1. Copyright ©2004, South-Western College Publishing International Economics By Robert J. Carbaugh 9th Edition Chapter 16: Exchange-Rate Systems

2. Carbaugh, Chap. 16 2 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)

3. Carbaugh, Chap. 16 3 Exchange rate system alternatives Exchange rate arrangements of IMF members, 2001 Exchange arrangements with no separate legal tender39 Currency board arrangements8 Conventional pegged (fixed) exchange rates31 Pegged rates within horizontal bands6 Crawling pegged exchange rates4 Exchange rates within crawling bands5 Managed floating exchange rates33 Independently floating exchange rates47 Number Exchange Arrangementof Countries

4. Carbaugh, Chap. 16 4 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

5. Carbaugh, Chap. 16 5 Exchange rate system alternatives Key currencies: Share of national currencies in total identified official holdings of foreign exchange, 2000 US dollar68.2%73.3%64.3% Japanese yen5.36.54.4 Pound sterling3.92.05.2 Swiss franc0.70.21.1 Euro12.710.214.6 Other9.27.810.4 AllIndustrialDeveloping Key currencycountriescountriescountries

6. Carbaugh, Chap. 16 6 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

7. Carbaugh, Chap. 16 7 Exchange rate stabilization under fixed rates Exchange rate system alternatives

8. Carbaugh, Chap. 16 8 Exchange rate stabilization under fixed rates Exchange rate system alternatives

9. Carbaugh, Chap. 16 9 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

10. Carbaugh, Chap. 16 10 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

11. Carbaugh, Chap. 16 11 Devaluation/revaluation: legal and economic impact Devaluation and revaluation

12. Carbaugh, Chap. 16 12 Devaluation/revaluation: legal and economic impact Devaluation and revaluation

13. Carbaugh, Chap. 16 13 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

14. Carbaugh, Chap. 16 14 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

15. Carbaugh, Chap. 16 15 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

16. Carbaugh, Chap. 16 16 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

17. Carbaugh, Chap. 16 17 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

18. Carbaugh, Chap. 16 18 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

19. Carbaugh, Chap. 16 19 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

20. Carbaugh, Chap. 16 20 Adjustable pegged rates Exchange rate system alternatives

21. Carbaugh, Chap. 16 21 Managed floating exchange rates Exchange rate system alternatives

22. Carbaugh, Chap. 16 22 Exchange rate stabilization and monetary policy Exchange rate system alternatives

23. Carbaugh, Chap. 16 23 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

24. Carbaugh, Chap. 16 24 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)