Before the Smithsonian Agreement in 1971, which ended the fixed exchange rate system of the Bretton Woods era, currency values were maintained by government economic policies that often included substantial controls on capital and trade. But when the breakup of Bretton Woods did finally occur international economists were not dismayed. Not only did they believe that greater flexibility of exchange rates was a good thing, they also believed that they understood reasonably well how the new system worked (Krugman, 1979).
But over the past twenty-five years the international monetary system has been subjected to one surprise after another, including greater and greater volatility in exchange rates and the potential for dramatic political and social consequences. The analysis which follows will first look generally at the role of speculative capital in the new international environment of floating or partially floating exchange rates. The discussion will then focus on a specific example of exchange rate volatility and its consequences, the 1994 devaluation of the Mexican peso. The analysis will conclude with some comments on exchange rates, current account deficits and the validity of macroeconomic measuremnts.
Fluctuating Exchange Rates: Their Importance and Brief History
With the growing international mobility of capital after 1970 it became increasingly clear that there were substantial stocks of capital that were prepared to move en masse from one currency to another. Countries that tried to fix their exchange rates could find their reserves quickly exhausted by massive speculative attacks and countries with floating exchange rates found that those rates fluctuated with the expectations of the speculators. In the early 1980s there was large capital flight from Argentina, Venezuela, and Mexico on the eve of its 1982 debt crisis. More recently, in September of 1992 the British pound was forced into a sudden devaluation...