Exchange-Rate Systems — Past to Present 69
Chapter Seven
Exchange-Rate Systems, Past to Present
I. Fundamental Issues
1. What is an exchange-rate system?
2. How does a gold standard constitute an exchange-rate system?
3. What was the Bretton Woods system of “pegged” exchange rates?
4. What post-Bretton Woods system of “flexible” exchange rates prevails today?
5. What are crawling-peg and basket-peg exchange-rate systems?
6. What is a currency board, and what is dollarization?
7. Which is best, a fixed or flexible exchange-rate system?
II. Chapter Outline
1. Exchange-Rate Systems
2. The Gold Standard
a. The Gold Standard as an Exchange-Rate System
b. Performance of the Gold Standard
c. The Collapse of the Gold Standard
3. The Bretton Woods System
a. The Bretton Woods Agreement
b. Performance of the Bretton Woods System
c. The Smithsonian Agreement and the Snake in the Tunnel
d. Policy Notebook: The International Monetary Fund—Dismantle or Reform?
4. The Flexible Exchange-Rate System
a. Economic Summits and a New Order
b. Performance of the Floating-Rate System
c. The Plaza Agreement and the Louvre Accord
5. Other Forms of Exchange-Rate Systems Today
a. Crawling Pegs
b. Currency Baskets
c. Independent Currency Authorities
d. Dollarization
e. Policy Notebook: Should Argentina Dollarize?
6. Fixed or Floating Exchange Rates?
7. Questions and Problems
III. Chapter in Perspective
This chapter provides a historical overview of various exchange-rate arrangements from the 1800s to today. The gold standard, the Bretton Woods system and the current “flexible” eras are explained. The rationale for the demise of the gold standard and the Bretton Woods systems are also presented. Although the majority of IMF members now practice some form of floating exchange rates, other exchange-rate mechanisms used in practice are explained. The currency board will be of particular interest to students because of its usage in Indonesia and Argentina in recent years. A brief discussion of dollarization is presented in the text as well.
IV. Teaching Notes
1. Exchange-Rate Systems
The exchange-rate system (rules governing the management of foreign exchange values) is a subset of the broader monetary order that establishes the framework for business transactions in a given country. Most developed countries use fiat money today although historically commodity money or commodity-backed money was common.
Teaching Tip:
The instructor may wish to stress that the value of fiat money is based solely on people’s faith in the system, or faith that the money will retain its purchasing power. Because fiat money is backed by faith in the economy and government, its value can be easily eroded by inflation and other events such as war that severely erode consumer confidence. Fiat money is easier to manage and cheaper to create since it is not tied to any commodity, but it creates the temptation for governments to create too much money, which is of course inflationary. Historically, inflation as a long-term phenomenon was very rare before the advent of fiat money.
2. The Gold Standard
The gold standard era lasted from the 1830s to the outbreak of World War I in 1914. [Convertibility of U.S. currency to gold was suspended during the Civil War from 1861–1865.] By the mid 1870s most major economies had established a gold standard with a set mint parity value at which their currency could be converted to gold. The U.S. mint parity rate was $20.646 per ounce of gold. Note that this was a commodity backed monetary order.100
a. The Gold Standard as an Exchange-Rate System
When more than one country established the value of its currency per ounce of gold then a defacto fixed exchange-rate system was in place. For example, as explained in the text, Great Britain had fixed the value of the pound at £4.252 per ounce of gold. Consequently, the exchange rate between the pound and the dollar was fixed at:
$20.646 per ounce of gold = £4.252 / ounce of gold or $1 = £0.2059.
If the exchange rate was instead $1 = £0.25, one could buy an ounce of gold in Britain for £4.252. Next one would then ship the gold to America and sell it for $20.646 and then convert their dollars back to pounds at the exchange rate of £0.25 /$ and wind up with £5.1615 per ounce of gold shipped. If transaction costs were less than £5.1615 – £4.252 = £0.9095 per ounce one could come out ahead.
b. Performance of the Gold Standard
Advantages of a gold standard:
· The major advantage of the gold standard was that it promoted long-run price stability because the supply of money was closely tied to the supply of a relatively rare commodity; this limited the money supply growth in economies using the gold standard. Hawks against inflation sometimes call for a return to the gold standard for this reason.
Maintaining a gold standard does not require a central bank, which some economies, notably the U.S., did not have at this time.
· The gold standard established fixed exchange rates, which some people feel promotes global trade and investment.
Disadvantages of a gold standard:
· Probably the largest disadvantage is the lack of flexibility in managing the money supply. In other words, short run price stability is sacrificed in order to maintain the exchange rate value and large swings in the economy are likely, as we had during the gold standard era.
· The cost of obtaining, storing and transporting gold is significant, and much higher than for fiat money systems.
· The supply of gold available was not and is not predictable, thus, the money supply could change unpredictably, leading to inflation or liquidity crises.
c. The Collapse of the Gold Standard
The Bank for International Settlements (BIS) was formed after World War I to facilitate payments between nations, particularly German war reparations. The BIS:
· assists central banks in managing and transferring reserves,
· conducts economic research and is the main clearinghouse for data on derivative usage today, and
· promotes research and international standard for regulations for the financial industry.
After WWI, the major economies attempted to return to the gold standard but were unsuccessful, primarily because the parity rates set were based on pre-war values. The British pound was thus highly overvalued relative to the French franc because France’s economy had suffered more from the war. The incorrect parity values, coupled by the onset of depression in England in 1926, followed by the U.S. in 1929, eventually broke the gold standard as countries refused to convert their currencies to gold at fixed prices.
3. The Bretton Woods System
In 1944, as World War II was drawing to a close, a new exchange-rate agreement was drawn up in Bretton Woods, New Hampshire. The primary architects of the system were Harry White of the U.S. Treasury and some British economist called John Maynard Keynes. The official title of the conference was the International Monetary and Financial Conference of the United and Associated Nations.
a. The Bretton Woods Agreement
The main components of the Bretton Woods System included the creation of the main architecture of the modern international financial institutions including:
· International Monetary Fund (IMF)
The original purpose of the IMF was to lend funds to member countries temporarily short of foreign currency reserves. Countries became members by paying a quota based on the size of their economy and their importance in foreign trade. The member’s ability to obtain IMF funds was also based on their quota. Twenty-five percent of the quota was required to be paid in gold, and the remainder could be paid in the national currency. Today, the primary functions of the IMF are still to provide funds to member nations experiencing a shortage of foreign reserves, to monitor and provide research on the economies and policies of member nations, and to serve as a forum for policy cooperation.
· The International Bank for Reconstruction and Development, called the World Bank
The World Bank was created to provide funds for long-term development in the post war economies then and in developing nations today. The World Bank lends to about 100 countries today.
· General Agreement on Tariffs and Trade (GATT)
GATT was designed to liberalize trade, by encouraging signers to convert non-tariff barriers to trade to tariffs and then to reduce the tariffs. GATT was replaced by the WTO.
Beyond the institutions, the Bretton Woods Agreement also created a new fixed or pegged exchange-rate system. The dollar was selected as the standard currency, and member countries agreed to peg their currency values relative to the dollar within a narrow band of ± 1% of the parity value. The U.S. in turn would maintain convertibility of the dollar to gold at a fixed price of $35 per ounce. This resulted in an indirect gold standard, whereby all other countries’ currencies were indirectly linked to gold via the peg to the U.S. dollar. With IMF approval a country could devalue (revalue) its currency’s par value by raising (lowering) the domestic currency price of the foreign currency. As a result of choosing to peg currency values to the U.S. dollar, the dollar became the primary reserve currency in the world.
Teaching Tip:
Ask students the following for discussion purposes:
How is the advent of the Euro likely to change the reserve currency status of the dollar? Is this good, or bad, for the U.S.?
b. Performance of the Bretton Woods System
For the Bretton Woods system to function properly, the world had to be confident in the value of the dollar. This implied that the U.S. had to maintain relatively lower inflation rates than other participating countries and that the U.S. had to be able and willing to convert dollars to gold at the fixed price. For most of the time from 1945 to 1968, the U.S. and the rest of the global economy experienced strong growth, in part fueled by rapid growth in international trade. Nevertheless, the possibility of a run on the dollar was always present. In 1960, the U.S. and other nations began intervening in the gold market in coordinated fashion to maintain the value of the dollar (the so called “gold pool”) against gold. In the 1960s, U.S. government spending grew rapidly due to the Vietnam War and Johnson’s Great Society programs. One of the results was U.S. inflation was higher than inflation elsewhere. This brought speculative pressure on the value of the dollar. In the late 1960s first England, then Germany revalued their currencies against the dollar, but other countries did not. With the growth of private capital that was also occurring, it began to be clear that the U.S. would not be able to maintain the value of the dollar and people began to sell dollars, buying other currencies and buying gold. These actions obliged member nations to buy dollars, which they did. In 1971, Germany bought about $2 billion before realizing the value of the dollar could not be maintained. On August 8, 1971, President Nixon closed the gold window, ending the convertibility of the dollar to gold at fixed prices.
In the late 1960s, the U.S. saw its current account surplus shrink and turn into a large deficit in 1971, increasing speculation against the dollar as U.S. gold reserves were no longer sufficient to maintain the value of the dollar.
c. The Smithsonian Agreement and the Snake in the Tunnel
The Smithsonian Agreement of 1971 was an attempt to restore order to the exchange-rate system. The Smithsonian agreement had three major components:
· it revalued most currencies’ parity values against the dollar,
· it widened the bands of swings in allowable currency values from 1% to 2.5% of parity values, and
· it devalued the dollar relative to gold.
Nevertheless, the U.S. did not reestablish the convertibility of dollars to gold, thereby probably dooming the system. The Smithsonian Agreement was in effect for only 15 months, even though Nixon referred to it as the “most significant monetary agreement in the history of the world.”
During this time (1972), the EEC began the Exchange Rate Mechanism, euphemistically known as the “snake in the tunnel.” At first, the EEC attempted to maintain currency values against the dollar as per the Smithsonian Agreement, but they abandoned this in 1973.
d. Policy Notebook: The International Monetary Fund—Dismantle or Reform?
For Critical Analysis: Currently there is only one International Monetary Fund. Is financial market stability best served by one single institution or by a number of institutions spread out over the globe?
There is no definitive way to answer this question. Helpful references are:
· “The International Monetary Fund 50 Years after Bretton Woods,” New England Economic Review, 1994
· “Rethinking the International Monetary System: An Overview,” J. Little and G. Olivei, New England Economic Review, Nov/Dec 1999
· “Why the Interest in Reforming the International Monetary System?” New England Economic Review, Sept. Oct 1999.
The primary advantage of creating regional IMFs would be the additional knowledge about the local area that the IMF might achieve in this way. The IMF has been accused of employing a “one size fits all” policy, encouraging fiscal and monetary austerity and more open markets in most cases. Perhaps rather than splitting the IMF, simply increasing staffing or reducing its charge as the policy notebook discussion indicates would work as well. The IMF operates under a serious handicap in that it does not have the authority to change corrupt systems and regimes, which is often the biggest problem faced by countries in crisis.
4. The Flexible Exchange-Rate System
In a floating rate system, market supply and demand forces set the exchange rate. In this environment, future expectations of relative economic performance set the exchange rate.
a. Economic Summits and a New Order
The Jamaica Accords in 1976 formalized the floating rate era by amending the IMF constitution to allow each member nation to determine its own exchange-rate system. Economic summits then began to meet routinely each year with varying numbers of nations such as the Group of 5 (G5) or the Group of 8 (G8).
b. Performance of the Floating-Rate System
The primary advantage of a floating-rate system is that it allows a country to focus monetary policy on domestic objectives, rather than using monetary policy to maintain the currency peg. Moreover, allowing the exchange rate to float may theoretically at least protect the economy from forced changes in real variables that would result due to shocks and other changes in comparative advantage between nations. It is doubtful that any fixed exchange-rate system could have survived the shocks of the 1970s and 1980s. The quid pro quo however is that the exchange rate could (and did) change dramatically (see Text Figure 7-4). In the late 1970s, the dollar began a steep decline, only to turn around after Paul Volcker (an inflation hawk) became chairman of the Federal Reserve. The dollar continued to more or less climb from 1979 to its peak in March 1985 when it began an even sharply decline than the previous climb.