McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. History of Exchange Rate Systems Chapter 33 Appendix

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gold Standard: A Fixed Exchange Rate System n Between 1867 and 1933, most of the world’s economies used the gold standard. n Gold standard – a system of fixed exchange rates in which the value of currencies was fixed relative to the value of gold and gold was used as the primary reserve asset.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gold Standard: A Fixed Exchange Rate System n Under the gold standard, the amount of money a country issued was directly tied to gold. n By fixing its currency’s price to gold, it automatically fixed its currency’s price to other currencies.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gold Standard: A Fixed Exchange Rate System n The gold specie flow mechanism was the long-run mechanism that maintained the gold standard. n Gold flowed out of the country when it experienced a balance of payments deficit and into the country with a balance of payments surplus.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gold Standard: A Fixed Exchange Rate System n The gold standard determined a country’s monetary policy. n This prevented governments from using expansionary monetary policy to deal with recessions.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gold Standard: A Fixed Exchange Rate System n The Depression led the U.S. to partially abandon the gold standard in n U.S. citizens could no longer exchange gold for their dollars, but instead were given silver. n That ended in the late 1960s.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gold Standard: A Fixed Exchange Rate System n In 1971, the U.S. totally cut off the relationship between dollars and gold.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Bretton Woods System: A Fixed Exchange Rate System n Bretton Woods system – an agreement that fixed exchange rates that governed international financial relationships from the period after World War II until 1971.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Bretton Woods System: A Fixed Exchange Rate System n The Bretton Woods system established the International Monetary Fund (IMF) and the World Bank. l The International Monetary Fund ( IMF ) arranges short-term loans between countries. l The World Bank makes longer-term loans to developing countries.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Bretton Woods System: A Fixed Exchange Rate System n The Bretton Woods system was not based on a gold standard. n A country would buy or sell other currencies when it experienced a balance of payments deficit or surplus.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Bretton Woods System: A Fixed Exchange Rate System n A stabilization fund was set up to make short-term loans to countries that ran out of currency reserves. n Exchange rate adjustments were overseen by the IMF.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Bretton Woods System: A Fixed Exchange Rate System n The Bretton Woods system helped to maintain the value of European currencies as they rebuilt after World War II. n It also provided a mechanism for long-term loans to Europe from the U.S.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Bretton Woods System: A Fixed Exchange Rate System n The IMF created a type of international money called special drawing rights (SDRs). n SDRs never became established as an international currency. n Instead, U.S. dollars served as official reserves for individuals and countries.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Bretton Woods System: A Fixed Exchange Rate System n By the early 1970s, the number of U.S. dollars held by foreigners exceeded the amount of U.S. gold.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Bretton Woods System: A Fixed Exchange Rate System n When France and other countries demanded gold for their dollars, the U.S. ended its policy of exchanging gold for dollars in n With that change, the Bretton Woods system was dead.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Present System: A Partially Flexible Exchange Rate System n The exchange rates of most Western countries are now allowed to fluctuate. n At various times, governments buy or sell their own currencies to affect the exchange rate.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Present System: A Partially Flexible Exchange Rate System n Under the present system, countries must continually decide whether a balance of payments surplus or deficit is temporary or permanent.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Present System: A Partially Flexible Exchange Rate System n Some countries have agreed to fix the exchange rates of their currencies to the currencies of other countries.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. History of Exchange Rate Systems End of Chapter 33 Appendix