Exchange Rate Systems

Past to Present

INTERNATIONAL MONETARY AND

FINANCIAL ECONOMICS

Third Edition

Joseph P. DanielsDavid D. VanHoose

Copyright © South-Western, a division of Thomson Learning. All rights reserved.

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Concepts

• Monetary Order: A set of laws and regulations that establishes the framework within which individuals conduct and settle transactions.

• Exchange-Rate System: A set of rules that determine the international value of a nation’s currency.

• Convertibility: The ability to freely exchange a currency for a reserve commodity or reserve currency.

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The Gold Standard

• Came into effect in the mid-1870s when most of the major economies unilaterally pegged to gold.

• Nations fixed the value of their currency relative to gold via a mint parity rate.

• Established the convertibility of a currency for gold.

• Gold parity rates determined the exchange rate between currencies.

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The Gold Standard

• Pegging the value of each currency to gold, established an exchange rate system by indirectly establishing exchange rates.

• The mint parity rates could be used to determine the exchange rate.

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Gold Standard and Exchange Values

• Pegging the value of each currency to gold established an exchange rate system.

• The mint parity rates determined the exchange value between two currencies.

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Gold Standard: Costs and Benefits

• The gold standard promoted long-run stability of nation’s money stock and long-run stability of real output, prices, and the exchange rate.

• It can be very costly to maintain a gold standard because of significant resource costs, such as mining and transportation costs.

• The political costs of maintaining the gold standard became too significant for nations such as the United Kingdom. By 1936 most nations had left the gold standard.

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The Bretton Woods Agreement

• The 1944 conference was originally named the “International Monetary and Financial Conference of the United and Associated Nations,” but became better known as the Bretton Woods Conference.

• This conference established:– The International Monetary Fund

– The International Bank for Reconstruction and Development, or “World Bank”

– The General Agreement on Tariffs and Trade, or “GATT”

– The Bretton Woods Exchange Rate System

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The International Monetary Fund

• A multinational organization of more than 180 member nations that seeks to encourage global growth.

• The IMF attempts to promote– international monetary cooperation

– effective exchange rate arrangements

• The IMF provides– temporary and long-term financial for countries

experiencing balance-of-payments difficulties

– surveillance of macroeconomic conditions and policies.

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The Bretton Woods System

•The value of the dollar was pegged to gold and the dollar was convertible to gold at the mint parity rate.•A pegged exchange rate system in which a country pegs the value of its currency to the currency of another nation.•In practice a dollar-exchange-rate system as nations pegged to the dollar and freely exchanged the domestic currency for the dollar at the parity rate.

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Changes in Parity Rates

• A devaluation is a situation in which a nation changes the parity value of its currency so that it takes a greater number of domestic currency units to purchase the foreign currency.

• A revaluation is a situation in which a nation changes the parity value of its currency so that it takes a greater number of domestic currency units to purchase the foreign currency.

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Collapse of Bretton Woods System

•The U.S. balance on goods and services shifted to a surprising deficit in 1971. These deficits supported speculations that the dollar was overvalued.•Because of massive gold outflows from the United States, President Nixon suspended convertibility of the dollar in August 1971. This ended the Bretton Woods System.

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Smithsonian Agreement

• In an attempt to restore order to the exchange market, 10 leading nations met at the Smithsonian on December 16 and 17, 1971.

• The “Smithsonian Agreement” was a new system of exchange-parity values. Although this new system was still a dollar-standard exchange-rate system, the dollar, was still not convertible to gold.

• Nixon hailed this agreement as the “most significant monetary agreement in the history of the world.”

• Smithsonian Agreement collapsed within 15 months and a de facto system of floating rates emerged.

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Economic Summits

• November 1975 French President, Valery Giscard d’Estaing hosts the first economic summit.

• Invited France, US, UK, Germany, Japan (G5).

• Italy added to represent the EU (G6).

• Agreed to a system of flexible exchange rates and that countries would intervene when needed to ensure stability.

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Jamaica Accords

• January 1976 meeting of IMF member country nations.

• Amended the articles of agreement of the IMF to recognize flexible exchange rate systems.

• Member nations could adopt an arrangement of their own choice.

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Summits “Institutionalized”

• 1976 President Ford hosts a second summit.

• He invites Canada in addition to the G6 countries (G7).

• Summits now occur ever summer, rotating from country to country.

• British PM, Tony Blair, added President Yeltsin (Russia) as a “full member” for the 1998 Birmingham Summit (G8).

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Performance of the U.S. Dollar

•Between 1981and 1985, the U.S. dollar appreciated relative to a weighted-average value of several major currencies. •Within two years, this appreciation had reversed.

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Plaza Agreement

• The “Plaza Agreement” refers to a September 1985 meeting of the G5 central bankers and finance ministers.

• The G5 bankers and ministers had been meeting quietly for a number of years.

• Following this meeting they announced a belief that the dollar was overvalued and that the nations would intervene on a coordinated basis to drive down the value of the dollar.

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Louvre Accord

• The “Louvre Accord” refers to a February 1987 meeting of the G7 (less Italy) central bankers and finance ministers.

• Following the meeting it was announced that the ministers believed that the dollar was now “consistent with economic fundamentals.”

• They agreed to intervene only when required to ensure stability.

• A managed float system emerged from this accord.

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The Euro

•The euro was launched in January 1999. •On its first day of trading it reached a high of 1.19 ($/€).•During the next two years it depreciated relative to the dollar. •The euro eventually began appreciating in 2002.

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Exchange Rate Arrangements Today

•A nation’s policymakers may choose any type of exchange rate system.•Hence, there is a wide range of arrangements in place at this time.

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Dollarization

• Dollarization is the replacement of the domestic currency with the currency of another nation.

• Two possible problems are the loss of seigniorage revenues and the loss of discretionary monetary policy.

• Seigniorage is the revenue created through the manufacturing of money, and can be quite important to developing nations.

• Examples are Panama, El Salvador and Ecuador.

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Seigniorage

• On average, seigniorage finances 10.5% of government spending.

• Comparison:– US 2.0, Germany 2.4, Japan 5.6.– Thailand 6.3, Indonesia 6.9, Malaysia 5.3, Brazil

19.0, and Argentina (before float) 62.0%.

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Currency Board

• Establishes and maintains a hard peg between the domestic currency and another currency.

• Issues domestic notes.• Notes issued depend on the value of the exchange

rate and the amount of foreign reserves.• Hence, monetary base is determined by the stock of

foreign reserves.

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Currency Board - Continued

• Replaces central bank– Cannot hold domestic debt.– Not a lender of last resort– Does not set reserve requirements

• Theoretically shielded from political pressure.

• Examples are Hong Kong, Estonia, and Bulgaria.

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Pegged and Pegged with Bands

• Parity value established relative to another currency.• Central bank must conduct monetary policy to

maintain parity.• “Parity band” allows limited flexibility on either side

of the parity rate.• Bands can be very narrow or very wide.• Examples are Bangladesh, China, and Egypt.

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Currency Basket Peg

• Currency is pegged to a “basket” currencies.

• Parity value is the weighted average of a basket of currencies in various quantities. Each currency has an implicit weight assigned to it.

• Provides some degree of flexibility against individual currencies.

• Examples are Kuwait and Latvia.

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Crawling Peg

• Parity value is changed on a periodic basis.• Crawl is typically designed to compensate for

differences between the economic performance of the pegging country and the country being pegged to.

• Bands may be established around the crawling parity rate. Bands may be symmetric or asymmetric.

• Examples are Boliva, Costa Rica, and Nicaragua.

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Nicaragua

Nicaragua’s crawling-peg exchange-rate arrangement allows for a 1 percent monthly rate of crawl of depreciation of the cordoba relative to the U.S. dollar.

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Managed Float

• Currency value is determined in the interbank market.

• Monetary authority may intervene periodically to maintain stability without any preannounced path for the currency value..

• Sometimes referred to as a “dirty float.”• Examples are Indonesia and India.

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Floating

• Value of domestic currency is determined in the foreign exchange market.

• Forces of supply and demand are the sole determinants of currency value movements.

• Examples are United States, United Kingdom, and Mexico.