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Economic Research Institute Study paper


Utah State University

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The Bretton Woods system broke down in 1971 and since that time the developing countries have faced serious problems in keeping their exchange rates stable. Since 1975, the situation has become more difficult with acclerating inflation rates in many industrial countries. To meet these problems, the major industrial countries opted for free floating currencies and the developing countries opted for either pegging their currencies to some major currencies or fixing the exchange rate of their currencies vis-a- vis a basket of major currencies. In addition to exchange rate problems, the developing countries also suffered from chronic monetary disequilibrium, which is reflected in domestic inflation. As inflation has eroded the competitive edge of exports, the balance of payments deteriorated, and the fixed exchange rate was overvalued, generating such illegal practices as underinvoicing exports and overinvoicing imports. These phenomena support the monetarist proposition that a domestic monetary disequilibrium will have spillover effects on both the balance of payments and on the exchange rate.