1. International Economics By Robert J. Carbaugh 7th Edition
Chapter 16:
Exchange-rate systems

2. 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

3. 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

4. Exchange rate system alternatives
Key currencies: Share of national currencies in total identified official holdings of foreign exchange, 1996
All Industrial Developing
Key currency countries countries countries
US dollar 58.9% 55.5% 62.5%
German mark
Japanese yen
British pound
French franc
Swiss franc
Netherlands guilder
Other
Carbaugh, Chap. 16

5. 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 cannot be defended and must be changed
Carbaugh, Chap. 16

6. Exchange rate stabilization under fixed rates
Exchange rate system alternatives
Exchange rate stabilization under fixed rates
Preventing a dollar depreciation
Dollars per Pound S0
2.90 F D1 S1 G E
2.80
Official exchange rate D0
Carbaugh, Chap. 16

7. Exchange rate stabilization under fixed rates
Exchange rate system alternatives
Exchange rate stabilization under fixed rates
Preventing a dollar appreciation
Dollars per Pound S0 D1 G
2.90 F S1 E
2.80
Official exchange rate D0
Carbaugh, Chap. 16

8. 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

9. 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

10. Devaluation/revaluation: legal and economic impact
Devaluation and revaluation
Devaluation/revaluation: legal and economic impact
Shilling devaluation
Shillings per SDR
2.2 shillings = 1 franc
2.0 shillings = 1 franc B
770 C
700 A
350
385
Carbaugh, Chap. 16

11. Devaluation/revaluation: legal and economic impact
Devaluation and revaluation
Devaluation/revaluation: legal and economic impact
Shilling revaluation
Shillings per SDR
2.0 shillings = 1 franc
1.8 shillings = 1 franc
700 A
630 B
350
Carbaugh, Chap. 16

12. Currency boards vs. central banks
Fixed exchange rate systems
Currency boards vs. central banks
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
Carbaugh, Chap. 16

13. Currency boards vs. central banks (cont’d)
Fixed exchange rate systems
Currency boards vs. central banks (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)
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

14. 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

15. 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

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

17. Adjustable pegged rates
Exchange rate system alternatives
Adjustable pegged rates
Dollars per Pound
+ 1%
Par value
Band
- 1%
Dollar devaluation (depreciation)
Dollar revaluation (appreciation)
Time
Carbaugh, Chap. 16

18. Managed floating exchange rates
Exchange rate system alternatives
Managed floating exchange rates
Dollars per Mark
Long-term change
Dollars per Mark
Short-term fluctuation S0 S0 B B A C A D1 D1 D0 D0
Carbaugh, Chap. 16

19. Exchange rate stabilization and monetary policy
Exchange rate system alternatives
Exchange rate stabilization and monetary policy
Dollars per Pound
Dollars per Pound S1 S0 S0 B S1 C A A C B D1 D0 D0 D1
Carbaugh, Chap. 16

20. European Monetary Union
Exchange rate system alternatives
European Monetary Union
European Monetary System (1979)
Exchange rate mechanism set par values and required member nations to keep their currency within a band around that rate
Crisis of caused several nations to leave the EMS and allow their currencies to float
Carbaugh, Chap. 16

21. European Monetary Union (cont’d)
Exchange rate system alternatives
European Monetary Union (cont’d)
European Monetary Union (1999-)
Eleven of fifteen EU members agree to create a single central bank with one currency (the Euro) and one common monetary policy
System is intended to avoid the problems of the EMS, but its viability remains to be seen
Carbaugh, Chap. 16

22. 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

23. 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