International Economics By Robert J. Carbaugh 7th Edition

1. International EconomicsBy Robert J. Carbaugh7th Edition Chapter 16: Exchange-rate systems

2. Exchange rate systems Exchange rate practices • Floating rate - market determined • Float independently • Float in unison with a group of other countries • Adjust according to a formula • Fixed (“pegged”) rate • Peg to a single major currency • Peg to a basket of currencies • Peg to gold (obsolete) Carbaugh, Chap. 16

3. Exchange rate system alternatives Fixed exchange rates • Fixed exchange rates are normally used by small developing nations to peg to a key currency • For international settlement purposes • To stabilize import/export prices with the main trading partner • To reduce inflationary expectations • Pegs can be established • To a single currency • To a trade-weighted basked of currencies • To the special drawing right (SDR), a basket established by the IMF Carbaugh, Chap. 16

4. Exchange rate system alternatives Key currencies: Share of national currencies in total identified official holdings of foreign exchange, 1996 All Industrial Developing Key currency countries countries countries US dollar 58.9% 55.5% 62.5% German mark 13.6 16.4 10.6 Japanese yen 6.2 6.2 6.2 British pound 3.4 2.0 1.5 French franc 1.6 1.6 1.5 Swiss franc 0.7 0.1 1.4 Netherlands guilder 0.3 0.2 0.5 Other 15.3 18.0 12.4 Carbaugh, Chap. 16

5. Exchange rate system alternatives Fixed exchange rate system • Establish a par value against one or more key currencies • Create a stabilization fund to defend this fixed rate • Government must be ready to make good on all demands to convert to/from foreign currency • At some point, because of basic economic changes, the fixed rate cannot be defended and must be changed Carbaugh, Chap. 16

6. S1 F 2.90 G D1 Exchange rate system alternatives Exchange rate stabilization under fixed rates Preventing a dollar depreciation Dollars per Pound S0 E Official exchange rate 2.80 D0 Carbaugh, Chap. 16

7. S1 G F 2.90 D1 Exchange rate system alternatives Exchange rate stabilization under fixed rates Preventing a dollar appreciation Dollars per Pound S0 E Official exchange rate 2.80 D0 Carbaugh, Chap. 16

8. Exchange rate system alternatives Devaluation and revaluation • Devaluation is intended to lower the value of a currency relative to other currencies, correcting a balance of payments deficit • Revaluation is intended to raise the currency’s value relative to other currencies, correcting a surplus Carbaugh, Chap. 16

9. Exchange rate system alternatives Devaluation and revaluation • Legally, the changes are made in the par value of the home currency in terms of the reference currency • Economically, the effect is to change the value of the currency relative to the main trading partners - who may retaliate by changing their own fixed rates Carbaugh, Chap. 16

10. Devaluation and revaluation Devaluation/revaluation: legal and economic impact Shilling devaluation Shillings per SDR 2.2 shillings = 1 franc 2.0 shillings = 1 franc B C 770 700 A 350 385 Carbaugh, Chap. 16

11. Devaluation and revaluation Devaluation/revaluation: legal and economic impact Shilling revaluation Shillings per SDR 2.0 shillings = 1 franc 1.8 shillings = 1 franc A 700 630 B 350 Carbaugh, Chap. 16

12. Fixed exchange rate systems Currency boards vs. central banks • A currency board is a monetary authority empowered to issue domestic currency which can be converted at a fixed exchange rate • The rate is usually set in law, and the board must have foreign exchange reserves large enough to cover the domestic currency in circulation • Put another way, the domestic money supply is limited by the amount of foreign reserves on hand Carbaugh, Chap. 16

13. Fixed exchange rate systems Currency boards vs. central banks (cont’d) • Currency boards have become popular as a solution for countries which have not been able to control inflation or hold to a fixed exchange rate • The boards guarantee stability, and political independence (sometimes more than central banks) • But the boards also leave no flexibility in monetary policy to respond to changing circumstances and require large foreign exchange reserves; experience has been mixed Carbaugh, Chap. 16

14. Exchange rate system alternatives Floating exchange rates • Currency prices established daily by an unrestricted market • Large foreign exchange reserves are not needed to defend a fixed rate • Rates respond to economic shifts; payments imbalances are corrected by rate changes • Gives greater freedom to domestic economic policy Carbaugh, Chap. 16

15. Exchange rate system alternatives Floating exchange rates (cont’d) • Works only if there is enough trade in a currency to make a viable market • Greater freedom for domestic policy may mean poor economic policy has fewer immediate consequences • Market rates may move erratically Carbaugh, Chap. 16

16. Exchange rate system alternatives Bretton Woods and after • Postwar economic system negotiated at Bretton Woods (1944) included adjustable pegged rates • In practice, countries were reluctant to adjust their exchange rates, causing stresses that ended the system by 1973 • In 1973, the adjustable peg system was replaced with a “managed float” system, which used government intervention in exchange markets to stay close to a target exchange rate Carbaugh, Chap. 16

17. Exchange rate system alternatives Adjustable pegged rates Dollars per Pound + 1% Band Par value - 1% Dollar devaluation (depreciation) Dollar revaluation (appreciation) Time Carbaugh, Chap. 16

18. Exchange rate system alternatives Managed floating exchange rates Long-term change Short-term fluctuation Dollars per Mark Dollars per Mark S0 S0 B B A A C D1 D1 D0 D0 Carbaugh, Chap. 16

19. Exchange rate system alternatives Exchange rate stabilization and monetary policy Dollars per Pound Dollars per Pound S1 S0 S0 B S1 A C A C B D1 D0 D0 D1 Carbaugh, Chap. 16

20. Exchange rate system alternatives European Monetary Union • European Monetary System (1979) • Exchange rate mechanism set par values and required member nations to keep their currency within a band around that rate • Crisis of 1992-3 caused several nations to leave the EMS and allow their currencies to float Carbaugh, Chap. 16

21. Exchange rate system alternatives European Monetary Union (cont’d) • European Monetary Union (1999-) • Eleven of fifteen EU members agree to create a single central bank with one currency (the Euro) and one common monetary policy • System is intended to avoid the problems of the EMS, but its viability remains to be seen Carbaugh, Chap. 16

22. Exchange rate system alternatives Crawling peg • Establishing a fixed exchange rate is difficult in an economy with high inflation • A number of nations use a crawling peg, under which the fixed rate is frequently adjusted to account for inflation or other factors • Frequent changes keep pegged rates from becoming unrealistic, and unannounced changes keep speculators at bay Carbaugh, Chap. 16

23. Exchange rate system alternatives Exchange controls • Some nations (most, until the 1950s) use controls over foreign exchange to control the balance of payments • At the extreme, the government can have a monopoly over buying and selling foreign exchange, capturing export income and limiting import expenditures • Multiple exchange rates are also used, with different rates set for more or less desired transactions (discouraging imports, for example) Carbaugh, Chap. 16