© The McGraw-Hill Companies, 2008 Chapter 34 Exchange rate regimes David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

© The McGraw-Hill Companies, 2008 Key issues Exchange rate regimes and their implications for the world economy International policy co-ordination Policy co-ordination in Europe

© The McGraw-Hill Companies, 2008 Exchange rate regimes Exchange rateForex intervention Fixed Floating Free float None Gold standard currency board Automatic Adjustable peg Managed float Some discretion

© The McGraw-Hill Companies, 2008 The gold standard Characteristics of the gold standard: –The government of each country fixes the price of gold in terms of its domestic currency. –The government maintains convertibility of domestic currency into gold. –Domestic money creation is tied to the government's holding of gold. Adjustment to full employment is via domestic wages and prices –creating vulnerability to long and deep recessions.

© The McGraw-Hill Companies, 2008 The adjustable peg and the dollar standard In an adjustable peg regime, exchange rates are normally fixed, but countries are occasionally allowed to alter their exchange rate. Under the Bretton Woods system, each country announced a par value for their currency in terms of US dollars –the dollar standard.

© The McGraw-Hill Companies, 2008 The dollar standard Faced with a balance of payments deficit under the dollar standard countries could try to avoid monetary contraction by running down foreign exchange reserves but devaluation could not be postponed for ever, given finite reserves expansion of US money supply began to spread inflation world-wide.

© The McGraw-Hill Companies, 2008 Floating exchange rates Under pure/clean floating, forex markets are in continuous equilibrium the exchange rate adjusts to maintain competitiveness but in the short run, the level of floating exchange rates is determined by speculation –given that capital flows respond to interest rate differentials.

© The McGraw-Hill Companies, 2008 After the Dollar Standard After the BW system, two tendencies occured: The countries switched to the floating regimes They form monetary unions.

© The McGraw-Hill Companies, 2008 Fixed versus floating exchange rates Robustness –Bretton Woods system was abandoned because it could not cope with real and nominal strains –a flexible rate system is probably more robust Volatility –fixed rate system offers fundamental stability –flexible rate system is potentially volatile –but instability must be accommodated in other ways under a fixed rate system Financial discipline –fixed rate system imposes discipline and policy harmonisation.

© The McGraw-Hill Companies, 2008 The European Monetary System Established by members of the European Community (including the UK) in 1979 A system of monetary and exchange rate co- operation. Included the Exchange Rate Mechanism (ERM) –which the UK did not join until 1990 –and it left again in The system had some success in reducing exchange rate volatility –through co-ordination of monetary policy –plus exchange rate controls –even if it did not work for the UK.

© The McGraw-Hill Companies, 2008 From EMS to EMU A monetary union has –permanently fixed exchange rates within the union –an integrated financial market –a single central bank setting the single interest rate for the union. The Maastricht Treaty set criteria for EMU entry –to define ‘convergence’ The single currency area began in January 1999 with 11 member countries.

© The McGraw-Hill Companies, 2008 The Maastricht criteria Inflation rate –no more than 1.5% above the average of the inflation rate of the lowest 3 countries in the EMS Long-term interest rate –no more than 2% above the average of the lowest 3 EMS countries Exchange rate –in the narrow band of ERM for 2 years Budget deficit –no larger than 3% of GDP National debt –no greater than 60% of GDP