CHAPTER 3 Exchange Rate Systems: Past to Present : Concepts

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CHAPTER 3 Exchange Rate Systems Past to Present
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 nations
  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
  (Commodity-backed money)
• Nations fixed the value of their currency
  relative to gold via a mint parity rate fixing
  an official price of gold in terms of the
  national currency.
• Established the convertibility of a currency for
  gold.
• Gold parity rates determined the exchange rate
  between currencies.

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The Gold Standard

• To maintain the mint parity or the exchange rate
  between gold and the currency, the country had
  ensure that its stock of money was closely
  related to the level of its gold reserves.
• 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.

USs Mint Parity Rate 20.646/ per fine
ounce UKs Mint Parity Rate 4.252/ per fine
ounce Thus, the USD/ 20.646/ 4.252 (USD/
) 4.856
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Gold Standard Costs and Benefits

• The gold standard promoted long-run stability of
  nations money stock and long-run stability of
  real output, prices, and the exchange rate
  Advantage
• It can be very costly to maintain a gold standard
  because of significant resource costs, such as
  mining and transportation costs Disadvantage
• The political costs of maintaining the gold
  standard became too significant for nations such
  as the United Kingdom high interest rates and
  unemployment if continued with an overvalued .
  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 (IMF)
• 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 (IMF)

• 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.
• The US has a complete disdain for any IMF
  pronouncements on the US economy!

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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 (Vietnam and Great
  Society expenditures.) 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
  dEstaing hosts the first economic summit. Idea
  Smithsonian Agreement violated the IMF charter
• 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). Russia (President Putin)
  just assumed chair of the G8 on January 1,2006
  Problem credibility of natural gas supplies to
  EU Ukraine issue.

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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.

Plaza Accord dollar status --- highly
appreciated (overvalued) decision to push down
its value (depreciate it)
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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
  without any government intervention..

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Exchange Rate Arrangements Today

• A nations 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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NicaraguaCrawling Peg
Nicaraguas 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 inter-bank
  market.
• Monetary authority may intervene periodically to
  maintain stability without any pre-announced 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.