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Fixed Exchange Rate Systems

Fixed Exchange Rate Systems. I. Gold Standard: 1879-1934. 1) Define currency to gold 2) Maintain fixed relationship stock of gold + M 3) Allow gold freely traded  fixed exchange rates (why pay more for dollars when could take the gold and sell it for pounds?). Forced Macro Adjustments.

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Fixed Exchange Rate Systems

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  1. Fixed Exchange Rate Systems

  2. I. Gold Standard: 1879-1934 • 1) Define currency to gold • 2) Maintain fixed relationship stock of gold + M • 3) Allow gold freely traded fixed exchange rates (why pay more for dollars when could take the gold and sell it for pounds?)

  3. Forced Macro Adjustments • Suppose US balance of payments deficit gold flows to B to balance US must reduce M to maintain gold/$ relationship recession + higher interest rates in US/expansion + lower rates in B •  lower US demand B goods + pounds, greater B investment in US greater supply pounds back to fixed exchange rate

  4. Distasteful • M determined by S+D of currency, economy at control of foreigners, cannot adapt to own conditions •  collapse of gold standard by crisis of GD through devaluations (increase exports)

  5. II. Bretton Woods: 1944-1971 • Adjustable-peg system + International Monetary Fund: advantaged of fixed w/o costs • Req: Define currency in gold or dollars (based on gold) + maintain stable exchange rate

  6. How maintain? • 1) Official reserves • 2) Gold sales • 3) IMF borrowing: members contribute to IMF, makes currency available as needed (w/strings attached)

  7. Adjustable Peg • Persistent, sizable deficit “orderly” devaluation up to 10% (more required IMF ok)

  8. Demise Bretton Woods • Dollar “good as gold”: redeemable on demand for gold at fixed $35/ounce • Problem: 50s+60s persistent deficits (selling gold + dollars) dwindling gold reserves, increasing supply dollars • Correction dilemma: eliminate deficit (foreign dollar reserves) limit int’l trade + finance • 1971: ends $35/oz floating currency

  9. III. Managed Float • “almost” flexible: allowed to float to equilibrium w/ gov’t interventions • Support of managed float: 1) trade has maintained previous levels + grown, 2) Mexico + Asian Contagion not float but internal problems + pegging to dollar, 3) survived economic turmoil (oil embargo, US budget deficits, etc.)

  10. Concerns of float: 1) excessive volatile currencies threat to trade growth, 2) speculation plays too large a role, 3) not eliminated trade imbalances (US, Japan, China), 4) “non-system”

  11. IV. US Trade Deficit • Massive trade + current account deficits • 1) US growing faster than others (esp. Japan) boost imports • 2) Massive budget deficits crowding out + greater foreign investment • 3) Declining US saving rate (saving/total income) vs. rising foreign saving rate greater foreign investment + US consumption: current account deficit causes trade deficit, not simply result

  12. Implications • 1) Increased current consumption (and less US investment) • 2) Increased US debt (capital owned by foreigners: China, Japan, Germany, Dubai) • = at some point domestic consumption will have to fall

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