History of Exchange Rate Regimes Historical Review • Over the past 200+ years, the world has gone though major changes its global exchange rate environment. • Starting with the gold standard regime of the latter part of the 19th century to today’s somewhat “mixed system” we can identify there 3 distinct periods: Gold Standard: 1816 - 1914 During the 1800s the industrial revolution brought about a vast increase in the production of goods and widened the basis of world trade. At that time, trading countries believed that a necessary condition to facilitate world trade was a stable exchange rate system. Stable exchange rates were seen as necessary for encouraging and settling commercial transactions across borders (both by companies and by governments). So by the second half of the 19th century, most countries had adopted the gold standard exchange rate regime. Gold Standard: 1870 – 1914 Bretton Woods System: 1944 – 1973 Floating Exchange Rate: 1973 - • • Basics of the• Gold Standard How it worked: The gold standard regime required that domestic currencies (national money) be defined in terms of a specific weight of gold. For example: – – – – The British pound was fixed at .23546% of an ounce of pure gold (in 1816). The U.S. dollar was fixed at 0.048379% of an ounce of pure gold (in 1879). Thus, the dollar pound “parity” (i.e., the exchange rate) was set at $4.867 .23546/.048379 = 4.867 The Gold Standard also required that each country adjust its domestic money supply in direct relation to the amount of gold it held. – Increase in gold would increase the domestic money and a reduction in its gold supply would reduce the money supply. • • • • • Assume the United Kingdom ran a trade deficit with the United States. As a result, gold would flow from the UK to the US (gold financed trade imbalances). Each country’s domestic money supply was tied into the amount of gold it held, thus the U.S. money supply would rise. The increase money supply would increase prices in the United States, which in turn would make U.S. goods less attractive to the UK. The net result was that the trade surplus of the US would decrease and the trade deficit of the UK would decrease. World War I (1914) Through World War II (1944) World War I marks the beginning of the end of the Gold Standard . During the war, countries suspended the convertibility of their currencies into gold. After WW I, various attempts were made to restore the “classical” gold standard. 1919: United States returned to a gold standard. 1925: Great Britain joined, followed by France and Switzerland. These attempts proved unsuccessful. Why: During this time, most countries were more concerned with their national economies than exchange rate stability. As a result, countries abandoned their attempts to return to an interwar gold standard. Bretton Woods: A Pegged Regime In July of 1944, as World War II is coming to an end, all 44 allied countries meet in Bretton Woods, New Hampshire for the purpose of establishing a new international monetary system. At Bretton Woods, countries agree that fixed exchange rates were necessary for “restarting” world trade and global investment (both of which had fallen dramatically). Especially during the Great Depression (1929 – 1930s) Britain and Japan dropped it in 1931, the U.S. in 1933. Bretton Woods Agreement 1. International Monetary Fund (IMF) Purpose: To lend FX to any member whose supply of FX had become scarce. (To help the countries facing difficulty: CA deficit tight monetary policy employment). Lending would be conditional on the member’s pursuit of economic policies that IMF would think appropriate (IMF Conditionality). Bretton Woods Agreement 2. The US dollar would be designed as a reserve currency, and other nations would maintain their FX reserves in the form of dollars. 3. Each country fixed its ex rate against the dollar and the value of dollar is defined by the official gold price $35 per ounce (Gold Exchange Standard). Bretton Woods Agreement Bretton Woods System 4. A Fund member could change its par value only with Fund approval and only if the country’s BOP was in “fundamental disequilibrium”. 5. Countries would have to make a payment (subscription) of gold and currency to the IMF in order to become a member. Fixed ex rate system imposes restriction on monetary policy of countries. Floating ex rates were regarded as a cause of speculative instability. Smithsonian Agreements, December 1971 In December 1971, ten major counties meet in Washington, D.C. with the aim of restoring stability to the international monetary system. Meeting concludes with the Smithsonian Agreements, whereby: Key countries agree to revalue their currencies and in essence set new par values against the US dollar (e.g., yen +17%, mark +13.5%, pound and franc +9%) The U.S. also agrees to raise the dollar price of gold from $35 to $38 an ounce (represents a further devaluation of the dollar). It was also agreed that currencies could now fluctuate + or – 2.25% around their new par values. The Final Collapse of the Dollar, February 1973 13 months after the Smithsonian Agreements, the dollar comes under renewed attack for being overvalued. In February 1973, markets sell off dollars again. As before, central banks intervene and buy dollars. On February, 12th, 1973 the dollar is devalued further to $42 per ounce. But the price of gold on the London gold markets trades at $70 per ounce. Japan and Italy finally let their currencies “float” on February 13th. France and Germany continue to manage their currencies in relation to the dollar. In response to mounting speculative currency flows, foreign exchange markets are closed on March 1, 1973, and reopen on March 19, 1973. The End of Bretton Woods On March, 19, 1973, when foreign exchange markets reopen, major countries announce that they are “floating” their currencies: On March 19, 1973, the list of countries floating their currencies includes Japan, Canada, and those in Western Europe. The Bretton Woods fixed exchange rate system effectively ends on this date. Approximately 3 months later, by June 1973, the dollar has “floated” down an average of 10% against the major currencies of the world. Exchange Rate Regimes Today Currently, current exchange rate regimes fall along a spectrum as represented by national government involvement in affecting (managing) their currency’s exchange rate. Very Little (if any) Involvement Active Involvement Forex Market is Determining Exchange rate Government is Managing or Pegging Exchange rate Post Bretton Woods Summary Since March 1973, the major currencies of the world have operated under a floating exchange rate system. While central banks of these major countries have occasionally interviewed in support of their currencies, this intervention has become less over the years. The US last intervened in 1998. In addition to the major currencies of the world, a growing number of other developing country currencies have also moved to a floating rate system. Thus: more and more, market forces are driving currency values. The post Bretton Woods’ period has resulted exchange rates become much more volatile and , perhaps, less predictable then they were during previous fixed exchange rate eras. This currency volatility complicates the management of global companies. Choice of Exchange Rate Regimes Fixed or pegged ex rates would work like a gold standard. To keep their prices fixed, countries have to buy or sell their currencies in FX market (FX market Intervention). Floating (Flexible) ex rates --- the ex rates are determined by the market forces of demand and supply. No intervention takes place. A variety of ex rate system Managed Floating: MA influences ex rates through active FX market intervention (Independently) Floating: the ex rate is market determined. No FX intervention. Currency Board: A legislative commitment to exchange A variety of ex rate system Fixed Peg: The ex rate is fixed against a major currency. Active intervention needed. Crawling Peg: The ex rate is adjusted periodically in small amounts at a fixed, preannounced rate. Dollarization: The dollar circulates as the legal tender. domestic currency for a specified foreign currency at a fixed ex rate. Choice of Peg or Float Peg Small size (GDP) Open economy Harmonious inflation rate Concentrated trade Float Large size Closed economy Divergent inflation rate Diversified trade Freely Floating Currencies by Country or Region, IMF data, 2006 Albania Congo, Dem. Rep. of Indonesia Uganda Australia Brazil Canada Chile Iceland Israel Korea Mexico New Zealand Norway Philippines Poland South Africa Sweden Turkey United Kingdom Tanzania Japan Somalia Switzerland United States Eurozone Advantage of Flexible rates Each country can produce independent macroeconomic policies. Countries can choose different inflation rates. Disadvantage of Flexible rates The system is subject to destabilizing speculation Increase the variability of ex rates Self-fulfilling prophecy “evening out” swings in ex rates Advantage of Fixed rates Stable ex rates Each country’s inflation rate is “anchored” to the inflation rate in the US. price stability Disadvantage of Fixed rates A country cannot follow macroeconomic policies independent of those of other countries. To maintain the fixed rates, countries need to share a common inflation experience. Recall the Definition of an Exchange Rate Regime • Defined: The way in which a country manages its currency and thus the arrangement by the price of that country’s currency is determined on foreign exchange markets. • Arrangements ranging from: – – – Floating Rate Managed Rate (AKA “Dirty Float”) Pegged Rate • Arrangement is determining by governments.
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