In a new paper, Sebastian Edwards details the numerous and varied contributions of University of Chicago faculty to exchange rates and monetary policy from 1892 to 1992.

Many people associate the University of Chicago’s views on international financial issues with Milton Friedman’s advocacy for floating exchange rates. Friedman’s 1953 essay “The case for flexible exchange rates” is, in fact, one of his most highly cited works. As soon as the paper was published, it became an important reference for those who favored market-based solutions to external imbalances and were critical of the Bretton Woods system of pegged exchange rates created at the end of World War II. However, Chicago’s contributions to the exchange rate and external adjustment literatures go well beyond Friedman. Indeed, since the University’s founding in 1892, many faculty members published important works on exchange rates, the balance of payments, gold, silver, and the adjustment process in open economies. Some of the most prominent Chicago names associated with exchange rates and balance of payments research include J. Laurence Laughlin, Jacob Viner, Lloyd Mints, Henry Simons, Lloyd Metzler, Robert Mundell, Harry G. Johnson, Arnold Harberger, Jacob Frenkel, Rudi Dornbusch, and Michael Mussa. Some of these scholars stayed in Chicago until retirement, while others departed for other schools or institutions where they had very productive careers.

In my new paper “One Hundred Years of Exchange Rates at the University of Chicago, 1892-1992,” I analyze how the work of several of the University’s faculty members influenced the policy debate during most of the twentieth century. Research by Chicago scholars was fundamental in shaping the international financial architecture as we know it today, including the evolving role of multilateral institutions such as the International Monetary Fund, the World Bank, and the World Trade Organization. This article highlights some of these scholars’ most important contributions.

Gold, silver, and bimetallism

In many of their works, Laughlin (who was the Department of Economics’ first chairman), Viner, Friedman, and Mundell discussed the merits and dangers of bimetallism, a monetary system where two standards—gold and silver—circulated side by side. With brief breaks, the United States observed the gold standard until 1971. Proponents argued that a bimetallic system was more flexible than monometallism and provided greater liquidity to help finance productive investments. Detractors believed that the ever-changing relative price of gold and silver—the two metals used as “money”—generated uncertainty and instability.

Laughlin rejected bimetallism with force, as did Viner and Friedman during the latter’s early years. All of them noted that sometimes gold was preferred to silver, while at other times the opposite was the case. This, in their view, created instability in financial markets and hindered commerce. Mundell was more tolerant and believed that a bimetal monetary regime was not necessarily unstable, and argued that movements in the relative price of gold and silver were usually gradual. With time, however, Friedman changed his view on the superiority of the gold standard. In 1990, and after reviewing numerous historical experiences and crisis episodes, he wrote: “Far from being a thoroughly discredited fallacy, bimetallism has much to recommend it on theoretical, practical, and historical grounds as superior to monometallism…” This discussion is current today, when many countries are considering allowing cryptocurrencies or a foreign currency (the U.S. dollar, in most cases) to circulate side by side with national monies.

In the early 1930s, Chicago economists were very active in the debates that preceded the United States’ temporary abandonment of the gold standard in 1933. In January 1932, 12 members of the faculty wrote a letter to President Herbert Hoover suggesting the adoption of a countercyclical monetary policy to bring the country out of the Great Depression. This would require increasing the money supply, which could be done by allowing the Federal Reserve to accept a greater variety of securities as collateral to provide credit. A few months later they wrote again, this time urging the president to devalue the dollar as a way to stimulate hiring and growth.

The US finally devalued the dollar relative to gold in January of 1934, during the first year of President Franklin D. Roosevelt’s administration. The official price of gold was raised from $20.67 an ounce to $35 an ounce. The new price was in effect until August 1971, when President Nixon closed the “gold window.” By 1934 Viner had become a trusted adviser of Secretary of the Treasury Henry Morgenthau. In this capacity, Viner helped create the Exchange Stabilization Fund at the Treasury, an institution that was key in helping Mexico deal with its severe 1994 currency crisis.

Exchange rates and prices

An important question, both then and today, is the relationship between changes in currency values and domestic prices. This debate is related to the validity of the so-called “Purchasing Power Parity” (PPP) doctrine, a theory that posits a strong one-to-one relation between inflation and changes in the exchange rates. Viner was a strong opponent of this doctrine, which he found to be superficial and not grounded in historical evidence. In contrast, Friedman, Metzler, Frenkel, and Johnson believed that under certain circumstances—especially during periods of rapid inflation—purchasing power parity was a useful tool for analyzing the extent to which currency values deviated from their long term equilibrium.

In their monumental work, A Monetary History of the United States (1963), Friedman and co-author Anna Schwartz used the PPP framework to assess whether the values of several currencies—including the pound sterling and the Swedish krone—were close to their “fair values” at different points in time.

In a 1951 article, Metzler used the PPP apparatus to assess if the original pegged exchange rates determined under the Bretton Woods agreement were close to “equilibrium.” The controversy on the usefulness of PPP has continued throughout the years. Currently, however, most economists use the principle carefully and only as one of many tools to assess whether a currency is valued fairly.

Friedman and floating exchange rates

In 1948, Friedman published an important paper in the American Economic Review, where he outlined his views on monetary policy. Famously, he argued that “rules” were superior to “discretion.” He also pointed out that for an active monetary policy to work properly the exchange rate had to be determined by market forces. His view contradicted the system of pegged currency values adopted at the Bretton Woods Conference in 1944, which created what some have called the “dollar-gold standard,” under which central banks could buy (or sell) gold from (to) the U.S. at a fixed price of $35 an ounce. Although Friedman was the strongest intellectual defender of flexible rates, he was not the first Chicago scholar to propose them. Mints and Simons, both of whom had been Friedman’s teachers, were staunch proponents of market-determined currency values.

Throughout the 50s and 60s, Friedman and his colleagues were lonely voices arguing for deep reforms to the international monetary system and the adoption of flexible rates. Friedman’s advocacy was relentless. In conferences and roundtables, he faced formidable adversaries, including Nobel Prize winners Paul Samuelson and Gunnar Myrdal. One of the important issues in the dispute was whether speculation was destabilizing, as the opponents of flexible rates maintained, or if it played a positive role and helped the economy to move faster to a new equilibrium, as Friedman forcefully argued.

On August 15, 1971, the United States “closed the gold window,” and the pegged exchange rates system that Friedman had criticized from its launch came to an end. The U.S. stopped selling gold to foreign central banks at the fixed price of $35 per ounce established in January 1934. In the years that followed a system of fluctuating, market-determined exchange rates similar to the one Friedman, Mints and Simon had advocated for over many years finally emerged.

In 1972, during the Horowitz Lectures in Israel, Friedman argued that his preferred exchange rate regime for poorer countries was an immutably fixed exchange rate, or what he called “a unified currency.” In contrast to the Bretton Woods regime, under this system poorer countries would not be allowed to alter the peg at any time. Friedman pointed out that for this regime to work properly the country in question had to eliminate its ability to print fiat money. This required getting rid of the central bank. Not surprisingly, this was a very controversial proposal, and few countries undertook it. The issue, however, continues to be current as several nations have either adopted a foreign currency as legal tender—e.g., Ecuador, El Salvador—or are considering full “dollarization” like Argentina.

The “Transfer Problem” and exchange rates

One of the most important policy debates in the mid-20th century had to do with the “Transfer Problem,” or the consequences of a country making a large transfer of resources to another nation. The issue acquired notoriety after World War I, when the victors imposed large transfer payments from Germany as reparations. The economic question was the impact of the transfer on interest rates, employment, income, and currency values in both the paying and receiving countries. Some of the most important contributors to this global debate included Viner, Johnson, Metzler, Mundell, and Harberger. These economists developed increasingly sophisticated models with multiple countries and multiple goods. The overall conclusion was that it was very difficult to determine a priori and in an unequivocal way the consequences of a transfer. At the end of the road, it was necessary to study the particularities of each case, and pay particular attention to whether the conditions for stable adjustment in the absence of globalization prevailed in both the receiving and paying countries.

Issues related to the transfer problems continue to be addressed today in debates on the consequences of foreign aid and large immigrants’ remittances to their families in the home country.

The monetary approach to exchange rates

In the late 1960s and early 1970s, scholars at the University of Chicago began to develop the “monetary approach” to the balance of payments and exchange rates. This perspective was promoted by Johnson, Frenkel, and Mussa, and emphasized a point made by the classics—and, especially, by David Hume—regarding the connection between the monetary system, the external accounts of a country (the balance of a country’s imports and exports in goods, services, and capital), and the value of its currency relative to other currencies. At the time, and because of several external shocks, including the sharp increase in the international price of oil, many economists believed that exchange rates and the balance of payment depended on “real” variables, such as the relative prices of the country’s imports and exports, or what economists call “the terms of trade.” Johnson and his colleagues argued that it was important to go back to basics, and noted that the fundamental determinant of the balance of payments and exchange rates were the supply and demand for monies in different countries. Countries that increased their money supply “too fast” would experience a balance of payments deficit and a depreciation of their currency. In contrast, countries with prudent monetary policy would see the value of their currencies go up in global financial markets.

It was quickly recognized that most monetary models were too simple to describe the complex world of currency markets. Consequently, an effort was made to develop more sophisticated portfolio approaches to study the dynamic behavior of macroeconomic variables in open economies. In these models, foreign exchange was one of the many assets that investors held in their portfolios. Notable work in this area was also undertaken by Chicago faculty at the time. Contributions by Dornbusch and Mussa were particularly significant and became extremely influential among researchers throughout the world. In a particularly important contribution Dornbusch argued that the exchange rate would react to a monetary stimulus by “overshooting” its new equilibrium value.

Robert Mundell and optimal currency areas

Mundell joined the faculty in 1966 and remained in Chicago until 1971, when he moved to Canada. During his Chicago years he published two important books in which he collected his work on international economics since the early 1960s. Much of Mundell’s research, including his work on exchange rates and adjustment, has been at the center of policy debates during the last 60 years or so. His extension of the Keynes-Hicks investment-saving and liquidity preference (IS-LM) model to the open economy—the so-called Mundell–Fleming model—became the workhorse of international finance for decades. Some of the most important insights from this work were: (a) There is a connection between the degree of capital mobility and the effectiveness of different macroeconomic policies; (b) There is an optimal assignment of policy tools to achieve different goals under alternative exchange rate regimes; and (c) The definition of criteria for determining the extent of optimal currency areas (the geographical area where the adoption of a single currency would maximize the economic benefits). Mundell also made important contributions to theoretical discussions on bimetallism, the gold standard, stability, the transfer problem, adjustment, exchange rates and portfolio models in open economies.

Although Mundell had done his seminal work on optimal currency areas before joining Chicago, he continued to push the idea of the optimality of fixed exchange rates within certain geographical areas once he joined the Department of Economics. His views were very influential in Europe and helped build the conceptual base for the euro. These ideas were also debated in several developing countries that had suffered from recurrent currency crises. For instance, during the late 1990s there was an intense debate on whether Argentina and other Latin American countries should give up their currencies and adopt the U.S. dollar as legal tender. Those who supported this view often referred to Mundell’s work as an intellectual justification for their position. This debate pitched the experiences of Panama, a country without a currency of its own, against those of Argentina and Brazil, countries with loose monetary policy, chronic inflation and instability.

Exchange rates and fundamentals

In the early 1970s, a group of young researchers at Chicago (and elsewhere) began to emphasize the role of goods that are not traded internationally—the so-called nontradable goods—in the adjustment process. While this was not completely new, it was a highly influential development. Dornbusch, Mussa, and Frenkel are the better-known Chicago names associated with this emphasis. The three were students of Mundell and Johnson, and, in turn, had many students that contributed to transforming the “real exchange rate”—that is the exchange rate adjusted by inflation differentials across countries—into one of the most important variables in global macroeconomics. Real exchange rate analyses also became central to discussions about stabilization and external sustainability in less-developed nations and countries from the former Soviet sphere.

During the 1980s, several researchers and PhD students examined the behavior of real exchange rates in various countries and under different circumstances. Mussa’s 1986 paper “Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications,” was, possibly, the most influential early contribution on the subject. Mussa found that real exchange rates behaved very differently under fixed versus floating exchange rate regimes. Volatility was significantly higher under flexible exchanges, and the main source of volatility was changes in the nominal exchange rate. Mussa concluded that “the observed empirical regularities provide strong evidence against theoretical models that embody the property of ‘nominal exchange rate neutrality.’” These findings were considered, by Mussa and others, to support models with sluggish price adjustments, including Dornbusch’s overshooting model discussed above, and to cast doubt on models that relied extensively on the PPP doctrine.

Arnold Harberger and “shadow” exchange rates

In 1987, the World Bank named Harberger one of 15 “pioneers of development.” In his lecture to celebrate the occasion, Harberger chose to address the issue of “social project evaluation,” or the methodology he had developed to determine whether public sector investments made a net “social” contribution. A fundamental element of Harberger’s approach was calculating the “shadow” or “social” value of foreign exchange.

Harberger’s method recognizes that, at the margin and with other things given, a public sector project that uses foreign exchange will result in a more depreciated domestic currency in real terms. His method is based on the “sourcing” principle. Each unit of foreign exchange used in a public project comes from two possible sources. A fraction comes from imports crowded out because of the investment, and another fraction comes from additional exports that would not have taken place in the absence of the project. The “shadow” exchange rate—or, as Harberger prefers to call it, the “social opportunity cost of foreign exchange”—is a weighted average of the import- and export-related sources. The weights are given by the elasticities of demand for imports with respect to the foreign exchange and the elasticity of exports relative to the real exchange rate.      

Over the course of its founding in 1890, the University of Chicago has hosted some of the most defining scholars working on monetary policy. This brief survey sought to highlight their contributions.

Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.