Question

Marking the benchmarks along your route (ie, Bretton Woods, Smithsonian, Jamaica, Plaza, and the Louvre Accords, etc), trace this evolution from its origins in the gold standard, through the fixed and the floating exchange rate systems to the managed float system we are living in today (15 pts).

Answer 1

Exchange-Rate Systems:

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.

• Monetary Order -A set of laws and regulations that establishes the framework within which individuals conduct and settle transactions.
• Exchange-Rate System -A set of rules that determine the international value of a currency.
• Convertibility -The ability to freely exchange a currency for a reserve commodity (e.g., gold) or reserve currency.

There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged

The Gold Standard:

Under this system, the external value of all currencies was denominated in terms of gold with central banks ready to buy and sell unlimited quantities of gold at the fixed price. Each central bank maintained gold reserves as their official reserve asset.

The Gold Standard As an Exchange-rate System

1. Allowed the exchange of a currency, both domestically and internationally, at the mint parity rate for the currency.
2. Determines the international exchange value of the currency between gold and the currency.

Positive of a Gold Standard:

1. Creates long-run stability of the nation’s money stock and long-run stability of prices and exchange rates.
2. Changes in a nation’s money stock depend only on changes in the mining and production of monetary gold.  
3. Using monetary gold does not require a central bank.

• Nigative of a Gold Standard:

1. Has significant resource costs, such as minting and transportation costs.
2. Can result in inflation or a liquidity crisis if gold supply is unstable.
3. Can be very costly for a nation to maintain and exchange physical gold.
4. Prevents policymakers from pursing a discretionary monetary policy

The Bretton Woods System: Following the Second World War, the Bretton Woods system (1944–1973) replaced gold with the U.S. dollar as the official reserve asset.

International Monetary Fund- A supranational organization whose major responsibility is to lend reserves to member nations experiencing a shortage. •

World Bank -A sister institution of the International Monetary Fund that is more narrowly specialized in making loans to about 100 developing nations in an effort to promote their long-term development and growth.

The Bretton Woods Agreement-

• Pegged Exchange-Rate System -An exchange rate system in which a country pegs the international value of the domestic currency to the currency of another nation.
• Dollar-Standard Exchange-Rate System -An exchange rate system in which a country pegs the value of its currency to the U.S. dollar and freely exchanges the domestic currency for the dollar at the pegged rate.
• Devalue -Changing the pegged, or parity, value of a currency so that it takes a greater number of domestic currency units to purchase one unit of the foreign currency.
• Revalue -Changing the pegged, or parity, value of a currency so that it takes a smaller number of domestic currency units to purchase one unit of the foreign currency.
• Reserve Currency-he currency commonly used to settle international debts and to express the exchange value of other nation’s currencies.

Smithsonian:

The Smithsonian Agreement and the Snake in the Tunnel

Group of Ten (G10) -France, Germany, Japan, the United Kingdom, the United States, Canada, Italy, Belgium, the Netherlands, and Sweden

European Economic Community (EEC) -France, West Germany, Italy, Belgium, the Netherlands, and Luxembourg agreed to maintain exchange values by selling or buying each other’s currencies.

Flexible Exchange-Rate System -An exchange rate system whereby a nation allows market forces to determine the international value of its currency.

Jamaica Accords (1976) -A meeting of the IMF that amended the constitution of the IMF to allow each member nation to determine its own exchange-rate system.

Group of Eight (G8) -France, Germany, Japan, the United Kingdom, the United States, Canada, Italy, and Russia.

The Plaza Agreement-

• Group of Five (G5) -France, Germany, Japan, the United Kingdom, the United States.
• Plaza Agreement (1985) -A meeting of the G5 nations’ central bankers and finance ministers at the Plaza Hotel in New York. Announced that the exchange value of the dollar was too strong and that the nations would coordinate their intervention actions in order to drive down the value of the dollar.

The Louvre Accord-

• Group of Seven (G7) -France, Germany, Japan, the United Kingdom, the United States, Canada and Italy.
• Louvre Accord (1987) -A meeting of the G7 nations’ central bankers and finance ministers (less Italy). Announced that the exchange value of the dollar had fallen to a level consistent with “economic fundamentals” and that the central banks would intervene in the foreign exchange market only to ensure stability of exchange rates.
• Managed or Dirty Float -An exchange rate system in which a nation allows the international value of its currency to be primarily determined by market forces but intervenes from time to time to stabilize its currency.

Forms of Exchange-Rate Systems:

1. Crawling Peg -An exchange rate system in which a country pegs its currency to the currency of another nation but allows the parity value to change at regular time intervals.
2. Exchange-rate Band -A range of exchange values, with an upper and lower limit within which the exchange value of the domestic currency can fluctuate.
3. Crawling Band -A range of exchange values that combines crawling peg features with exchange-rate band flexibility.
4. Currency-Basket Peg -An exchange-rate system in which a country pegs its currency to the weighted average value of a basket, or selected number of currencies.

Independent Currency Authorities:

• Currency Board -An independent monetary authority that substitutes for a central bank. The currency board pegs the value of the domestic currency, and changes in the foreign reserve holdings of the currency board determine the level of the domestic money stock.
• Dollarization -A system in which the currency of another nation circulates as the sole legal tender of a nation.

Floating Exchange Rate:

A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate.

Floating exchange rate systems mean long-term currency price changes reflect relative economic strength and interest rate differentials between countries.

Short-term moves in a floating exchange rate currency reflect speculation, rumors, disasters, and everyday supply and demand for the currency. If supply outstrips demand that currency will fall, and if demand outstrips supply that currency will rise.

Extreme short-term moves can result in intervention by central banks, even in a floating rate environment. Because of this, while most major global currencies are considered floating, central banks and governments may step in if a nation's currency becomes too high or too low.

A currency that is too high or too low could affect the nation's economy negatively, affecting trade and the ability to pay debts. The government or central bank will attempt to implement measures to move their currency to a more favorable price.

Floating Versus Fixed Exchange Rates

Currency prices can be determined in two ways: a floating rate or a fixed rate. As mentioned above, the floating rate is usually determined by the open market through supply and demand. Therefore, if the demand for the currency is high, the value will increase. If demand is low, this will drive that currency price lower.

A fixed or pegged rate is determined by the government through its central bank. The rate is set against another major world currency (such as the U.S. dollar, euro, or yen). To maintain its exchange rate, the government will buy and sell its own currency against the currency to which it is pegged. Some countries that choose to peg their currencies to the U.S. dollar include China and Saudi Arabia.

The currencies of most of the world's major economies were allowed to float freely following the collapse of the Bretton Woods system between 1968 and 1973.

Fixed Exchange Rates -

• Promote sound macroeconomic policy
• Help reduce inflation
• Lead to a stable economic environment.
• Exchange rates may appreciate and reduce the competitiveness of the nation’s exporters.

Flexible Exchange Rates-

• Help a country overcome external shocks such as an unusual inflow of capital from abroad or a sudden price increases of resource.
• Introduce an additional element of uncertainty and additional volatility.