Ch 16 Exchange Rate Systems

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Ch 16 Exchange Rate Systems
For forty years I have analyzed stocks and other
money markets, and Ive made a remarkable
discovery. The Confederate dollar has risen in
value 7.4 per year since 1965, outperforming the
German mark, the Japanese yen and the Swiss
franc. Vincent W. Allen
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Ch 16 Exchange Rate Systems

• Nations Have to Choose
• Fixed rates ( pegged)
• Peg to a single currency
• Peg to a basket of currencies
• Peg to a commodity (gold not since 1971)
• Floating rates (free market forces)
• Float independently
• Float with other currencies
• Crawl according to a formula reflecting market
  fundamentals.

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Ch 16 Exchange Rate Systems

• Members of IMF can choose the system they prefer,
  as long as
• Exchange rates are not manipulated to gain unfair
  competitive advantage.
• Members act to counter short-term disruptions in
  exchange rates.
• Members consider other members interests when
  intervening in markets.

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Ch 16 Exchange Rate Systems

• Developing nations tend to choose a fixed system,
  pegged to a key currency.
• Stabilize domestic-currency prices of imports and
  exports.
• Prices are generally determined in industrial
  nations.
• Pegging to their currency can help keep prices
  stable.
• Nation can benefit from lower inflation rates of
  industrial nation.
• Shows commitment to stable currency.

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Ch 16 Exchange Rate Systems

• Developing nations can peg to single currency or
  basket of currencies.
• Nations that have relationships with one primary
  trade partner will peg to their partners
  currency
• Pegging to currency basket done by nations with
  multiple major trade partners.
• Basket is weighted based on volume of trade done
  with each nation.
• Reduces the effect of single exchange rate
  fluctuations by responding to several exchange
  rates.
• Special Drawing Rights (SDR or XDR)
• First established as basket of five currencies
  established by IMF containing currencies of
  members with largest exports in previous five
  years.
• Now only four currencies euro, dollar, yen and
  pound.

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Ch 16 Exchange Rate Systems

• Par Value / Official Exchange Rate
• Under fixed system, nation assigns a par value in
  terms of other currencies (or gold before 1971)
• When these par values are compared, official
  exchange rates can be determined.
• ex. US buys gold at 35/oz.
• British buy gold at 12.50/oz.
• 35/12.5 2.80/
• Today, fixed par values are set based on US
  dollar.

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Ch 16 Exchange Rate Systems

• Exchange Stabilization Fund
• Currencies bought and sold to keep exchange rate
  at official rate.

• At D1, equilibrium exchange rate 1.50. Assume
  official exchange rate also 1.50
• If interest rates increase in Britain, demand for
  pound will increase, shifting demand curve to
  right.
• Free market would let exchange rate float up to
  1.60
• Excess demand for British pounds excess supply
  of US dollars in Britain.

Price of Pounds
S
1.50
D1
Qty Pounds
Q1
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Ch 16 Exchange Rate Systems

• Exchange Stabilization Fund
• Currencies bought and sold to keep exchange rate
  at official rate.

• Fixed exchange system will attempt to keep market
  rate official rate.
• US dollar has depreciated relative to pound. US
  exchange stabilization fund will try to keep
  dollar from depreciating more and return it back
  to official rate.
• Purchase of excess supply of dollars with pounds
  will increase supply of pounds, shifting supply
  curve right, lowering exchange rate.

Price of Pounds
S1
1.50
D1
Qty Pounds
Q1
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Ch 16 Exchange Rate Systems

• Exchange Stabilization Fund
• Currencies bought and sold to keep exchange rate
  at official rate.

• Effective for short run stabilization, but long
  run disequilibrium can be from market fundamental
  changes.
• May need to change official rate.

Price of Pounds
S1
1.50
D1
Qty Pounds
Q1
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Ch 16 Exchange Rate Systems

• Devaluation (Revaluation)
• Legal redefinition of currencys par value
  (official rate)
• Devaluation causes home currencys exchange value
  to depreciate, counteracting balance of payments
  deficit.
• Raising home price of foreign currencies makes
  exports cheaper and imports more expensive.
• Expenditure-switching instrument switches
  domestic expenditures from foreign to home goods
• Exports rise, imports fall. (Revaluation works in
  opposite direction switches expenditures from
  domestic to foreign goods, imports rise, exports
  fall)
• Usually done in secret to avoid speculative
  trades..

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Ch 16 Exchange Rate Systems

• Stabilization Devices in Developing Nations
• 1. Currency Board
• Monetary authority that issues currency
  convertible into anchor currency at any time.
  Anchor currency is one that is stable and
  internationally accepted usually US dollar,
  Euro or British pound.
• Exchange rate between home and anchor currencies
  set by law, so difficult to change.
• Currency board must maintain at least 100 of
  anchor currency in reserve (anchor backs
  domestic currency)
• Government can finance expenditures only by
  taxing or borrowing, NOT by printing new money.

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Ch 16 Exchange Rate Systems

• Stabilization Devices in Developing Nations
• 1. Currency Board
• Benefits
• Monetary system more credible and predictable
• Prevents inflationary tendencies
• Promotes trade, investment and economic growth
  due to increased confidence in currency.
• Disadvantages
• Reduces economic independence of nation
• Reduces ability to use discretionary monetary
  policy
• Subject to panic because there is no lender of
  last resort.

(Ex. Brunei, Antigua, Estonia, Lithuania, Hong
Kong, until 2002, Argentina)
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Ch 16 Exchange Rate Systems

• Stabilization Devices in Developing Nations
• 2. Dollarization
• When residents of a nation use US dollar
  either with or instead of their currency.
• a) Unofficial (partial)
• Usually follows functions of money as stages of
  development Store of value, medium of exchange,
  unit of account.
• As store of value, much of wealth is held in form
  of dollar denominated bank deposits.
• Usually done to protect against high inflation
  rates.
• As medium of exchange, dollars are used for large
  purchases, i.e. houses, cars, property.

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Ch 16 Exchange Rate Systems

• Stabilization Devices in Developing Nations
• 2. Dollarization
• When residents of a nation use US dollar
  either with or instead of their currency.
• b) Official (full)
• Domestic currency is eliminated and replaced with
  US dollar.
• Only one currency (dollar) is given legal status
  as currency, but private parties can contract to
  use any currency they choose.

Unofficially dollarized Bolivia Mexico Peru Turkey
Argentina
Officially dollarized East Timor Guam Marshall
Islands Panama Puerto Rico
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Ch 16 Exchange Rate Systems

• Stabilization Devices in Developing Nations
• 2. Dollarization
• When residents of a nation use US dollar
  either with or instead of their currency.
• Effects
• Dollarized countries are dependent on US monetary
  policy.
• If their business cycles dont coincide with
  ours, Fed cant help them.
• Fed will not be their lender of last resort.
• Country cannot obtain seigniorage from monetary
  system

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Ch 16 Exchange Rate Systems

• Floating Exchange Rates
• Values are not set by official rates or par
  values, but by market forces.
• 1. Adjustable Pegged Rates
• Developed at Bretton Woods in 1944
• Somewhere between completely fixed and freely
  floating with market.
• Currencies are tied to each other with band of
  long-run equilibrium where rates are allowed to
  fluctuate (usually 1 on either side of parity).
• US left the Bretton Woods standard in 1971,
  allowed dollars to float.

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Ch 16 Exchange Rate Systems

• Floating Exchange Rates
• Values are not set by official rates or par
  values, but by market forces.
• 2. Managed Float
• Adopted by US and other industrial nations in
  1973.
• Nation can determine degree to which they
  intervene in FX market.
• Short run market intervention to stabilize
  rates. Long run market forces determine rates.
• Fed uses buying and selling of currencies, and
  monetary policy to stabilize short run rates.

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Ch 16 Exchange Rate Systems
Floating Exchange Rates Values are not set by
official rates or par values, but by market
forces. 2. Managed Float Example to
counteract appreciation of currency
Price of Pounds

• Starting at A, decrease in demand for pounds
  causes dollar to appreciate.
• Expansionary policy will lower interest rates in
  US, decrease supply of pounds, and push price of
  pound back up to original rate, restoring
  equilibrium.

S1
A
1.50
D1
Qty Pounds
Q1
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Ch 16 Exchange Rate Systems
Floating Exchange Rates Values are not set by
official rates or par values, but by market
forces. 2. Managed Float Example to
counteract appreciation of currency
Price of Pounds

• Fed has to choose between stabilizing exchange
  rates or responding to recessionary /
  inflationary gaps.

S2
S1
C
A
1.50
B
1.40
D1
D2
Qty Pounds
Q3
Q2
Q1