1. International Economics By Robert J. Carbaugh 8th 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, 1998
All Industrial Developing
Key currency countries countries countries
US dollar 60.3% 64.3% 57.1%
German mark
Japanese yen
British pound
French franc
ECU
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 can become impossible to defend and must be changed
Carbaugh, Chap. 16

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

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

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

12. Currency boards vs. dollarization
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
Carbaugh, Chap. 16

13. Currency boards vs. dollarization (cont’d)
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
Carbaugh, Chap. 16

14. Currency boards vs. dollarization (cont’d)
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
Carbaugh, Chap. 16

15. Currency boards vs. dollarization (cont’d)
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
Carbaugh, Chap. 16

16. 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

17. 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

18. 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

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

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

21. Exchange rate stabilization and monetary policy
Exchange rate system alternatives
Exchange rate stabilization and monetary policy
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