1. Past, Present, and Future
Exchange Rate Systems
Past, Present, and Future

2. The Evolution of Money
The evolution of the international financial structure is really more about the evolution of domestic monetary systems
“Money” is any commodity which satisfies the following:
Medium of Exchange
Store of Value
Unit of Account

3. Prior to 561BC, Commodity were used as the medium of exchange
561BC – 1600AD, Coins created standardized weights of precious metal
The evolution of money
1600AD – 1972AD: Paper was used as a proxy for gold
1972 AD: Ties between gold and paper currency are completely severed

4. With a commodity money system, the money supply is simply equal to the gold stock= M S P M - +
L (i, Y ) PY = G
(1+i) 1 G
(1+i) M P = Y

5. Trade with commodity money
British ships sail to the US with gold to buy American goods
(US Exports = Inflow of gold)
American ships set sail for England – loaded with gold to buy British goods
(US Imports = Outflow of gold)

6. Note: the exchange rate is fixed at 1!!
If the US runs a trade deficit with Britain, then gold is flowing out of the US and into Britain
US prices fall relative to British prices which reduces the trade deficit P P G G M M
Note: the exchange rate is fixed at 1!!

7. Starting in the 1600’s, paper money began to replace gold/silver coins as the dominant medium of exchange

8. With 100% reserve banking, bank notes simply act as a proxy for the physical metal
Assets
Liabilities
$100
$100
Bank issues $100 worth of notes
Individual deposits $100 worth of gold
Reserve Ratio = 100%

9. However, banks would create more notes than it held in gold!
Assets
Liabilities
$100 (Gold)
$200 (Notes)
$100 (Loan)
The notes are loaned out to create a business loan
The bank prints $100 worth of new notes
Reserve Ratio = 50%

10. Now the supply of money us related to the supply of gold, but that relationship can change! (rr = reserve ratio) d S M = M S P M - +
L (i, Y ) PY G =
(1+i) rr 1 G
(1+i) M P = Y rr

11. When gold prices rose, individuals would redeem their gold and melt it down!
Assets
Liabilities
$50 (Gold)
$150 (Notes)
$100 (Loan)
Suppose $50 worth of gold is redeemed and melted down
Reserve Ratio = 30%

12. Note: the exchange rate is still fixed at 1!!
Still, bank notes didn’t interfere with the stabilizing force of gold flows – trade deficit countries would see a net outflow of gold which would contract the money supply
US prices fall relative to British prices which reduces the trade deficit P P S S M M M M
Note: the exchange rate is still fixed at 1!!

13. By 1860, most countries had adopted national currencies had adopted national currencies. The values of these currencies were maintained by tying them to gold

14. The Gold Standard (1860-1945) The Gold Standard had three basic rules:
In each country, currency was convertible into gold on demand at a fixed, pre-specified rate ($20.67 = 1 oz)
Each country allowed for coinage of gold at a mint
No restrictions on imports/exports of gold

15. The Gold Standard Liabilities Assets
Currency: $6,614,400 Gold: 10 tons (320,000 oz)
x $20.67/oz
$6,614,400
In this example, the reserve ratio is 100%. That is, the dollar is 100% backed by gold

16. The Gold Standard Liabilities Assets
Currency: $56,222,400 Gold: 10 tons (320,000 oz)
x $20.67/oz
$6,614,400
Other Assets: $49,608,000
During the gold standard, the ratio of gold to currency in the US was approximately 8.5 (Reserve Ratio = 11.7% backed by gold)

17. Gold and The Money Supply
Under a gold standard, the central bank can’t increase (or decrease) the money supply:
Suppose the central bank prints new money and uses it to buy gold:
This purchase forces up the market price of gold. When the market price rises above the official price ($20.67), individuals buy gold from the fed to sell on the open market – this reverses the central bank’s initial transaction.

18. Gold and The Money Supply
Under a gold standard, the central bank can’t increase (or decrease) the money supply:
Suppose the central bank prints new money and uses it to buy other assets (say, government securities):
As money in circulation increases (reserve ratio drops), the price level rises. As dollars lose their purchasing power, individuals start buying gold from the central bank – this, again reverses the original currency transaction

19. Devaluations Liabilities Assets
Currency: $56,222,400 Gold: 10 tons (320,000 oz)
x $20.67/oz
$6,614,400
Other Assets: $49,608,000
Current Reserve Ratio = 11.7%
Suppose that the US increases the official price of gold to $35/oz

20. Devaluations Liabilities Assets
Currency: $56,222,400 Gold: 10 tons (320,000 oz)
x $35.00/oz
$11,200,000
Other Assets: $49,608,000
Current Reserve Ratio = 20%

21. The Gold Standard as an Foreign Exchange System
P = $20.67
P* = L 4.87
$20.67
e =
= 4.25
L 4.87
If e = $5.00 (the pound is overvalued), an arbitrage opportunity exists
Buy gold in US ($1 = 1/20.67 oz)
Sell gold in Britain (1/20.67)*L4.87 = L.2356
Convert Pounds back to $s ( L.2356 * 5.00 = $1.18)

22. The Gold Standard as an Foreign Exchange System
The gold standard system still maintained the “price/specie” flow mechanism that stabilized trade balances
$20.67
P = $20.67
e =
= 4.25
L 4.87
P* = L 4.87
Trade deficits would tend to depreciate the dollar in currency markets – this would lead to gold flowing out of the US through arbitrage

23. The Bretton Woods System (1945 – 1972)
1L = $2.80
$35/oz.
625 Lira = $1
DM 2 = $1
The dollar became the “nominal anchor” - tying (indirectly) every other currency to gold

24. $35/oz.
DM 2 = $1
Assets
Liabilities
Assets
Liabilities
$100M (Gold)
$500M (Currency)
$30M ($)
DM 100M (Currency)
DM 10 (Gold)
$400M (T-Bills)
DM 30M (Bonds)
While gold would be the primary reserve asset in the US, $s were the primary reserve asset in Europe

25. $35/oz.
DM 2 = $1
Assets
Liabilities
Assets
Liabilities
$100M (Gold)
$500M (Currency)
$30M ($)
DM 100M (Currency)
DM 10 (Gold)
$400M (T-Bills)
DM 30M (Bonds)
- $5M ($)
- DM 10
Suppose that trade imbalances were causing a Deutschemark depreciation. Germany would be obliged to use its dollar reserves to buy back its currency – this costs them reserves!!

26. $35/oz.
DM 2 = $1
Assets
Liabilities
Assets
Liabilities
$100M (Gold)
$500M (Currency)
$30M ($)
DM 100M (Currency)
DM 10 (Gold)
$400M (T-Bills)
DM 30M (Bonds)
+$5M ($)
+ DM 10
However, if the US ran a trade deficit that was causing the dollar to depreciate (all other currencies are appreciating), again Germany would need to respond – buying dollars

27. The Twin Deficits Trade Balance Government Deficit
With the Vietnam War and Johnson’s Great Society programs, the US began running sizable trade deficits and government deficits – this creates a perceived weakness in the dollar.

28. Collapse of Bretton Woods
In : the British pond devalues to $2.40 (-14%). This triggers a massive run on US gold. The US loses $3.2B (20% of reserves) in three months! Private market prices of gold rise as high as $45! Convertibility of gold is suspended in open markets
: The US enters a recession. This creates even more speculation against the dollar.
: In an effort to stimulate the economy (and to get re-elected), Nixon pressures the Fed to cut interest rates
August 15, 1971: Nixon officially closes the gold window. Without implicit gold backing, the system totally collapses.

29. Creation of the Euro
1979: European Community Members (Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, UK) agree to the European Exchange Rate Mechanism
An artificial currency (European currency unit) is created. Each country fixes to the ECU. Margins of 2.25% are set for each bilateral rate.
1992: high German interest rates and a recession in Britain led George Soros to speculate against the pound. The pound is devalued by 25%. Italy and Britain drop out of the ERM
1998: Euro introduced. ECU converted to Euros at 1:1 rate.
January 2002: Euros begin circulating

30. The Eurozone
Current member countries (12): Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain
Will join in 2004 (10): Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia
Will join in 2007 (4): Bulgaria, Croatia, Romania, Turkey
Will most likely NOT join (3): Denmark, Sweden, UK

31. Requirements of the Eurozone
A Budget Deficit of no more than 3% of GDP
National debt of no more than 60% of GDP
Inflation within 1.5% of 3 best performing EU countries
Long term interest rates within 2% of 3 lowest interest rate EU countries

32. Can the Euro Last?
The common currency makes it much more difficult for countries to abandon the system.
Decision making power of ECB spread out over a large number of people – each with their own national interests
Monetary policy must compete with several fiscal policies.