Real gross domestic
income grew at an annual rate of 4.2% per annum in the USA between 1949
and 1973. From when the US exchange rate was floated in March 1973, the
rate of economic growth has declined to average 2.7% up until 2011.
In Australia, real gross domestic
income was growing at an annual rate of 5.2% per annum between
1960 and 1973. That was under the fixed exchange rate
system. Between 1973
and 1983, after the USA had floated its currency but before Australia
had floated, the average real rate of economic growth in Australia declined to 2.0%.
Since 1983, when Australia floated its exchange rate, real gross domestic income has grown at
an average rate of 3.8% per annum (to 2009). Rather than raising
the rate of economic growth, floating the exchange rate has slowed
the rate of economic growth by 34% in the USA and 27% in Australia.
Floating the dollar has had an effect on
wages growth. In the USA, average weekly earnings for the
private non-farm sector was rising at 1.2% per annum in real terms,
from 1964 to 1972, immediately before the US dollar was floated. In the next 20 years they declined at
an average rate of 1.2% per annum. Then, between 1992 and 2004, they have been rising
slowly at an average rate of 0.6% per
annum in real terms: half the rate of the first period. Even
real wages for private non-farm workers in the USA in 2010 are
still 16% below the levels they were in 1972 as shown in Figure 1.
If average real wages in the US had maintained
their pre-float growth rate, they would be 70% higher
than they are today.
Figure 1. USA: Average
Weekly Wages at constant 1992 prices for all private non-farm workers
Source: US Bureau
of Labour Statistics
In Australia, average
real wages were rising up until June 1984. The real rate of
wages growth had been around 4% between 1969 to 1975. Then it slowed to
0.6% until 1983 when Australia floated its dollar. It jumped
more than 8% in the year to June 1984 following the float,
when the value of the Australian dollar declined rapidly.
In the six years from June 1984 to
June 1990, average real wages declined at an average rate of
more than 1.6% per annum. Since then, average real wages have been rising
at about 1.4% per annum. Despite this improvement,
the rate of real wages growth is less than half the rate it was
in the 1960ís and 70ís. Average real wages did not
return to their June 1984 levels again until June 2003. That
is, Australia experienced nineteen years without any growth in
average real wages above 1984 levels. Average real weekly wages for Australian
workers are shown in the Figure 2. As minimum wages are
regulated in Australia, Australian workers did not experience
the same dramatic reduction in wages as in the USA.
Figure 2. Australia:
Average Real Weekly Wages (Discounted by CPI base 1989/90)
Floating the dollar
also affected unemployment. In the USA, the rate of unemployment has
increased significantly since 1973 when the US dollar was floated,
as shown below in Figure 3.
USA: Unemployment Rate
In Australia, unemployment was
below 2%, generally, in the 1950ís and 60ís. From 1973, when the US
dollar was floated, unemployment rose rapidly until 1983, when the
Australian dollar was floated. Since then, unemployment has been
relatively high, rising and falling with the economic cycles as
shown below in Figure 4. Unemployment fell to below 4% in Australia in 2008
before rising again in 2009. In addition to the unemployed,
Australia has experienced a large increase in the number of people of working
age receiving government pensions. The number of working age people on
pensions far exceeds the official level of unemployment.
Therefore, the effective rate of unemployment is likely to be significantly
higher than revealed in the official statistics.
4. Australia Unemployment Rate
R.G. Gregory ďA Longer Run Perspective on Australian Unemployment" &
Australian Bureau of Statistics
1973, when the US dollar was floated, the Australian dollar was
tied to the US dollar. From September 1974, the Australian dollar was
tied to a basket of currencies until it was floated in December 1983. These
links to other floated currencies help explain why Australia was affected
by the floating exchange rate system, even before it had adopted
equilibrium under fixed exchange rates
main reason for the decline in wages growth and the rise in the level of
unemployment is due to the way the fixed and the floating exchange rate systems attain
equilibrium between foreign receipts and foreign payments.
The following charts explain the issue. The output, income, imports and exports of an economy are represented on the horizontal axis.† The real exchange rate (on the vertical axis) is fixed at e1.† In Figure 5, the economy is initially at equilibrium with exports (the supply of which is represented by the X1-X1 line) equal to imports (the demand for which is represented by the M1-M1 line) at the point A1.† The total national income or output of the economy is at the point Z1.† The economy earns income from two sources:
exports equal to 0-A1; and
domestic sales of A1-Z1.
It spends 0-A1 on imports and A1-Z1 on
domestic products (which generates the domestic sales).
Figure 5. The
initial equilibrium position (fixed exchange rate)
Figure 6, we assume that there is a permanent increase in the supply
of exports from the X1-X1 line to the X2-X2
line. As the exchange rate is fixed, exporters will supply
exports of 0-A2. The income from exports will be equal to
0-A2 while the income from domestic sales will initially
be at A1-Z1. Adding the income from exports
to the income from domestic sales raises total income to 0-Z2
There is now disequilibrium in the economy with the foreign
revenue from exports exceeding foreign payments on imports.
Also, national income, or output, exceeds national
Disequilibrium- an increase in exports (fixed
The increased national income enables the economy to increase its
spending. This expenditure is directed at both
domestic products and imports. The proportion of
spending spending on domestic products and imports will
tend to be fixed because the relative prices of imports are fixed (because the
exchange rate is fixed). The proportion of additional
income spent on imports is called the 'marginal
propensity to import'. The expenditure on domestic products raises
of those that produced and sold the products.
Therefore, it further raises national income. The expenditure on imports does not raise national
income. National income will continue to rise
while the income form exports is greater than spending
on imports. When export income is equal to import
payments, the economy will
stop growing and return to equilibrium.
This growth in income from export sales is known as the multiplier
effect. The value of the export multiplier is equal to the inverse of the marginal
propensity to import. Thus if a country spends 10% of its
additional income on
imports, a $1 billion increase in exports would increase national
income by $10 billion. That is, when the national income has increased
by $10 billion, the economy would be spending 10% of
that, $1 billion, on additional imports. At that
additional spending on imports would be equal to the additional income from
exports and the economy would be at equilibrium again.
This new equilibrium position is shown in Figure
7. National income
has increased to 0-Z3 with exports equal to 0-A2
and the income from domestic sales equal to A2-Z3.
With the higher level of income, expenditure on, or demand for,
imports would have shifted to line M2-M2 with
spending on imports increasing to 0-A2. The
mechanism for achieving equilibrium in an
environment of fixed exchange rates is to raise or lower demand for
imports by raising (or lowering) aggregate
demand (and thereby national income).
Figure 7. New equilibrium-
imports rise to equal exports (fixed exchange rates)
It was in such an environment of fixed exchange rates that
growth in export income was able to stimulate the economies
countries such as Australia and the US so that they experienced
wages growth and high level of employment. This was possible
union pressure to raise wages. Demand for labour was
high and there was full employment.
equilibrium under floating exchange rates
The effect of floating the dollar
is described below. Figure 8
presents a similar equilibrium position to that considered in Figure 4.
Exports and imports are equal at 0-A1 with income from
and spending on domestic products equal to A1-Z1.
The exchange rate is floating and is assumed to be initially at e1.
Figure 8. Initial equilibrium with floating exchange rates
in Figure 6 for fixed exchange rate system above, in Figure 9
we now assume that there is a permanent increase in the supply of
exports from the X1-X1 line to the X2-X2
line. As the exchange rate is now variable and set
in the market to ensure that international payments and
receipts are equal (at equilibrium), the exchange rate rises from e1
to e2. At the new exchange rate,
spending on imports rise from 0-A1 to 0-A2 to equal exports. Imports
increase because the higher exchange rate makes them
cheaper. In the same way as for the example with fixed exchange rates, the income from
exports has increased form 0-A1 to 0-A2. However, the higher exchange rate has made domestic products
relatively more expensive and so spending on domestic products
declines from A1-Z1 to A2-Z1 following
the increase in spending on imports rising from
Therefore, despite the increase in exports, national income and
aggregate demand has remained constant at Z1.
Export growth no longer stimulates the whole economy.
Figure 9. New
equilibrium with increased exports (floating exchange rates)
Under floating exchange rates, the foreign exchange market changes
the relative price of imports and domestic products to shift demand
between domestic products and imports. International
transactions no longer raise national income in the domestic economy.
is no need for national income and aggregate demand to
change because the exchange rate moves (or floats) to continuously
The change from fixed to floating
exchange rates changed the means by which the economy achieve equilibrium.
the rate of economic growth, increased unemployment and stopped
wages growth in countries such as the US and Australia that shifted
from fixed to floating exchange rates. Under the
fixed exchange rate system, they had
enjoyed high rates of economic growth, high levels of
employment and wages growth, all generated by
increased exports. Floating the exchange rate removed the
forces of disequilibrium that had previously generated
growth and prosperity.
the environment of floating exchange rates, the growth in exports
increases imports and reduces local spending on domestic
products. In such an environment, export and import
industries grow more rapidly, relative to import competing industries that
supply the domestic market. This growth in the relative size of
exports and imports compared to the remainder of the economy has
become known as globalization. In
Australia, imports and exports increased from between 12% and 14% of
national income to more than 20%. The Australian Government
recognizes that the high exchange rate is a problem for domestic industries. In the
Treasurer's 2011 budget speech he states that "the
dollar is around post‑float highs and this makes it
difficult for some sectors, particularly those that
compete in international markets."
10. Australia: Exports and imports as a share of GDP
In the USA, exports and imports
increased from between 4% and 5% of GDP to between 12% and 18% of
GDP as shown in Figure 11.
Figure 11. USA: Exports
and imports as a share of GDP
This rise in the significance of imports and exports is represented
in Figure 9 as the shift in exports and imports from 0-A1
(4%-5%) to 0-A2 (12%-18%).
While floating the dollar has increased trade as a share of GDP,
trade would have been significantly higher if there had been fixed
exchange rates. Figure 12 is uses to compare the effect of an increase in
exports under the fixed exchange rate system and the floating
exchange rate system.
Equilibrium with increased exports (comparing floating
and fixed exchange rates)
Under the floating exchange rate system, an increase in the supply
of exports from X1-X1 to X2-X2
would have prompted an increase in the exchange rate from e1
to e2 and an increase in exports and imports from A1
to A2. National income would have remained constant at Z1.
Under the fixed exchange rate system, an increase in the supply of
exports from X1-X1 to X2-X2
would have prompted an increase in exports from A1 to A3
and national income from Z1 to Z2. The
amount of international trade associated with the floating exchange
rate and globalisation is at A2
and is actually lower than the outcome with fixed exchange rates
which would have reached equilibrium at A3. This
lower level of trade was particularly hard felt in the ship-building
industries in the mid to late 1970ís when countries such as the USA,
UK and Germany floated their currencies. For
example, evidence for this reduction in trade is evident in events such
as the UK
Shipbuilding (Redundancy Payments) Bill 1978.
initial reduction in the growth of economic demand associated with
the change from fixed to floating exchange rate was called the World
Oil Crisis. This "spin", shifting the blame to OPEC, was accepted because the recession coincided
with the OPEC decision to raise prices. However, while oil prices were
high, they were not responsible for the recession. The
recession had started before OPEC raised oil prices.
Also, world trade
did not recover when oil prices fell. Oil prices have
fallen, risen and fallen again without the same
significant changes in the world economy.
US was able to eventually move out of recession by deregulating the growth
of bank credit. However, bank credit has not been as effective at
stimulating the economy as money from the growth of foreign
reserves. Also, it has been more inflationary
caused current account
deficits which have
generally added to foreign debt. So far this
century, the USA current account deficit has averaged
$1.6 billion per day.
Since 1973, US exports have tripled relative to GDP. If US exports
had tripled under a fixed exchange rate system US national income
would have tripled, also. The floating exchange rate system has
quarantined the US economy from receiving the benefits of trade growth
and free trade. In
addition, it has contributed to the rising level of
Australian exports have nearly doubled since 1983
despite the floating exchange rate system. If Australia had
continued with fixed exchange rates, its national income would
have been substantially higher, also. Floating the exchange rate has
slowed economic growth, reduced real wages and raised foreign debt.
The floating exchange rate system
has reduced world trade. Consequently, the whole world has been
made poorer by it. Although China has continued to hold to its fixed
exchange rate system, trade
with China could have been greater if its trading
partners had not adopted the floating exchange rate system.
The fixed exchange rate system
generated economic growth, despite the inefficient
labour market, without a major education campaign and
without micro-economic reform. The floating exchange
rate system has not been able to generate significant economic
growth despite improvements in labour market efficiency,
extensive investment in education, micro-economic
reform and free trade agreements.
The reason for this is that these
policies are attempts to
shift the economy away from the stable equilibrium
position. Efforts to improve productivity and make
domestic products more competitive on both domestic and
international market are attempts to move from
equilibrium and force
imports to fall and exports to rise. The floating
exchange rate responds to such attempts to change relative
prices by raising the exchange rate to make imports
cheaper again. Therefore, no matter how a country
tries to make its products more attractive, the exchange
rate system will respond to restore the relative prices
that bring equilibrium to the economy.
We do not need to return to fixed
exchange rates to stimulate our economies. Market
determined exchange rates can allow export to grow and raise
aggregate demand to provide full employment. Trade
driven economic growth can be achieved with
external stability using a variable exchange rate system such
as the guided
exchange rate and liquidity system or the optimum exchange rate system. The
principle behind the optimum exchange rate system is to provide incentives to the market to set
the exchange rate at a level that would achieve full
employment without excessive inflation. The
economy is allowed to export more than it imports and
thereby raise aggregate demand to a level that provides
full employment. A model
comparing the operation of the floating and optimum exchange rates
systems is available here.
The principle of the optimum exchange rate system is
explained in Figure 13 below. Assume that a country has
income of Z1 with exports and imports equal
to 0 - A1 and exchange rate
e1. Full employment would
be achieved if income were at
Z2. Under the optimum exchange rate
system, incentives are given to
the financial system so that it maximise profits
when there is full employment. Those incentives would
encourage the financial market to drive the exchange
e2. Exports would now exceed imports
and so national income would rise. Exports would stop rising when
imports have shifted the imports schedule from
M1-M1 to M2-M2
so that imports equal exports at A2 and
national income has increased to Z2 with
sufficient income to raise demand to the level
that provides full
Achieving full employment with the Optimum Exchange Rate System
In this example, the export
schedule stayed constant. It was the lower
exchange rate that raised the proceeds of existing exports
and stimulated additional exports so that
incomes rose to
It is the rise in income raises the demand for imports,
shown as the shift in the import schedule. It is
movement along the export schedule that causes national income rises to attain full employment.
There is another model of the optimum exchange rate
system in Figure 14 of the
formula for the current account balance page.
The optimum exchange rate system would
raise incomes and allows policies designed to improve
social welfare and the environment to be undertaken
without causing harm to the economy or to employment
Figure 14 below shows exports and imports
in the Philippines as a share of gross national product.
The Central Bank of the Philippines has modified its
exchange rate system to maintain its international
competitiveness. it has reduced the share of
GNP that was spent on imports by nearly half, from 59 per
cent in 1997 to 32 per cent in 2013. However, as in Figure 13, the
economy has grown so much as a consequence of the rise
in income that the real
amount of imports have increased 61 per cent over that
period, despite the reduced share of income spent on
Philippines- exports and imports as a share of GNP
(World Bank data)
While the approach in the Philippines is an ad-hoc
approach it shows that the exchange rate system can be be used
to increase national income and employment.
"I am the most unhappy man. I
have unwittingly ruined my country. A great industrial
nation is now controlled by its system of credit.
We are no longer a government by free opinion, no longer a
government by conviction and the vote of the majority, but a
government by the opinion and duress of a small group of