International Economics By Robert J. Carbaugh 8th Edition Chapter 16: Exchange-Rate Systems

Exchange rate practices Exchange rate systems Exchange rate practices Floating rate - market determined Float independently Float in unison with a group of other countries Adjust according to a formula Fixed (“pegged”) rate Peg to a single major currency Peg to a basket of currencies Peg to gold (obsolete) Carbaugh, Chap. 16

Exchange rate system alternatives Fixed exchange rates Fixed exchange rates are normally used by small developing nations to peg to a key currency For international settlement purposes To stabilize import/export prices with the main trading partner To reduce inflationary expectations Pegs can be established To a single currency To a trade-weighted basked of currencies To the special drawing right (SDR), a basket established by the IMF Carbaugh, Chap. 16

Exchange rate system alternatives Key currencies: Share of national currencies in total identified official holdings of foreign exchange, 1998 All Industrial Developing Key currency countries countries countries US dollar 60.3% 64.3% 57.1% German mark 12.1 14.7 10.1 Japanese yen 5.1 7.0 3.7 British pound 3.9 3.1 4.6 French franc 1.3 1.4 1.2 ECU 0.8 1.8 - Swiss franc 0.7 0.2 1.0 Netherlands guilder 0.4 0.3 0.4 Other 15.4 7.2 21.9 Carbaugh, Chap. 16

Fixed exchange rate system Exchange rate system alternatives Fixed exchange rate system Establish a par value against one or more key currencies Create a stabilization fund to defend this fixed rate Government must be ready to make good on all demands to convert to/from foreign currency At some point, because of basic economic changes, the fixed rate can become impossible to defend and must be changed Carbaugh, Chap. 16

Exchange rate stabilization under fixed rates Exchange rate system alternatives Exchange rate stabilization under fixed rates Carbaugh, Chap. 16

Exchange rate stabilization under fixed rates Exchange rate system alternatives Exchange rate stabilization under fixed rates Carbaugh, Chap. 16

Devaluation and revaluation Exchange rate system alternatives Devaluation and revaluation Devaluation is intended to lower the value of a currency relative to other currencies, correcting a balance of payments deficit Revaluation is intended to raise the currency’s value relative to other currencies, correcting a surplus Carbaugh, Chap. 16

Devaluation and revaluation Exchange rate system alternatives Devaluation and revaluation Legally, the changes are made in the par value of the home currency in terms of the reference currency Economically, the effect is to change the value of the currency relative to the main trading partners - who may retaliate by changing their own fixed rates Carbaugh, Chap. 16

Devaluation/revaluation: legal and economic impact Devaluation and revaluation Devaluation/revaluation: legal and economic impact Carbaugh, Chap. 16

Devaluation/revaluation: legal and economic impact Devaluation and revaluation Devaluation/revaluation: legal and economic impact Carbaugh, Chap. 16

Currency boards vs. dollarization Stabilizing developing country currencies Currency boards vs. dollarization A currency board is a monetary authority empowered to issue domestic currency which can be converted at a fixed exchange rate The rate is usually set in law, and the board must have foreign exchange reserves large enough to cover the domestic currency in circulation Put another way, the domestic money supply is limited by the amount of foreign reserves on hand Currency boards do not make loans or finance government deficits Carbaugh, Chap. 16

Currency boards vs. dollarization (cont’d) Stabilizing developing country currencies Currency boards vs. dollarization (cont’d) Currency boards have become popular as a solution for countries which have not been able to control inflation or hold to a fixed exchange rate The boards guarantee stability, and political independence (sometimes more than central banks, which they sometimes replace) But the boards also leave no flexibility in monetary policy to respond to changing circumstances and require large foreign exchange reserves; experience has been mixed Carbaugh, Chap. 16

Currency boards vs. dollarization (cont’d) Stabilizing developing country currencies Currency boards vs. dollarization (cont’d) Dollarization: residents of a country use the US dollar with or instead of their local currency Unofficial dollarization: residents hold assets and bank accounts denominated in dollars Official dollarization: US dollar replaces local currency Countries use dollarization to reduce risks for investors and avoid problems with domestic inflation and devaluations Carbaugh, Chap. 16

Currency boards vs. dollarization (cont’d) Stabilizing developing country currencies Currency boards vs. dollarization (cont’d) Dollarization implies acceptance of monetary policy set in the US by the Federal Reserve Less subject to domestic politics Cannot respond to local problems, or run deficits US Federal Reserve would not be a lender of last resort, however By holding dollars rather than US government bonds, the country gives an interest-free loan to the US Carbaugh, Chap. 16

Floating exchange rates Exchange rate system alternatives Floating exchange rates Currency prices established daily by an unrestricted market Large foreign exchange reserves are not needed to defend a fixed rate Rates respond to economic shifts; payments imbalances are corrected by rate changes Gives greater freedom to domestic economic policy Carbaugh, Chap. 16

Floating exchange rates (cont’d) Exchange rate system alternatives Floating exchange rates (cont’d) Works only if there is enough trade in a currency to make a viable market Greater freedom for domestic policy may mean poor economic policy has fewer immediate consequences Market rates may move erratically Carbaugh, Chap. 16

Bretton Woods and after Exchange rate system alternatives Bretton Woods and after Postwar economic system negotiated at Bretton Woods (1944) included adjustable pegged rates In practice, countries were reluctant to adjust their exchange rates, causing stresses that ended the system by 1973 In 1973, the adjustable peg system was replaced with a “managed float” system, which used government intervention in exchange markets to stay close to a target exchange rate Carbaugh, Chap. 16

Adjustable pegged rates Exchange rate system alternatives Adjustable pegged rates Carbaugh, Chap. 16

Managed floating exchange rates Exchange rate system alternatives Managed floating exchange rates Carbaugh, Chap. 16

Exchange rate stabilization and monetary policy Exchange rate system alternatives Exchange rate stabilization and monetary policy Carbaugh, Chap. 16

Exchange rate system alternatives Crawling peg Establishing a fixed exchange rate is difficult in an economy with high inflation A number of nations use a crawling peg, under which the fixed rate is frequently adjusted to account for inflation or other factors Frequent changes keep pegged rates from becoming unrealistic, and unannounced changes keep speculators at bay Carbaugh, Chap. 16

Exchange rate system alternatives Exchange controls Some nations (most, until the 1950s) use controls over foreign exchange to control the balance of payments At the extreme, the government can have a monopoly over buying and selling foreign exchange, capturing export income and limiting import expenditures Multiple exchange rates are also used, with different rates set for more or less desired transactions (discouraging imports, for example) Carbaugh, Chap. 16