Why Are G-3 Exchange Rates So Fickle?

• Author: Kenneth S. Rogoff
• Position: IMF Economic Counsellor and Director of the IMF's Research Department

The mystery of the volatility of the world's three key currencies continues, despite leading economist Rudiger Dornbusch's path-breaking insights.

Last November, at the IMF's Second Annual Research Conference, it was my good fortune to be able to pay tribute to the twenty-fifth anniversary of Rudiger Dornbusch's famed "overshooting" model of exchange rates. Dornbusch's 1976 paper became an instant classic because it seemed to make sense of the chaotic new world of flexible exchange rates, which had only just replaced the serene "Bretton Woods" system of fixed rates.

In Dornbusch's view, excessive exchange rate volatility was the inevitable result of the chaotic monetary policies that had led to the breakup of fixed rates in the first place. If domestic monetary policies are unpredictable, then so, too, will be domestic inflation differentials. Ergo, the exchange rate must be volatile because, in the very long run, there has to be a tight link between national inflation differentials and exchange rates. (At least, this is what we have all believed since Swedish economist Gustav Cassel championed his theory of "purchasing power parity"-that exchange rates adjust to reflect differences in consumer price levels-as the way to reset world exchange rates after the system broke down during World War I.)

If Dornbusch had merely pointed out that monetary policy had lost its way in the 1970s, he would have been regarded as sensible but not necessarily brilliant. The stroke of genius in his paper was "overshooting." According to Dornbusch's now famous logic, monetary policy volatility is not only reflected in exchange rate volatility but is also amplified. The core idea is that the sluggishness of domestic prices and wages forces the exchange rate to be the shock absorber for monetary policy. Dornbusch's theory, which he spiced up by incorporating the exciting new theory of "rational expectations"-when private agents form exchange rate expectations based on reasoned and intelligent examination of available economic data-suggested that modest improvements in monetary stability would be rewarded with large gains in exchange rate stability.

The new world of flexible exchange rates was too young in 1976 to provide enough data to meaningfully test what is now often labeled the Mundell-Fleming-Dornbusch model. Nobody really cared. It was a beautiful theory, and Dornbusch's new view of flexible exchange rates reinvigorated the field...