INTERNATIONAL MONETARY

AND
FINANCIAL ECONOMICS
Exchange Rate
Third Edition
Systems

Past to Present
Joseph P. Daniels
David D. VanHoose

Copyright © South-Western, a division of Thomson Learning. All rights reserved.

 Concepts
• 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 nation’s
currency.
• Convertibility: The ability to freely exchange a
currency for a reserve commodity or reserve
currency.
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 The Gold Standard
• Came into effect in the mid-1870s when most
of the major economies unilaterally pegged to
gold.
• Nations fixed the value of their currency
relative to gold via a mint parity rate.
• Established the convertibility of a currency for
gold.
• Gold parity rates determined the exchange rate
between currencies.
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 The Gold Standard
• Pegging the value of each currency to gold,
established an exchange rate system by
indirectly establishing exchange rates.
• The mint parity rates could be used to
determine the exchange rate.

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 Gold Standard and Exchange Values
• Pegging the value
of each currency to
gold established an
exchange rate
system.
• The mint parity
rates determined
the exchange value
between two
currencies.
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 Gold Standard: Costs and Benefits
• The gold standard promoted long-run stability of
nation’s money stock and long-run stability of real
output, prices, and the exchange rate.
• It can be very costly to maintain a gold standard
because of significant resource costs, such as mining
and transportation costs.
• The political costs of maintaining the gold standard
became too significant for nations such as the United
Kingdom. By 1936 most nations had left the gold
standard.

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 The Bretton Woods Agreement
• The 1944 conference was originally named the
“International Monetary and Financial Conference of
the United and Associated Nations,” but became
better known as the Bretton Woods Conference.
• This conference established:
– The International Monetary Fund
– The International Bank for Reconstruction and
Development, or “World Bank”
– The General Agreement on Tariffs and Trade, or “GATT”
– The Bretton Woods Exchange Rate System
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 The International Monetary Fund
• A multinational organization of more than 180
member nations that seeks to encourage global
growth.
• The IMF attempts to promote
– international monetary cooperation
– effective exchange rate arrangements
• The IMF provides
– temporary and long-term financial for countries
experiencing balance-of-payments difficulties
– surveillance of macroeconomic conditions and policies.
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 The Bretton Woods System
•The value of the dollar was
pegged to gold and the dollar
was convertible to gold at the
mint parity rate.
•A pegged exchange rate
system in which a country pegs
the value of its currency to the
currency of another nation.
•In practice a dollar-exchange-
rate system as nations pegged
to the dollar and freely
exchanged the domestic
currency for the dollar at the
parity rate.

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 Changes in Parity Rates
• A devaluation is a situation in which a nation
changes the parity value of its currency so that
it takes a greater number of domestic currency
units to purchase the foreign currency.
• A revaluation is a situation in which a nation
changes the parity value of its currency so that
it takes a greater number of domestic currency
units to purchase the foreign currency.

10
 Collapse of Bretton Woods System
•The U.S. balance on goods and
services shifted to a surprising
deficit in 1971. These deficits
supported speculations that the
dollar was overvalued.
•Because of massive gold
outflows from the United
States, President Nixon
suspended convertibility of the
dollar in August 1971. This
ended the Bretton Woods
System.

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 Smithsonian Agreement
• In an attempt to restore order to the exchange market, 10
leading nations met at the Smithsonian on December 16
and 17, 1971.
• The “Smithsonian Agreement” was a new system of
exchange-parity values. Although this new system was
still a dollar-standard exchange-rate system, the dollar, was
still not convertible to gold.
• Nixon hailed this agreement as the “most significant
monetary agreement in the history of the world.”
• Smithsonian Agreement collapsed within 15 months and a
de facto system of floating rates emerged.

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 Economic Summits
• November 1975 French President, Valery
Giscard d’Estaing hosts the first economic
summit.
• Invited France, US, UK, Germany, Japan (G5).
• Italy added to represent the EU (G6).
• Agreed to a system of flexible exchange rates
and that countries would intervene when needed
to ensure stability.
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 Jamaica Accords
• January 1976 meeting of IMF member country
nations.
• Amended the articles of agreement of the IMF
to recognize flexible exchange rate systems.
• Member nations could adopt an arrangement of
their own choice.

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 Summits “Institutionalized”
• 1976 President Ford hosts a second summit.
• He invites Canada in addition to the G6
countries (G7).
• Summits now occur ever summer, rotating from
country to country.
• British PM, Tony Blair, added President Yeltsin
(Russia) as a “full member” for the 1998
Birmingham Summit (G8).
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 Performance of the U.S. Dollar
•Between 1981and 1985, the U.S. dollar appreciated relative to a weighted-
average value of several major currencies.
•Within two years, this appreciation had reversed.

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 Plaza Agreement
• The “Plaza Agreement” refers to a September 1985
meeting of the G5 central bankers and finance
ministers.
• The G5 bankers and ministers had been meeting
quietly for a number of years.
• Following this meeting they announced a belief that
the dollar was overvalued and that the nations
would intervene on a coordinated basis to drive
down the value of the dollar.

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 Louvre Accord
• The “Louvre Accord” refers to a February 1987
meeting of the G7 (less Italy) central bankers and
finance ministers.
• Following the meeting it was announced that the
ministers believed that the dollar was now “consistent
with economic fundamentals.”
• They agreed to intervene only when required to
ensure stability.
• A managed float system emerged from this accord.
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 The Euro
•The euro was launched in
January 1999.
•On its first day of trading it
reached a high of 1.19 ($/€).
•During the next two years
it depreciated relative to the
dollar.
•The euro eventually began
appreciating in 2002.

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 Exchange Rate Arrangements Today

•A nation’s
policymakers may
choose any type of
exchange rate system.
•Hence, there is a
wide range of
arrangements in place
at this time.

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 Dollarization
• Dollarization is the replacement of the domestic
currency with the currency of another nation.
• Two possible problems are the loss of seigniorage
revenues and the loss of discretionary monetary
policy.
• Seigniorage is the revenue created through the
manufacturing of money, and can be quite important
to developing nations.
• Examples are Panama, El Salvador and Ecuador.

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 Seigniorage
• On average, seigniorage finances 10.5% of
government spending.
• Comparison:
– US 2.0, Germany 2.4, Japan 5.6.
– Thailand 6.3, Indonesia 6.9, Malaysia 5.3, Brazil
19.0, and Argentina (before float) 62.0%.

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 Currency Board
• Establishes and maintains a hard peg between the
domestic currency and another currency.
• Issues domestic notes.
• Notes issued depend on the value of the exchange
rate and the amount of foreign reserves.
• Hence, monetary base is determined by the stock of
foreign reserves.

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 Currency Board - Continued
• Replaces central bank
– Cannot hold domestic debt.
– Not a lender of last resort
– Does not set reserve requirements
• Theoretically shielded from political pressure.
• Examples are Hong Kong, Estonia, and
Bulgaria.

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 Pegged and Pegged with Bands
• Parity value established relative to another currency.
• Central bank must conduct monetary policy to
maintain parity.
• “Parity band” allows limited flexibility on either side
of the parity rate.
• Bands can be very narrow or very wide.
• Examples are Bangladesh, China, and Egypt.

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 Currency Basket Peg
• Currency is pegged to a “basket” currencies.
• Parity value is the weighted average of a
basket of currencies in various quantities.
Each currency has an implicit weight assigned
to it.
• Provides some degree of flexibility against
individual currencies.
• Examples are Kuwait and Latvia.
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 Crawling Peg
• Parity value is changed on a periodic basis.
• Crawl is typically designed to compensate for
differences between the economic performance of the
pegging country and the country being pegged to.
• Bands may be established around the crawling parity
rate. Bands may be symmetric or asymmetric.
• Examples are Boliva, Costa Rica, and Nicaragua.

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 Nicaragua

Nicaragua’s crawling-peg
exchange-rate arrangement
allows for a 1 percent
monthly rate of crawl of
depreciation of the cordoba
relative to the U.S. dollar.

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 Managed Float
• Currency value is determined in the interbank
market.
• Monetary authority may intervene periodically
to maintain stability without any preannounced
path for the currency value..
• Sometimes referred to as a “dirty float.”
• Examples are Indonesia and India.

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 Floating
• Value of domestic currency is determined in
the foreign exchange market.
• Forces of supply and demand are the sole
determinants of currency value movements.
• Examples are United States, United Kingdom,
and Mexico.

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