwe, Marc Janssens and Hilde Leliaert, Real-Exchange-RateVariability from 1920 to 1926 and 1973 to 1982. (September 1985)

57. Stephen S. Golub, The Current-Account Balance and the Dollar: 1977-78 and1983-84. (October 1986)

58. John T. Cuddington, Capital Flight: Estimates, Issues, and Explanations. (De-cember 1986)

59. Vincent P. Crawford, International Lending, Long-Term Credit Relationships,and Dynamic Contract Theory. (March 1987)

60. Thorvaldur Gylfason, Credit Policy and Economic Activity in DevelopingCountries with IMF Stabilization Programs. (August 1987)

61. Stephen A. Schuker, American “Reparations” to Germany, 1919-33: Implicationsfor the Third-World Debt Crisis. (July 1988)

62. Steven B. Kamin, Devaluation, External Balance, and Macroeconomic Perfor-mance: A Look at the Numbers. (August 1988)

31

63. Jacob A. Frenkel and Assaf Razin, Spending, Taxes, and Deficits: International-Intertemporal Approach. (December 1988)

64. Jeffrey A. Frankel, Obstacles to International Macroeconomic Policy Coordina-tion. (December 1988)

65. Peter Hooper and Catherine L. Mann, The Emergence and Persistence of theU.S. External Imbalance, 1980-87. (October 1989)

66. Helmut Reisen, Public Debt, External Competitiveness, and Fiscal Disciplinein Developing Countries. (November 1989)

67. Victor Argy, Warwick McKibbin, and Eric Siegloff, Exchange-Rate Regimes fora Small Economy in a Multi-Country World. (December 1989)

68. Mark Gersovitz and Christina H. Paxson, The Economies of Africa and the Pricesof Their Exports. (October 1990)

69. Felipe Larraín and Andrés Velasco, Can Swaps Solve the Debt Crisis? Lessonsfrom the Chilean Experience. (November 1990)

70. Kaushik Basu, The International Debt Problem, Credit Rationing and LoanPushing: Theory and Experience. (October 1991)

71. Daniel Gros and Alfred Steinherr, Economic Reform in the Soviet Union: Pasde Deux between Disintegration and Macroeconomic Destabilization. (November1991)

72. George M. von Furstenberg and Joseph P. Daniels, Economic Summit Decla-rations, 1975-1989: Examining the Written Record of International Coopera-tion. (February 1992)

73. Ishac Diwan and Dani Rodrik, External Debt, Adjustment, and Burden Sharing:A Unified Framework. (November 1992)

74. Barry Eichengreen, Should the Maastricht Treaty Be Saved?. (December 1992)

SPECIAL PAPERS IN INTERNATIONAL ECONOMICS

15. Gene M. Grossman and J. David Richardson, Strategic Trade Policy: A Surveyof Issues and Early Analysis. (April 1985)

16. Elhanan Helpman, Monopolistic Competition in Trade Theory. (June 1990)17. Richard Pomfret, International Trade Policy with Imperfect Competition. (August

1992)18. Hali J. Edison, The Effectiveness of Central-Bank Intervention: A Survey of the

Literature After 1982. (July 1993)

REPRINTS IN INTERNATIONAL FINANCE

25. Jorge Braga de Macedo, Trade and Financial Interdependence under FlexibleExchange Rates: The Pacific Area; reprinted from Pacific Growth and FinancialInterdependence, 1986. (June 1986)

26. Peter B. Kenen, The Use of IMF Credit; reprinted from Pulling Together: TheInternational Monetary Fund in a Multipolar World, 1989. (December 1989)

27. Peter B. Kenen, Transitional Arrangements for Trade and Payments Among theCMEA Countries; reprinted from International Monetary Fund Staff Papers 38(2), 1991. (July 1991)

32

The work of the International Finance Section is supportedin part by the income of the Walker Foundation, establishedin memory of James Theodore Walker, Class of 1927. Theoffices of the Section, in Fisher Hall, were provided by agenerous grant from Merrill Lynch & Company.

ISBN 0-88165-097-8Recycled Paper