Exchange-Rate Determination
In February 1985, one U.S. dollar traded on international markets for 260 Japanese yen;
in January 1988, a dollar was worth only 123 yen. This change had effects that reached far
beyond financial markets. In February 1985, the average Japanese worker in manufacturing was
paid a wage in yen that, converted into dollars at the prevailing rate of exchange, was only about
half that of his U.S. counterpart. Three years later Japanese wages were about the same as U.S.
wages. With their labor cost advantage vis-a-vis the United States gone, and in the face of
competition from low-wage competitors like Korea and Taiwan, Japanese manufacturers were
initially forced into layoffs that drove the Japanese unemployment rate to its highest level since
the 1950s, after which they began investing heavily in acquiring production facilities in other
countriesespecially in the U.S.
One of the key differences between international economics and other areas of
economics is that countries have different currencies. It is usually possible to convert one
currency into another (though even this is illegal in some countries), but as the example of the
dollar-yen exchange rate indicates, relative prices of currencies may change over time,
sometimes drastically.
4
The study of exchange-rate determination is a relatively new part of international
economics, for historical reasons. For most of the past century, exchange rates have been fixed
by government action rather than determined in the marketplace. Before World War I the values
of the world's major currencies were fixed in terms of gold, while for a generation after World
War II the values of most currencies were fixed in terms of the U. S. dollar. The analysis of
international monetary systems that fix exchange rates remains an important subject, especially
since a return to fixed rates in the fu ture
Remains a real possibility. Chapters 17 and 18 are devoted to the working of fixedrate
systems, and Chapter 19 to the debate over which system is better. For the time being, however,
some of the world's most important exchange rates fluctuate minute by minute and the role of
changing exchange rates remains at the center of the international economics story. Chapters 13
through 16 focus on the modem theory of floating exchange rates.