Foreign Exchange System

1

• Foreign Exchange System
• 1) Gold Standard System
• a. Ex. rate pegged to a certain of gold.
• b. Gold convertibility maintained.
• (
  )
• Advantage
• a. Stability in F.X. system.
• b. Built-in adjustment mechanism.
• (ability to correct the problem by
  itself)
• Trade
  Trade
• deficit Gold Ms Price Export
  Balance
• Disadvantage

2

• 2) Flexible (Floating) Exchange System
• Money was supplied w/o any linkage
• to gold ex. rate was solely decided
• by ( ).
• Demand for Y U.S. demand for Japanese
  product
• Supply of Y Japanese demand for U.S
  product
• Adv
• a.
• b.
• Disadv.
  
• a.
• b.
• World trade didnt increase!

Y
S


D

3

• 3) Fixed Ex. (Bretton Woods) System
• a. all currencies were pegged to and
  was pegged to
• gold.
• b. obligated to maintain their ex. rates
  with respect to
• within ( ) margin.
• Adv. relatively stable.
• Disad a. a large of FX will be needed to
  defend fixed rate.
• BOP deficit will put a pressure
  on them to
• ( ) their
  currencies. To defend the fixed rate
• under this pressure, they need
  to create an
• artificial demand for their own
  currency
• (how?
  ).
• This means they have to pay in FX
  ( ) and
• that will make them to lose even
  more FX.
• b. When they run out of FX, there
  will be a chaos.

4

• Other problems under Bretton Woods System
• A. Shortage of international money
• a.
• b.
• B. Mistrust of
• a.
• b.
• Jamaica Agreement (1976)
• a. abolished Bretton Woods System
• b. each country selected its own F.X. system
• c. all kind of variations concurrently
  exist.

5

• Exchange-rate Regimes (IMF)
• No legal tender use other countrys currency or
  share common
• currency among the monetary union ( El
  Salvador, EU, CFC).
• 2) Conventional peg peg to a major currency
  w/narrow margin (Egypt).
• Peg with band peg to a major currency w/wider
  margin(i.e. 2.5).
• Crawling Peg periodically adjust in small
  amount, at pre-announced
• rate (i.e.0.05 daily) in response to a
  basket/indicator(China, Aussie).
• Crawling with band periodically adjusted with a
  certain margin for
• fluctuation (Denmark to Euro).
• Managed floating w/no pronounced path Monetary
  authorities
• actively intervene to establish at a
  certain level (India).
• Independent floating market determined but
  occasional intervention
• to prevent undue fluctuation (US, Canada,
  Japan, Mexico).

6

• Exchange-rate Regime
• stability
• no separate legal tender
• conventional peg
• peg
  with band
• 
  crawling peg
• 
  managed floating
• 
  independent
  floating
• 
  flexibility

7

• Government Intervention in FX market
• Governments intervene in FX market thru
  open market
• operation to achieve a certain
  objectives.
• US FRB has an authority to intervene FX
  market
• using Exchange Stabilizing Fund.
• Open Market Operation
• 1. when US is too week, FRB buys to
  appreciate it
• by creating additional demand for (
  sell F.X.).
• 2. when US is too strong, FRB sells to
  depreciate it
• by providing additional supply of (
  buy F.X.).
• In case we are concerned about high
  inflation
• we can do Sterilized Intervention.
• a. sell (buy F.X.) to depreciate in FX
  market and
• b. sell T- Bill to siphon out extra
  gradually to check
• inflation under control.

8

• Sterilized Intervention
• If we have too strong , FRB may want to
• devaluate by increasing supply of
• ( buy FX ).
• However, this additional supply of can cause
• inflation domestically.
• Thus, in order to depreciate without causing
• inflation, FRB simultaneously can do
  followings
• a. sell (buy F.X.) to depreciate in FX
  market and
• b. sell T- Bill to siphon out extra
  gradually to check
• inflation under control.

9

• Chinese Ex. Rate System
• Accused that Yuan(RMB) has been deliberately
  under-
• valued more than 40 (unfair advantage to
  their export).
• Recently they abandoned decade long pegged
  system.
• Adopted crawling peg that allows to fluctuate
  within
• 0.3 band (0.55/18/07) set each day
  based on a
• basket of F.X.
• Reasons for limited convertibility (govt
  approval)
• 1. free flow of foreign capital can
  destabilize their
• economy.
• 2. concern for capital exodus by the
  citizens in crisis.
• Recently they start to allow their currency
  appreciation
• to some extent but still significantly
  undervalued.

10

• International Monetary Fund
• Objective
• To promote stability in F.X. system and
  supervise operation of FX
• system of the member countries.
• Achievements
• a. Creation of SDR (artificial intl money) to
  increase international liquidity.
• b. Creation of stand by reserve loan to help
  the countries w/BOP deficit to maintain fixed
  rate.
• c. Provision of loans to debt stricken countries.
• Recent Issues associated w/ IMF.
• 1) The conditions for IMF loan are controversial
• (economic sovereignty of the borrower is
  lost).
• 2) Exercises too much political power.
• 3) Necessity to increase of Fund
• many countries in trouble simultaneously.
• 4) Fairness in distributing the fund.
• 5) Inability to punish the countries who
  exercise
• unfair practices in exchange rate
  management.