4. International Monetary System and Foreign Exchange Rate Policy International Financial Services 1 Karel Bruna

Introduction The institutional arrangements that countries adopt to govern exchange rates are known as the international monetary system An eclectic currency arrangement (1973 – present) The International Monetary Fund classifies all exchange rate regimes into eight specific categories –Exchange arrangements with no separate legal tender –Currency board arrangements –Other conventional fixed peg arrangements –Pegged exchange rates within horizontal bands –Crawling pegs –Exchange rates within crawling pegs –Managed floating with no pre-announced path –Independent floating

Main Characteristics of Fixed (Pegged) Exchange Rates central bank defines central parity and oscillation bands market exchange rate fluctuates within oscillation bands central bank intervenes at exchange rate on lower or upper oscillation band central bank manages portfolio of foreign exchange reserves unsustainable position results in devaluation or revaluation

Main Characteristics of Floating Exchange Rates central bank defines neither central parity nor oscillation bands market exchange rate fluctuates free of central bank’s interventions (floating exchange rate regime) market exchange rate is intervened in case of instability or strong trends (managed exchange rate regime) dynamics of exchange rate is a result of demand for and supply of foreign currency central bank does not need high level of foreign exchange reserves

Main Problems of Fixed/Floating Exchange Rates Fixed currency regimes –foreign exchange interventions on upper band are prone to be ineffective –risk of monetary crises –foreign exchange interventions changes liquidity of bank system Floating currency regimes –existence of foreign exchange risk –higher volatility of exchange rates –strong trend reversals

IMF Statistics

US Dollar and Chinese Renminbi

History of International Monetary Systems Gold Standard (from 19th century to WWI or WWII) Bretton Woods (from 1944 to early 70´s) Floating Regimes (from early 70´s to now) ERM I and ERM II (from 1979 (replaced in 1998) to now)