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2.a Flexible Exchange Rates

2.a Flexible Exchange Rates. 1973 – present After the abandonment of the Bretton Woods system. The Jamaica Agreement (1973) abandoning Bretton Woods. Exchange Rate Arrangements.

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2.a Flexible Exchange Rates

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  1. 2.a Flexible Exchange Rates 1973 – present After the abandonment of the Bretton Woods system

  2. The Jamaica Agreement (1973) abandoning BrettonWoods

  3. Exchange Rate Arrangements

  4. If a central bank pegs or fixes its own currency against another (the US$, say), the central bank must be ready to buy its own money in exchange for dollars at the stated pegged or fixed exchange rate. Conversely, if foreign currency flows out of the economy – to pay for imports or to pay back foreign debts, for example – dollar reserves will flow out of the central bank. Foreign currency inflows – from exports, foreign investment, or foreign borrowing, for example - work through businesses, into their retail banks, and eventually add to central bank foreign reserves. Retail Banks Central Bank reserves businesses

  5. Generally speaking, foreign money coming into the country will either….. …be absorbed by the central bank and add to reserves …or force up the value of the local currency …or some combination thereof.

  6. Generally speaking, foreign money leaving the country will either….. …leavethe central bank and take away from reserves …or force down the value of the local currency …or some combination thereof.

  7. Problems with Currency Pegs

  8. Pegging/Fixing Currency Requires Reserves: Case Study Thailand In the early 1990’s, Thailand was a net importing country, funded by foreign investment. Indeed, there was enough foreign investment in Thailand to support Thailand’s imports AND add to BoT $ reserves. To keep the baht strong, the BoT kept interest rates high; it was “cheaper” for Thai business to borrow US$, thereby bringing in more US$ into Thailand and the BoT. Combined with a continued and persistent trade deficit, US$ reserves at the BoT where falling fast. In July 1997, with rapidly depleting foreign reserves, the BoT could not guarantee to give US$ for Thai baht, and had to float their currency. The baht fell as low as $1 = Bt 56 before stabilizing and rising gradually to where it is today……..the trade balance also improved…..and the BoT has replenished its reserves. In the mid-90’s, foreign investors lost confidence in Thailand, they took their investments back. And foreign banks stopped lending to Thailand; they wanted to be repaid instead. Bank of Thailand (BoT) pegs baht at $1 = Bt 26 BoT $ Reserves BoT

  9. Thailand’s Merchandise Trade (US$ bil.) Baht devaluation /float 1997 Source: IMF Financial Statistics Yearbook 1999

  10. Discussion Questions So, if a central bank has a fully free-floating exchange rate, what determines the value of the currency? The exchange rate is determined by supply and demand. The main factors that affect currency value(s) are… The main buyers and sellers of currencies include….

  11. In the next presentation, we will see that flows of foreign currency go through either the capital account or the current account. Capital Account = international monetary flows associated with investment, lending, etc. Current Account = international monetary flows associated with trade in goods and services. Balance of Payments = capital account flows + current account flows

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