Chapter 34 Exchange rate regimes

1
Chapter 34Exchange rate regimes

• David Begg, Stanley Fischer and Rudiger
  Dornbusch, Economics,
• 7th Edition, McGraw-Hill, 2003
• Power Point presentation by Alex Tackie

2
Key issues

• Exchange rate regimes and their implications for
  the world economy
• International policy co-ordination
• Policy co-ordination in Europe

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Exchange rate regimes
Exchange rate
Forex intervention
Floating
Fixed
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The gold standard

• Characteristics of the gold standard
• The government of each country fixes the price of
  gold in terms of its domestic currency.
• The government maintains convertibility of
  domestic currency into gold.
• Domestic money creation is tied to the
  government's holding of gold.
• Adjustment to full employment is via domestic
  wages and prices
• creating vulnerability to long and deep
  recessions.

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The adjustable peg and the dollar standard

• In an adjustable peg regime, exchange rates are
  normally fixed, but countries are occasionally
  allowed to alter their exchange rate.
• Under the Bretton Woods system, each country
  announced a par value for their currency in terms
  of US dollars
• the dollar standard.

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The dollar standard

• Faced with a balance of payments deficit under
  the dollar standard
• countries could try to avoid monetary contraction
  by running down foreign exchange reserves
• but devaluation could not be postponed for ever,
  given finite reserves
• expansion of US money supply began to spread
  inflation world-wide

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Floating exchange rates

• Under pure/clean floating, forex markets are in
  continuous equilibrium
• the exchange rate adjusts to maintain
  competitiveness
• but in the short run, the level of floating
  exchange rates is determined by speculation
• given that capital flows respond to interest rate
  differentials.

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Fixed versus floating exchange rates

• Robustness
• Bretton Woods system was abandoned because it
  could not cope with real and nominal strains
• a flexible rate system is probably more robust
• Volatility
• fixed rate system offers fundamental stability
• flexible rate system is potentially volatile
• but instability must be accommodated in other
  ways under a fixed rate system
• Financial discipline
• fixed rate system imposes discipline and policy
  harmonization.

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International policy co-ordination

• Can a concerted attempt by a group of countries
  to co-ordinate their policy bring benefits to the
  group?
• Externality argument
• non-co-operative policy can impose costs that can
  be avoided by agreement between governments
• Reputation argument
• co-ordination may allow individual governments to
  pre-commit to policies that would otherwise not
  be credible

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The European Monetary System

• Established by members of the European Community
  (including the UK) in 1979
• A system of monetary and exchange rate
  co-operation.
• Included the Exchange Rate Mechanism (ERM)
• which the UK did not join until 1990
• and it left again in 1992.
• The system had some success in reducing exchange
  rate volatility
• through co-ordination of monetary policy
• plus exchange rate controls
• even if it did not work for the UK.