History of Exchange Rates

Subject: International finance

Presented to : Prof Kapil

GROUP MEMBERS:

KAUSHIK SONAWANE : A-59

ABHISHEK JAISWAL: B-17

AVIJIT SARKAR: B-39

TANIMA SEN: B-41

SHILPA TRIPATHI: B-51

What are Foreign Exchange Rates

An exchange rate (also known as a foreign-exchange rate, forex rate, FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.

Why Are Exchange Rates Important?

• When the currency of our country appreciates relative to another country, our country’s goods prices ↑ abroad and foreign goods prices ↓ in our country.

• Makes domestic businesses less competitive.

• Benefits domestic consumers .

History of Exchange Rates To explain the nature of the forex exchange

market, it's important to first examine and learn some of the important historical events relating to currencies and currency exchange. In this section we will look at the international monetary system and how it has evolved to its current state. Then we'll look at the major players that occupy the forex market - something that is important for all potential forex traders to understand.

International Monetary Systems

Evolution of International Monetary Fund

• Bimetallism: 1870-1875

• 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”: both gold and silver were used as money, accepted as means of payment.

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

• Exchange rates among currencies were determined by either their gold or silver contents.

• Bimetallism was intended to increase the supply of money, stabilize prices, and facilitate setting exchange rates.

The 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.

• Many country set a par value for its currency in terms of Gold and tried to maintain it.

The Classical Gold Standard (1875-1914)The exchange rate between two country’s

currencies would be determined by their relative

gold contents.

Implied Dollar/Pound Exchange Rate• Dollar pegged to gold at U.S.$30 = 1 ounce

of gold

• British pound pegged to gold at £6 = 1 ounce of gold

• Exchange rate determined as:

• £6 = 1 ounce of gold = $30

• £1 = $5

The Classical Gold Standard (1875-1914)• Highly stable exchange rates under the

classical gold standard provided an environment that was conducive to international trade and investment.

• The outbreak of World war I Suspended the operation of Gold Standard

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

Price-Specie-Flow Mechanism

• Suppose Great Britain exported more to France than France exported to Great Britain.

• This cannot persist under a gold standard.– Net export of goods from Great Britain to France will

be accompanied by a net flow of gold from France to Great Britain.

– This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain.

• The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

In Gold Standard how much money could be printed?

 The gold standard prevents a country from printing too much money.

If the supply of money rises too fast, then people will exchange money (which has become less scarce) for gold (which has not). If this goes on too long, then the treasury will eventually run out of gold.

A gold standard restricts the Federal Reserve from enacting policies which significantly alter the growth of the money supply which in turn limits the inflation rate of a country.

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.

Interwar Period: 1915-1944

• Only U.S. and Britain allowed to hold gold reserves.

• Other countries could hold both gold, dollars or pound reserves.

• During World war I: currencies fluctuate over wide ranges to gold.

• Due to Supply & Demand for imports/exports.

What Happened in the World War - I

Governments with insufficient tax revenue suspended convertibility repeatedly in the 19th century.

By the end of 1913, the classical gold standard was at its peak but World War I caused many countries to suspend or abandon it. According to Lawrence Officer the main cause of the gold standard’s failure to resume its previous position after World War 1 was “the Bank of England's precarious liquidity position and the gold-exchange standard.”

Price levels doubled in the US and Britain, tripled in France and quadrupled in Italy. Exchange rates change less, even though European inflations were more severe than America’s. This meant that the costs of American goods decreased relative to those in Europe.

Between August 1914 and spring of 1915, the dollar value of US exports tripled and its trade surplus exceeded $1 billion for the first time. Because inflation levels varied between states, when they returned to the gold standard at a higher price that they determined themselves.

(Cont.)The US did not suspend the gold standard during

the war. For example, Germany had gone off the gold

standard in 1914, and could not effectively return to it because War reparations had cost it much of its gold reserves.

The newly created Federal Reserve intervened in currency markets and sold bonds to “sterilize”some of the gold imports that would have otherwise increased the stock of money.

By 1927 many countries had returned to the gold standard. As a result of World War 1 the United States, which had been a net debtor country, had become a net creditor by 1919.

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 (1945-1971)• 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.

Bretton Woods (1945-1971)

Bretton Woods ConferenceBretton Woods Conference, formally United Nations

Monetary and Financial Conference,  meeting at Bretton Woods, N.H. (July 1–22, 1944), during World War II to make financial arrangements for the post-war world after the expected defeat of Germany and Japan.

The conference was attended by experts noncommittally representing 44 states or governments, including the Soviet Union. It drew up a project for the International Bank for Reconstruction and Development (IBRD) to make long-term capital available to states urgently needing such foreign aid, and a project for the International Monetary Fund (IMF) to finance short-term imbalances in international payments in order to stabilize exchange rates. After governmental ratifications the IBRD was constituted late in 1945 and the IMF in 1946, to become operative, respectively, in the two following years.

TRIFFINS PARADOXThe Triffin paradox, is the fundamental problem of the United States

dollar's role as reserve currency in the Bretton Woods system, or more generally of a national currency as reserve currency.

By the early 1960s, an ounce of gold could be exchanged for $40 in London, even though the price in the U.S. was $35.

This difference showed that investors knew the dollar was overvalued and that time was running out. 

There was a solution to the Triffin dilemma for the U.S.: reduce the number of dollars in circulation by cutting the deficit and raising interest rates to attract dollars back into the country. 

Triffin Paradox pointed out the basic contradiction in the Bretton Woods system especially when dollar started losing its credibility to convert into gold at the promised rate of $35 per ounce of gold.

The contradiction was that only when US ran deficits, could other countries build up forex reserves; but as soon as the US BoP deficits became unsustainably large, other countries lost faith, leading to demise of Bretton Woods in 1971.

Why Nixon’s suspended the convertibility of US Dollars into Gold

• Richard Nixon's August 1971 decision to suspend the convertibility of dollars into gold was one of the most important chapters in modern economic history.

• Nixon's move, which was precipitated by rising U.S. balance of payments deficits, ended the system of fixed exchange rates that had been established at the Bretton Woods conference of 1944 and ushered in a regime of floating rates.

• Spending on the Vietnam War and Great Society as well as the revival of Western Europe and Japan led to a decline in the U.S. balance of payments. This, in turn, placed significant pressure on the dollar: U.S. gold holdings could not keep pace with the expanded money supply required by domestic and international economic growth.

Why Nixon’s suspended the convertibility of US Dollars into Gold

• Nixon decision to suspend the convertibility of US$ into Gold was a plan to combat inflation , effectively ended the Bretton Woods monetary regime and brought about a system of floating exchange rates within a few years. The implications of the "Nixon shock" for domestic and international affairs were numerous.

• Since the dollar no longer had to be backed by gold, the end of the Bretton Woods fixed exchange rate system increased the freedom of the U.S. Federal Reserve to engage in counter-cyclical monetary policy

World BankThe World Bank is a United Nations international financial

institution that provides loans to developing countries for capital programs. The World Bank is a component of the World Bank Group, and a member of the United Nations Development Group.

The World Bank's official goal is the reduction of poverty. According to its Articles of Agreement, all its decisions must be guided by a commitment to the promotion of foreign investment and international trade and to the facilitation of capital investment.

The World Bank was created at the 1944 Bretton Woods Conference, along with three other institutions, including the International Monetary Fund (IMF). Although many countries were represented at the Bretton Woods Conference, the United States and United Kingdom were the most powerful in attendance and dominated the negotiations.

International Monetary Fund (IMF)

The International Monetary Fund (IMF) is an international organization that was initiated in 1944 at the bretton woods conference and formally created in 1945 by 29 member countries.

The IMF's stated goal was to assist in the reconstruction of the world's international payment system post–World War II. Countries contribute funds to a pool through a quota system from which countries with payment imbalances temporarily can borrow money and other resources.

The IMF is a self-described "organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.”

The IMF works to foster global growth and economic stability. It provides policy advice and financing to members in economic difficulties and also works with developing nations to help them achieve macroeconomic stability and reduce poverty.

(Cont.)Stepping up crisis lending: The IMF responded quickly

to the global economic crisis, with lending commitments reaching a record level of more than US$250 billion in 2010. This figure includes a sharp increase in concessional lending (that’s to say, subsidized lending at rates below those being charged by the market) to the world’s poorest nations.

Greater lending flexibility:The IMF has overhauled its lending framework to make it better suited to countries’ individual needs. It is also working with other regional institutions to create a broader financial safety net, which could help prevent new crises.

Drawing lessons from the crisis: The IMF is contributing to the ongoing effort to draw lessons from the crisis for policy, regulation, and reform of the global financial architecture.

Historic reform of governance:The IMF’s member countries also agreed to a significant increase in the voice of dynamic emerging and developing economies in the decision making of the institution, while preserving the voice of the low-income members.

SDRThe SDR is an international reserve asset, created by the IMF in

1969 to supplement its member countries' official reserves.

Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies.

Created in response to concerns about the limitations of gold and dollars as the sole means of settling international accounts, SDRs are designed to augment international liquidity by supplementing the standard reserve currencies.

The SDR interest rate provides the basis for calculating the interest charged to members on regular (non-concessional) IMF loans, the interest paid to members on their SDR holdings and charged on their SDR allocation, and the interest paid to members on a portion of their quota subscriptions. The SDR interest rate is determined weekly and is based on a weighted average of representative interest rates on short-term debt instruments in the money markets of the SDR basket currencies.

Buying and Selling SDR’s

IMF members often need to buy SDRs to discharge obligations to the IMF, or they may wish to sell SDRs in order to adjust the composition of their reserves.

The IMF may act as an intermediary between members and prescribed holders to ensure that SDRs can be exchanged for freely usable currencies.

For more than two decades, the SDR market has functioned through voluntary trading arrangements

Flexible Exchange Rate: 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 and World Bank.

Current Exchange Rates• 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.