Exchange Rate Systems

The Gold Standard Pre World War 2 The Bretton Woods System Period From 1944 until 1971/73 . Flexible Exchange Rate Systems From 1973 Onwards

The Gold Standard: Fixed Exchange Rates

Between 1879 and 1934 the major nations of the world adhered to a fixed-rate system called the gold standard. Under this system, each nation must: Define its currency in terms of a quantity of gold. Maintain a fixed relationship between its stock of gold and its money supply. Allow gold to be freely exported and imported.

The Gold Standard

The gold standard collapsed under the weight of the worldwide Depression of the 1930s. As domestic output and employment fell worldwide

The conference produced a commitment to a modified fixed-exchange rate system called an adjustable-peg system

The Bretton Woods System Period From 1944 until 1971/73 Creation of the System Post World War 2
establish a stable exchange rate system The new system sought to capture the advantages of the old gold standard (fixed exchange rate) while avoiding its disadvantages (painful domestic macroeconomic adjustments).

ensure additional international liquidity

Furthermore, the conference created the International Monetary Fund (IMF) to make the new exchange-rate system feasible and workable.

How did the adjustable-peg system of exchange rates work?

First, as with the gold standard, each IMF member had to define its currency in terms of gold (or dollars), thus establishing rates of exchange between its currency and the currencies of all other members. In addition, each nation was obligated to keep its exchange rate stable with respect to every other currency. To do so, nations would have to use their official currency reserves to intervene in foreign exchange markets.

Under the Bretton Woods system there were three main sources of the needed pounds:
Official reserves The United States might currently possess pounds in its official reserves as the result of past actions against a payments surplus. Gold sales The U.S. government might sell some of its gold to Britain for pounds. The proceeds would then be offered in the exchange market to augment the supply of pounds. IMF borrowing The needed pounds might be borrowed from the IMF. Nations participating in the Bretton Woods system were required to make contributions to the IMF based on the size of their national income, population, and volume of trade. If necessary, the United States could borrow pounds on a short-term basis from the IMF by supplying its own currency as collateral.

Demise of the system

But a major problem arose. The United States had persistent payments deficits throughout the 1950s and 1960s. Those deficits were financed in part by U.S. gold reserves but mostly by payment of U.S. dollars. The problem culminated in 1971 when the United States ended its 37-year-old policy of exchanging gold for dollars at $35 per ounce. It severed the link between gold and the international value of the dollar, thereby floating the dollar and letting market forces determine its value.

Present exchange rate systems

1. Flexible exchange rate systems (also known as floating exchange rate systems.) 2. Managed floating rate systems. 3. Fixed exchange rate systems (also known as pegged exchange rate systems).

Flexible Exchange Rate Systems

1. In a flexible exchange rate system, the value of the currency is determined by the market, i.e. by the interactions of thousands of banks, firms and other institutions seeking to buy and sell currency for purposes of transactions clearing, hedging, arbitrage and speculation.

2.

So higher demand for a currency, all else equal, would lead to an appreciation of the currency. Lower demand, all else equal, would lead to a depreciation of the currency. An increase in the supply of a currency, all else equal, will lead to a depreciation of that currency while a decrease in supply, all else equal, will lead to an appreciation.
Essentially, we can characterize the equilibrium exchange rate under a flexible exchange rate system as the value that is consistent with covered and uncovered interest rate parity given values for the expected future spot rate and the forward exchange rate.

3.

4.

Since 1971, economies have been moving towards flexible exchange rate systems although only relatively few currencies are classifiable as truly floating exchange rates.
Most OECD countries have flexible exchange rate systems: the U.S., Canada, Australia, Britain, and the European Monetary Union.

5.

Managed Floating Rate Systems

1. A managed floating rate systems is a hybrid of a fixed exchange rate and a flexible exchange rate system. In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market. Unlike in a fixed exchange rate regime, the central bank does not have an explicit set value for the currency; however, unlike in a flexible exchange rate regime, it doesnt allow the market to freely determine the value of the currency. Instead, the central bank has either an implicit target value or an explicit range of target values for their currency: it intervenes in the foreign exchange market by buying and selling domestic and foreign currency to keep the exchange rate close to this desired implicit value or within the desired target values.

2.

3.

4.

Example: Suppose that Thailand had a managed floating rate system and that the Thai central bank wants to keep the value of the Baht close to 25 Baht/$. In a managed floating regime, the Thai central bank is willing to tolerate small fluctuations in the exchange rate (say from 24.75 to 25.25) without getting involved in the market.

Managed Floating Rate System(Contd)

5. If, however, there is excess demand for Baht in the rest of the market causing appreciation below the 24.75 level the Central Bank increases the supply of Baht by selling Baht for dollars and acquiring holdings of U.S dollars. Similarly if there is excess supply of Baht causing depreciation above the 25.25 level, the Central Bank increases the demand for Baht by exchanging dollars for Baht and running down its holdings of U.S dollars.
6. So under a managed floating regime, the central bank holds stocks of foreign currency: these holdings are known as foreign exchange reserves. It is important to realize that a managed float can only work when the implicit target is close to the equilibrium rate that would prevail in the absence of central bank intervention. Otherwise, the central bank will deplete its foreign exchange reserves and the country will be in a flexible exchange rate system because they can no longer intervene. 7. Some managed floating regimes use an explicit range of target values instead of using an implicit range of values. For example, in the early 1990s, many European countries participated in an arrangement called the Exchange Rate Mechanism (ERM) in which they set a range of values (a band that was 2.25 percentage points wide on either side of a central value) in which their currencies were free to move in but agreed to intervene to prevent currencies from moving outside that range.

8. Suppose the central rate was 0.5 British pounds/German mark. Then the pound-mark exchange rate would be allowed to fluctuate in the range 0.48875 Pounds/DM and 0.51125 Pounds/DM. However, if the pound depreciated and the exchange rate approached 0.51125 Pounds/DM or if the pound appreciated and the exchange rate approached 0.48875 Pounds/DM, the Bank of England would intervene to make sure that the exchange rate never went outside the range.

Pegged rate system

In a peg a country ties its currency to the currency of another country (single peg) or to several currencies (basket peg). 43 countries have pegged their currencies to the US dollar, 28 to the euro. Most Asian countries have implicitly pegged their currencies to the US dollar. The advantage of pegs is that producers and consumers face stable currency prices. In a basket peg, a country ties its currency to the currencies of its main trading partners.

 A crawling peg is applied when it is expected that the inflation rate in a country will tend to be higher than abroad over a longer period of time. Then the exchange rate is brought in line with the inflation differential, normally with a preannounced rate of change of the exchange rate. It may be used when a country wants to get out of a hyper inflation or after a currency reform.

Crawling Peg

Currency boards & dollarization

1. A currency board is a special form of an exchange-rateoriented monetary policy. 2. In such an approach, the domestic currency has to be covered completely by foreign currency reserves at a given rate. 3. The central bank binds itself to provide domestic money only to the extent that foreign monetary reserves are available. 4. To gain credibility in such a policy, the foreign currency can be authorized as legal tender in contracts. 5. In a currency board, the domestic currency has to be as stable as the foreign currency, or it is driven out of the market. 6. Argentina had followed this approach since 1991; it had to give up the policy of a currency board in 2001. Hong Kong uses a currency board tying the Hong Kong dollar to the US dollar. Estonia also has pursued a currency board approach since 1992. 7. An important condition for a currency board is that the internal markets of the currency board country, including the labor market, are flexible.

Dollarization
In dollarization, the foreign currency is used as legal tender in dayto-day operations. The country no longer issues its own money; it does not have a central bank.

Foreign Exchange
In the international foreign exchange market, the US dollar is the dominating currency. Of the total transactions in the international currency markets, 89 percent have the US dollar on one side of the transaction, 37 percent the euro. The yen and the sterling follow with 20 respectively 17 percent. The daily average turnover on the foreign exchange market amounts to US$4 trillion. Spot market transactions account for US$ 620 billion. Outright forwards for US$ 208 billion. Foreign exchange swaps for US$ 944 billion.

Exchange Rate Systems

Out of the currencies of the 184 member countries of the IMF and of three non-members(Aruba, Hong Kong & Netherlands), 43 currencies are pegged to the dollar (including managed floats) and 28 to the euro. Thirty other countries let their currencies float independently, 53 have a managed float. Most of the Asian countries use the dollar standard where their currencies are linked to the US dollar. Since mid-2005, China applies a basket for its renmimbi, reflecting the weight of its trading partners.

The Foreign Exchange Market(Key*)

The Foreign Exchange Market (Key*)

A) Four of them within a currency board. Also included are the seven member countries of European Exchange Rate Mechanism II (Cyprus, Denmark, Estonia, Latvia, Lithuania, Malta, Slovenia). - b Two of them within a currency board, seven use the US dollar as only legal tender.- c Two more countries (Bhutan and Nepal) peg their currency to the Indian rupee, which itself is a managed float (and which is counted as one of the 53 managed floats here). A further country (Belarus) is pegged to the Russian rouble, which also is a managed float. One more country (Brunei) is pegged to the Singapore dollar (again a managed float). Seven other countries restrict the flexibility of their home currency against another basket of currencies.

Countries & their Balance of Payments Situations

Exchange Rate Regimes & Economic Performance