Definition of The Era of the Managed Float

The Era of the Managed Float

By March 1985 the dollar had hit its peak. The US current account deficit was at the unheard of level of over USD 100 billion a year. Most economists agreed that the dollar was far above its long-term PPP equilibrium level. The arguments of why this was so ranged from the Dornbusch sticky hypothesis to fiscal irresponsibility to the reassuring argument that the high exchange rate was a sign of confidence in the US economy. Whatever the reason, it was decided that the dollar had to come down in order to defuse protectionist sentiment in the US Congress that was that was mounting with the mounting trade deficit.

Intervention in the foreign exchange markets was the method to be used to achieve this goal. In September 1985 the Group of Five- the United States, France, Japan, Great Britain and West Germany- came up with the Plaza Agreement, named after the Hotel in New York where they met. This was essentially a coordinated program to force down the value of the dollar against the other major currencies.

The policy worked like a charm. In fact, it worked too well. The dollar fell like a stone, losing close to 11 percent of its SDR value in 1985. The Group of Five reversed field and began to support the dollar in 1986, to no avail. The dollar lost another 10 percent in 1986.

The Group of Five plus Canada and Italy, now called the Group of Seven (G-7) countries to slow the dollar’s fall by coordinating their economic policies and supporting the dollar on the exchange markets within some undisclosed target range.

This seemed to work for a while. The United States promised to cut the budget deficit and reduce the rate of growth of the money supply while Japan and Germany promised to stimulate their economies.

Although the US did manage to reduce the rate of growth of the money supply, the budget cuts were not forthcoming, and neither did Germany and Japan come through with their promised stimulatory measures. When worldwide stock markets crashed in October 1987 all pretense of policy coordination collapsed. The flooded the markets with dollars and the dollar fell nearly 10 percent against the SDR in the last quarter of 1987.