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©The McGraw-Hill Companies, 2008
Chapter 34Exchange rate regimes
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008
PowerPoint presentation by Alex Tackie and Damian Ward
©The McGraw-Hill Companies, 2008
Key issues
• Exchange rate regimes and their
implications for the world economy
• International policy co-ordination
• Policy co-ordination in Europe
©The McGraw-Hill Companies, 2008
Exchange rate regimes
Exchange rate ForexinterventionFixed Floating
Freefloat
None
Gold standardcurrency board
Automatic
Adjustable peg Managedfloat
Some discretion
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The gold standard• Characteristics of the gold standard:
– The government of each country fixes the price of gold in terms of its domestic currency.
– The government maintains convertibility of domestic currency into gold.
– Domestic money creation is tied to the government's holding of gold.
• Adjustment to full employment is via domestic wages and prices– creating vulnerability to long and deep
recessions.
©The McGraw-Hill Companies, 2008
The adjustable peg and the dollar standard
• In an adjustable peg regime, exchange rates are normally fixed, but countries are occasionally allowed to alter their exchange rate.
• Under the Bretton Woods system, each country announced a par value for their currency in terms of US dollars– the dollar standard.
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The dollar standard• Faced with a balance of payments deficit
under the dollar standard
• countries could try to avoid monetary contraction by running down foreign exchange reserves
• but devaluation could not be postponed for ever, given finite reserves
• expansion of US money supply began to spread inflation world-wide.
©The McGraw-Hill Companies, 2008
Floating exchange rates
• Under pure/clean floating, forex markets are in continuous equilibrium
• the exchange rate adjusts to maintain competitiveness
• but in the short run, the level of floating exchange rates is determined by speculation– given that capital flows respond to interest rate
differentials.
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After the Dollar Standard
• After the BW system, two tendencies occured:
• The countries switched to the floating regimes
• They form monetary unions.
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Fixed versus floating exchange rates
• Robustness– Bretton Woods system was abandoned because it
could not cope with real and nominal strains– a flexible rate system is probably more robust
• Volatility– fixed rate system offers fundamental stability– flexible rate system is potentially volatile– but instability must be accommodated in other ways
under a fixed rate system
• Financial discipline– fixed rate system imposes discipline and policy
harmonisation.
©The McGraw-Hill Companies, 2008
The European Monetary System
• Established by members of the European Community (including the UK) in 1979
• A system of monetary and exchange rate co-operation.
• Included the Exchange Rate Mechanism (ERM)– which the UK did not join until 1990– and it left again in 1992.
• The system had some success in reducing exchange rate volatility– through co-ordination of monetary policy– plus exchange rate controls– even if it did not work for the UK.
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From EMS to EMU
• A monetary union has– permanently fixed exchange rates within the
union
– an integrated financial market
– a single central bank setting the single interest rate for the union.
• The Maastricht Treaty set criteria for EMU entry– to define ‘convergence’
• The single currency area began in January 1999 with 11 member countries.
©The McGraw-Hill Companies, 2008
The Maastricht criteria
• Inflation rate – no more than 1.5% above the average of the inflation rate
of the lowest 3 countries in the EMS
• Long-term interest rate– no more than 2% above the average of the lowest 3 EMS
countries
• Exchange rate– in the narrow band of ERM for 2 years
• Budget deficit– no larger than 3% of GDP
• National debt– no greater than 60% of GDP
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