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Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

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Page 1: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Exchange Rate Systems; Past, Present, and Future

FIN 40500: International Finance

Page 2: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

The evolution of the international financial structure is really an extension of the evolution of domestic monetary systems

Recall that money must satisfy three basic properties:

Unit of Account

Store of Value

Medium of Exchange One US Dollar = 0.056 ounces of Gold

Initially, currencies were defined as standardized weights of metal

Paper currency was initially a proxy for the underlying metal

Nixon removed dollar convertibility completely in 1971 – the beginning of the current international system!

Price of Gold = $17.86 per ounce

Page 3: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

iPY

M d

1dM

PMG

M

Households choose money holdings based on income, interest rates and prices

P

In the long run, the price level equates supply and demand

Y

iGP

1

During the days of commodity money (i.e. gold coins), the money supply was essentially fixed.

Page 4: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

dMP G

M

P

One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold!

When gold production outpaces economic growth (which drives money demand), prices rise.

Y

iGP

1

Page 5: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

dMP G

M

P

One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold!

However, when gold production can’t keep up with economic growth, prices must fall.

Y

iGP

1

Page 6: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold!

During the late 1800’s to the early 1900’s, US growth averaged around 3% per year

REAL GDP PER CAPITA (000s)

Page 7: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Gold Discovered at Sutter’s Mill, CA – California gold rush begins

New mining technologies rapidly increase gold production

One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold!

Page 8: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Correspondingly, we had severe deflation followed by severe inflation!!

P

M

P

M

MGMG

dM

dM

Page 9: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

American ships set sail for England – loaded with gold to buy British goods

(US Imports = Outflow of gold)

British ships sail to the US with gold to buy American goods

(US Exports = Inflow of gold)

International trade will dictate the international flow of gold.

Page 10: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

If the US runs a trade deficit with Britain, then gold is flowing out of the US and into Britain

US prices fall relative to British prices which reduces the trade deficit

Note: the exchange rate is fixed at 1!!

P

M

MGdM

P

M

MG

Page 11: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Assets Liabilities

Individual deposits $100 worth of gold

$100 $100

As early as 1600, paper money began to be used as a proxy for gold.

Reserve Ratio = 100%

Bank issues $100 worth of notes

Acme National Bank

Page 12: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Assets Liabilities

$100 (Gold) $100 (Notes)

+ $100 (Loan)

However, banks would create more notes than it held in gold!

Reserve Ratio = 50%

The notes are loaned out to create a business loan

The bank prints $100 worth of new notes

The reserve ratio is dependant on the bank’s loan policy

+ $100 (Notes)

$200 $200

Acme National Bank

Page 13: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Now the supply of money us related to the supply of gold, but

that relationship can change! (rr = reserve ratio)

dMP

SM

M

P

iPY

M d

1

Households choose money holdings based on income, interest rates and prices

rr

GM

MS

Page 14: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

The trade adjustment process was unaffected because international transactions were done in gold.

Assets Liabilities

- $50 (Gold) - $50(Notes)A $50 import would require a conversion of notes into gold

The conversion would pull $50 in notes out of circulation in the US

That gold would flow to England to be exchanged for British gold notes

Acme National Bank

Page 15: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Therefore, bank notes didn’t interfere with the stabilizing force of gold flows – trade deficit countries would see a net outflow of gold which would contract the money supply

US prices fall relative to British prices which reduces the trade deficit

Note: the exchange rate is still fixed at 1!!

P

M

sMdM

P

M

SM

Page 16: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Assets Liabilities

$100 (Gold) $200 (Notes)

However, reserves/money supplies were influenced by gold prices

Suppose that Acme bank is currently maintaining a 50% reserve ratio

GP

G

S

An increase in gold prices causes individuals to return their bank notes and redeem them for gold (say, $50 worth)

Assets Liabilities

$100 (Gold) $200 (Notes)-$50 (Gold) -$50 (Notes)

Page 17: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Assets Liabilities

$100 (Gold) $200 (Notes)-$50 (Gold) -$50 (Notes)

$50 (Gold) $150 (Notes)

The loss of gold reserves causes the reserve ratio to drop to 33%

GP

G

S

The increase in gold supplies returns the price of gold to its initial level

P

M

sMdM

The contraction of gold notes lowers the money supply – forcing down prices

Page 18: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

By 1860, most countries had adopted national currencies (i.e. had turned their money supply process over to a single entity.) The values of these currencies were maintained by tying them to gold – the beginning of the gold standard era

In the US, we went through three “phases” of money supply:

1. The US Treasury

2. Nationally Chartered Banks

3. The Federal Reserve System

Page 19: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

The Gold Standard had three basic rules: In each country, currency was convertible into gold on

demand at a fixed, pre-specified rate ($20.67 = 1 oz) Each country allowed for coinage of gold at a mint No restrictions on imports/exports of gold

Assets Liabilities

10 tons (320,000 oz)x $20.67/oz

$6,614,400 (Gold)

$56,222,400 (US Currency)

$49,608,000 (T-Bills)

US Federal Reserve System

117.400,222,56$

400,614,6$ The US maintained approximately an

11.7% reserve ration during the gold standard era

Page 20: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

The key property of the gold standard is that the central bank is left with very little flexibility to control the supply of it’s nation’s currency:

Assets Liabilities

$6,614,400 (Gold) $56,222,400 (US Currency)

$49,608,000 (T-Bills)

US Federal Reserve System

+ $10,000,000 (Gold) + $10,000,000 (US Currency)

Suppose that the federal reserve wishes to increase the supply of currency – it undertakes an open market purchase of gold

GP

G

S

Page 21: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Assets Liabilities

$6,614,400 (Gold) $56,222,400 (US Currency)

$49,608,000 (T-Bills)

US Federal Reserve System

+ $10,000,000 (Gold) + $10,000,000 (US Currency)

GP

G

S Rising gold prices causes individuals to redeem their currency for gold. – This contracts the money supply and returns to price of gold to parity

- $10,000,000 (Gold) - $10,000,000 (US Currency)

Page 22: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Assets Liabilities

$6,614,400 (Gold) $56,222,400 (US Currency)

$49,608,000 (T-Bills)

US Federal Reserve System

+ $10,000,000 (TBills) + $10,000,000 (US Currency)

Alternatively, the Federal could use the newly printed money to buy Treasury Bills – however, this influences the reserve ratio

099.400,222,66$

400,614,6$ A drop in the reserve ratio lowers the

value of a currency

Page 23: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Assets Liabilities

10 tons (320,000 oz)x $20.67/oz

$6,614,400 (Gold)

$56,222,400 (US Currency)

$49,608,000 (T-Bills)

US Federal Reserve System

117.400,222,56$

400,614,6$

Reserve Ratio

Suppose that the Federal Reserve raised the price of gold to $35

Assets Liabilities

10 tons (320,000 oz)x $35.00/oz

$11,200,400 (Gold)

$56,222,400 (US Currency)

$49,608,000 (T-Bills)

US Federal Reserve System

214.400,222,56$

400,200,11$

Reserve Ratio

Page 24: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Devaluations also allow the central bank to increase the money supply

Assets Liabilities

10 tons (320,000 oz)x $35.00/oz

$11,200,400 (Gold)

$56,222,400 (US Currency)

$49,608,000 (T-Bills)

US Federal Reserve System

214.400,222,56$

400,200,11$

Reserve Ratio

GP

G

S

$25

If the fed increases the price of gold to $35 while in private markets, the price of gold is $25, individuals will buy gold in private markets (demand for gold rises)

$35

+ Gold + Currency in Circ.

Page 25: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

P = $20.67

P* = L 4.87e = $20.67

L 4.87 = 4.25

If e = $5.00 (the pound is overvalued), an arbitrage opportunity exists

•Buy gold in US ($1 = 1/20.67 oz)

•Sell gold in Britain (1/20.67)*L4.87 = L.2356

•Convert Pounds back to $s ( L.2356 * 5.00 = $1.18)

The gold standard created an implied exchange rate system

Page 26: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

P = $20.67

P* = L 4.87e = $20.67

L 4.87 = 4.25

Trade deficits would tend to depreciate the dollar in currency markets – this would lead to gold flowing out of the US through arbitrage

Assets Liabilities

10 tons (320,000 oz)x $35.00/oz

$11,200,400 (Gold)

$56,222,400 (US Currency)

$49,608,000 (T-Bills)

US Federal Reserve System

- Gold - Currency in Circ.

These gold flows will contract the money supply in the US and lower US reserve assets – what can the Fed do about this?

Page 27: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Monetary systems such as the gold standard left currencies open to speculative attacks.

Assets Liabilities

10 tons (320,000 oz)x $35.00/oz

$11,200,400 (Gold)

$56,222,400 (US Currency)

$49,608,000 (T-Bills)

US Federal Reserve System

- Gold - Currency in Circ.

Suppose that speculators believed that the US Fed would devalue its currency (i.e. raise the price of gold). The correct move would be to buy gold in preparation.

GP

G

S

$35

$45

As current gold prices rose above the central banks conversion rate, individuals buy gold from the fed and sell it in open markets – the money supply contracts and the Fed’s reserves drop.

Page 28: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Currency pegs operate exactly like a gold standard except that the reserve asset becomes another country’s currency:

Assets Liabilities

10 Million Euro x $1.12/Euro $11,200,000 (Euro)

$60,808,000 (US Currency)

$49,608,000 (T-Bills)

For example, if the US decided to peg to the Euro at a price of $1.12 per Euro, we would need to acquire Euro assets (either cash or Euro bonds)

184.000,808,60$

000,200,11$

Reserve Ratio

There is one big difference here…what is it?

Page 29: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Mama knows best!

“If Billy jumped off the Brooklyn Bridge, would you do it to?”

Under a gold standard, the commodity to which you are pegged is in relatively fixed supply – Euros ARE NOT in fixed supply, but are controlled by the ECB.

Page 30: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Currency pegs force you to “adopt” the monetary policy of the country to which you are pegging:

Assets Liabilities

10 Million Euro x $1.12/Euro $11,200,000 (Euro)

$60,808,000 (US Currency)

$49,608,000 (T-Bills)

184.000,808,60$

000,200,11$

Reserve Ratio

P

M

sMdM

Suppose that the ECB increases the supply of Euros – this will (all else equal) cause the dollar to appreciate – the Fed would need to buy Euro in currency markets

*

*

* 1

1

i

i

Y

Y

M

Me

+ Euro Reserves + US Currency

Page 31: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Further, currencies that are pegged are subject to speculative attacks.

Assets Liabilities

10 Million Euro x $1.12/Euro $11,200,000 (Euro)

$60,808,000 (US Currency)

$49,608,000 (T-Bills)184.

000,808,60$

000,200,11$

Reserve Ratio

- Euro Reserves - US Currency

Suppose that the markets believe that the dollar is overvalued (i.e. that the $1.12 per Euro is too low)

The profitable move would be to buy Euro from the Fed with the intention of selling them back later at a higher price – this will cost the Fed its Euro reserves!!

Page 32: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

The Bretton Woods System (1945 – 1972)

$35/oz.

1L = $2.80

625 Lira = $1

DM 2 = $1The dollar became the “nominal anchor” - tying (indirectly) every other currency to gold

Page 33: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Assets Liabilities

$100M (Gold) $500M (Currency)$400M (T-Bills)

Assets Liabilities

$30M ($) DM 100M (Currency)DM 10 (Gold)

$35/oz. DM 2 = $1

DM 30M (Bonds)

While gold would be the primary reserve asset in the US, $s were the primary reserve asset in Europe

Page 34: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Suppose that trade imbalances were causing a Deutschemark depreciation. Germany would be obliged to use its dollar reserves to buy back its currency – this costs them reserves!!

Assets Liabilities

$100M (Gold) $500M (Currency)$400M (T-Bills)

Assets Liabilities

$30M ($) DM 100M (Currency)DM 10 (Gold)

$35/oz. DM 2 = $1

DM 30M (Bonds)

- Dollar Reserves - DM

Page 35: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

However, if the US ran a trade deficit that was causing the dollar to depreciate (all other currencies are appreciating), again Germany would need to respond – buying dollars

Assets Liabilities

$100M (Gold) $500M (Currency)$400M (T-Bills)

Assets Liabilities

$30M ($) DM 100M (Currency)DM 10 (Gold)

$35/oz. DM 2 = $1

DM 30M (Bonds)

+ Dollar Reserves + DM

Page 36: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

-3

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

1/1/60

1/1/61

1/1/62

1/1/63

1/1/64

1/1/65

1/1/66

1/1/67

1/1/68

1/1/69

1/1/70

1/1/71

1/1/72

1/1/73

1/1/74

-80000

-70000

-60000

-50000

-40000

-30000

-20000

-10000

0

10000

Trade Balance Government Deficit

The Twin Deficits

With the Vietnam War and Johnson’s Great Society programs, the US began running sizable trade deficits and government deficits – this creates a perceived weakness in the dollar.

Page 37: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

The perceived weakness of the dollar materializes in two ways:

Assets Liabilities

$100M (Gold) $500M (Currency)$400M (T-Bills)

Assets Liabilities

$30M ($) DM 100M (Currency)DM 10 (Gold)

$35/oz. DM 2 = $1

DM 30M (Bonds)

+ Dollar Reserves + DM

Downward pressure on the dollar forces European countries to buy dollars – increasing their dollar reserves

Upward pressure on gold prices forces the Fed to sell gold – losing reserves

- Gold - US Dollars

Page 38: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

1972

1971

1970

1969

1968

1967

In 1967-1968: the British pound devalues to $2.40 (-14%). This triggers a massive run on US gold. The US loses $3.2B (20% of reserves) in three months! Private market prices of gold rise as high as $45! Convertibility of gold is suspended in open markets

1969-1971: The US enters a recession. This creates even more speculation against the dollar.

1970-1971: In an effort to stimulate the economy (and to get re-elected), Nixon pressures the Fed to cut interest rates

August 15, 1971: Nixon officially closes the gold window. Without implicit gold backing, the system totally collapses.

1966

Page 39: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

The ERM (European Exchange Rate Mechanism) was the precursor to the Euro. The Basis of the ERM was the ECU (European Currency Unit)

Currency Amount Exchange Rate (per dollar) - 1971

Dollar Equivalent

Belgian Franc 3.80 49.64 .0766

German Mark .828 3.637 .2277

Danish Krone .217 7.485 .0290

French Franc 1.15 5.5192 .2084

British Pound .0885 .4177 .2112

Irish Punt .00759 .4156 .0182

Italian Lira 109 623.26 .1749

Dutch Guilder .286 3.5946 .0796

Total = $1.02 Per ECU

Page 40: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Assets Liabilities

30M ECU DM 100M (Currency)DM 10 (Gold)

DM 3.64 = 1 ECU

DM 30M (Bonds)

Each country in the mechanism pegged to the ECU at a specified rate (essentially the same rate as the dollar)

Each country’s foreign exchange reserves were made up of cash/assets of all the member countries

Page 41: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

2002

2000

1998

1995

1992

1979

1972

1979: European Community Members agree to the European Exchange Rate Mechanism

1992: George Soros speculates against the pound. The pound is devalued by 25%. Italy and Britain drop out of the ERM

1998: Euro introduced. ECU converted to Euros at 1:1 rate.

January 2002: Euros begin circulating

Page 42: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain

Will Join….

(2007 Slovenia

(2008) Estonia, Cyprus, Latvia, Malta

(2009) Slovakia, Lithuania

(2010) Czech Republic, Hungary

(2011) Poland

(Not Before 2012) Sweden

(???) Bulgaria, Romania

The Euro-zone consists of 12 countries

Page 43: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

A Budget Deficit of no more than 3% of GDP National debt of no more than 60% of GDP Inflation within 1.5% of 3 best performing EU

countries Long term interest rates within 2% of 3 lowest

interest rate EU countries

The Eurozone is an example of a currency union – the strictest of exchange rate systems. A currency union is very much a “permanent peg”. Its important that countries pegged to one another are similar in economic structure

Eurozone countries must meet strict entry requirements

Note: France and Germany routinely violate these conditions!

Page 44: Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

What does the future hold for exchange systems? Currency unions seem to be the trend!

Currency Unions Currently in Operation European Union: Euro West African Economic and Monetary Union (7 countries): CFA

Franc East Caribbean Monetary Union (8 countries): East Caribbean

Dollar Gulf Cooperation Council Monetary Union

Unions Still in the Planning Stages Central American Monetary Union Asia Currency Union North American Monetary Union: Amero?