Chapter 3

Chapter 3

Poorna Pal, MS MBA Ph.D.

Chapter Objective:

This chapter discusses:

1. alternative exchange rate systems

2. A brief history of the international monetary system

3. The European monetary system, and

4. The costs and benefits of a single currency

• Evolution of the International Monetary System

• Current Exchange Rate Arrangements

• European Monetary System

• Euro and the European Monetary Union

• The Mexican Peso Crisis

• The Asian Currency Crisis

• Fixed versus Flexible Exchange Rate Regimes

Alternative Exchange Rate Systems (Obvious but important point)

• People trade currencies for two primary reasons• To buy and sell goods and services

• To buy and sell financial assets

There are an enormous number of exchange rate systems, but generally they can be sorted into one of these categories

• Freely Floating • Managed Float• Target Zone• Fixed Rate

Important Note:

• Even though we may call it “free float” in fact the government can still control the exchange rate by manipulating the factors that affect the exchange rate (i.e., monetary policy)

Under a floating rate system, exchange rates are set by demand and supply.

• price levels • interest rates• economic growth

Alternate exchange rate systems: Managed Float (“Dirty Float”)

• Market forces set rates unless excess volatility occurs, then, central bank determines rate by buying or selling currency. Managed float isn’t really a single system, but describes a continuum of systems• Smoothing daily fluctuations• “Leaning against the wind” slowing the change to a

different rate• Unofficial pegging: actually fixing the rate without

saying so.• Target-Zone Arrangement: countries agree to maintain

exchange rates within a certain bound What makes target zone arrangements special is the understanding that countries will adjust real economic policies to maintain the zone.

Fixed Rate System: Government maintains target rates and if rates threatened, central banks buy/sell currency. A fixed rate system is the ultimate good news bad news joke. The good is very good and the bad is very bad.• Advantage: stability and predictability• Disadvantage: the country loses control of

monetary policy (note that monetary policy can always be used to control an exchange rate).

• Disadvantage: At some point a fixed rate may become unsupportable and one country may devalue. (Argentina is the most dramatic recent example.) As an alternative to devaluation, the country may impose currency controls.

A Brief History of the International Monetary System

• Pre 1875 Bimetalism• 1875-1914: Classical Gold Standard• 1915-1944: Interwar Period• 1945-1972: Bretton Woods System• 1973-Present: Flexible (Hybrid) System

The Intrinsic Value of Money and Exchange Rates

At present the money of most countries has no intrinsic value (if you melt a quarter, you don’t get $.25 worth of metal). But historically many countries have backed their currency with valuable commodities (usually gold or silver)—if the U.S. treasury were to mint gold coins that had 1/35th ounces of gold and sold these for $1.00, then a dollar bill would have an intrinsic value.

When a country’s currency has some intrinsic value, then the exchange rate between the two countries is fixed. For example, if the U.S. mints $1.00 coins that contain 1/35th ounces of gold and Great Britain mints £1.00 coins that contain 4/35th ounces of gold, then it must be the case that £1 = $4 (if not, people could make an unlimited profit buying gold in one country and selling it in another)

The Classical Gold Standard (1875-1914) had two essential features

Nations fixed the value of the currency in terms of Gold

Currencies were freely transferable between the countries

This was essentially a fixed rate system:

Suppose the US announces a willingness to buy

gold for $200/oz and Great Britain announces a

willingness to buy gold for £100. Then £1=$2

Advantage of the Gold System

Disturbances in Price Levels would be offset by the price-specie-flow mechanism. When a balance of payments surplus led to a gold inflow to the country with surplus, it led to higher prices there which reduced surplus. Likewise, gold outflow led to lower prices and increased surplus.

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http://www.gold.org/deliver.php?file=/value/stats/statistics/xls/monthly_prices.xls

The Interwar Period

Periods of serious chaos such as German hyperinflation and the use of exchange rates as a way to gain trade advantage.

Britain and US adopt a kind of gold standard (but tried to prevent the species adjustment mechanism from working).

The Bretton Woods System (1946-1971)

US$ was key currency valued at $1 = 1/35 oz. of gold

All currencies linked to that price in a fixed rate system.

In effect, rather than hold gold as a reserve asset, other countries hold the gold-backed US dollars.

German markBritish

poundFrench franc

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Pegged at $35/oz.

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Par ValuePar

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Collapse of Bretton Woods (1971)

high U.S. inflation rate

U.S.$ depreciated sharply.

Smithsonian Agreement (1971) US$ devalued to 1/38 oz. of gold.

1973 The US dollar is under heavy pressure, European and Japanese currencies are allowed to float

1976 Jamaica Agreement:

Flexible exchange rates declared acceptable Gold abandoned as an international reserve

Current Exchange Rate Arrangements

The largest number of countries, about 49, allow market forces to determine their currency’s value.

Managed Float. About 25 countries combine government intervention with market forces to set exchange rates.

Pegged to another currency such as the U.S. dollar or euro (through franc or mark). About 45 countries.

No national currency and simply uses another currency, such as the dollar or euro as their own.

Evolution of the International Monetary System

• Bimetallism: Before 1875• Classical Gold Standard: 1875-1914• Interwar Period: 1915-1944• Bretton Woods System: 1945-1972• The Flexible Exchange Rate Regime: 1973-

Present

Bimetallism: Before 1875

• A “double standard” in the sense that both gold and silver were used as money.

• Some countries were on the gold standard, some on the silver standard, some on both.

• Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents.

• Gresham’s Law implied that it would be the least valuable metal that would tend to circulate.

Classical Gold Standard: 1875-1914

• During this period in most major countries:• Gold alone was assured of unrestricted coinage

• There was two-way convertibility between gold and national currencies at a stable ratio.

• Gold could be freely exported or imported.

• The exchange rate between two country’s currencies would be determined by their relative gold contents.

For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents:


$30 = £6

$5 = £1


• Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment.

• Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.


• There are shortcomings:• The supply of newly minted gold is so restricted that

the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves.

• Even if the world returned to a gold standard, any national government could abandon the standard.

Interwar Period: 1915-1944

• Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market.

• Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”.

• The result for international trade and investment was profoundly detrimental.

Bretton Woods System: 1945-1972

• Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire.

• The purpose was to design a postwar international monetary system.

• The goal was exchange rate stability without the gold standard.

• The result was the creation of the IMF and the World Bank.

Bretton Woods System: 1945-1972

• Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar.

• Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary.

• The Bretton Woods system was a dollar-based gold exchange standard.

The Flexible Exchange Rate Regime: 1973-Present.

• Flexible exchange rates were declared acceptable to the IMF members.• Central banks were allowed to intervene in the

exchange rate markets to iron out unwarranted volatilities.

• Gold was abandoned as an international reserve asset.

• Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

Current Exchange Rate Arrangements

• Free Float • The largest number of countries, about 48, allow market

forces to determine their currency’s value.• Managed Float

• About 25 countries combine government intervention with market forces to set exchange rates.

• Pegged to another currency • Such as the U.S. dollar or euro (through franc or mark).

• No national currency• Some countries do not bother printing their own, they just

use the U.S. dollar. For example, Ecuador has recently dollarized.

European Monetary System

• Eleven European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies.

• Objectives:• To establish a zone of monetary stability in Europe.

• To coordinate exchange rate policies vis-à-vis non-European currencies.

• To pave the way for the European Monetary Union.

The Euro

• What is the euro? • When will the new European currency become a

reality? • What value do various national currencies have in

euro?

What Is the Euro?

• The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999.

• These member states are: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

Eurozone Membership

THE EURO CONVER-SION RATES

1 Euro is Equal to:

40.3399 BEF Belgian franc

1.95583 DEM German mark

166.386 ESP Spanish peseta

6.55957 FRF French franc

.787564 IEP Irish punt

1936.27 ITL Italian lira

40.3399 LUF Luxembourg franc

2.20371 NLG Dutch gilder

13.7603 ATS Austrian schilling

200.482 PTE Portuguese escudo

5.94573 FIM Finnish markka

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http://research.stlouisfed.org/fred2/series/EXUSUK/downloaddata?rid=15

What is the subdivision of the euro?

• During the transitional period up to 31 December 2001, the national currencies of the member states (Lira, Deutsche Mark, Peseta, Franc. . . ) will be "non-decimal" subdivisions of the euro.

• The euro itself is divided into 100 cents.

What is the official sign of the euro?

It was inspired by the Greek letter epsilon, in reference to the cradle of European civilization and to the first letter of the word 'Europe'.

The sign for the new single currency looks like an “E” with two clearly marked, horizontal parallel lines across it.

What are the different denominations of the euro notes and coins ?

• There will be 7 euro notes and 8 euro coins. • The notes will be: 500, 200, 100, 50, 20, 10, and 5

euro. • The coins will be: 2 euro, 1 euro, 50 euro cent, 20

euro cent, 10, euro cent, 5 euro cent, 2 euro cent, and 1 euro cent.

How will the euro affect contracts denominated in national currency?

• All insurance and other legal contracts will continue in force with the substitution of amounts denominated in national currencies with their equivalents in euro.

• Euro values will be calculated according to the fixed conversion rates with the national currency unit adopted on 1 January 1999.

• Generally, the conversion to the euro will take place on 1 January 2002, unless both parties to the contract agree to do so beforehand.

The Mexican Peso Crisis

• On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent.

• This decision changed currency trader’s expectations about the future value of the peso.

• They stampeded for the exits. • In their rush to get out the peso fell by as much as

40 percent.

The Mexican Peso Crisis

• The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital.

• Two lessons emerge:• It is essential to have a multinational safety net in place

to safeguard the world financial system from such crises.

• An influx of foreign capital can lead to an overvaluation in the first place.

The Asian Currency Crisis

• The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs.

• Many firms with foreign currency bonds were forced into bankruptcy.

• The region experienced a deep, widespread recession.

Currency Crisis Explanations

• In theory, a currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies. In the long run.

• In the short run, currency trader’s expectations play a much more important role.

• In today’s environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to “get to the exits first”.

• Thus, fears of depreciation become self-fulfilling prophecies.

Fixed versus Flexible Exchange Rate Regimes

• Arguments in favor of flexible exchange rates:• Easier external adjustments.

• National policy autonomy.

• Arguments against flexible exchange rates:• Exchange rate uncertainty may hamper international

trade.

• No safeguards to prevent crises.

Documents

Chapter 3