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

3. Free float None Gold standard currency board Automatic Adjustable peg Managed float Some discretion Exchange rate regimes Exchange rate Forex intervention Floating Fixed

4. 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.

5. 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.

6. 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

7. 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.

8. 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.

9. 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

10. 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.