No. 119 - Cooperation in managing the dollar (1985-87): interventions in foreign exchange markets and interest rates

In this paper we study the experience of cooperation between the United States, Japan and Germany in managing the dollar in 1985-87. The basic facts, with emphasis on the role played by the different policy tools (interventions in foreign exchange markets, monetary and fiscal policies) are reviewed in Section 2. In Section 3 we discuss the channels of monetary-financial interaction between countries participating in a managed exchange rate system, based on the model presented in the Appendix. In particular, we show that interest rate differentials (short and long-term) across countries and their maturity structure within countries may depend (together with many other factors) on intervention policies in foreign exchange markets (that is, on the degree to which market trends are "resisted") and the degree of sterilization of interventions. This result could be relevant for establishing a connection between exchange rate management under the Louvre accord and the steep rise in long-term interest rates in the US that "detonated" the October 1987 stock-market crash. We then present empirical evidence on intervention policies (Section 4), monetary policies and sterilization (Section 5), interest rates (Section 6) in the period under review; the critical relationships identified by the model are examined in some detail, with various quantitative techniques, to see whether actual developments lend any support to the propositions derived from the model. Our conclusions are summarized in Section 7.