Exchange Rate Systems

International Economics
By Robert J. Carbaugh
9th Edition
Chapter 16:
Exchange-Rate Systems
Copyright ©2004, South-Western College Publishing

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 2
Exchange rate system alternatives
Exchange rate arrangements of

IMF members, 2001
Number
Exchange Arrangement of Countries
Exchange arrangements with no

separate legal tender 39
Currency board arrangements 8
Conventional pegged (fixed) exchange rates 31
Pegged rates within horizontal bands 6
Crawling pegged exchange rates 4
Exchange rates within crawling bands 5
Managed floating exchange rates 33
Independently floating exchange rates 47
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
Key currencies: Share of national currencies in

total identified official holdings of foreign exchange, 2000
All Industrial Developing

Key currency countries countries countries
US dollar 68.2% 73.3% 64.3%

Japanese yen 5.3 6.5 4.4
Pound sterling 3.9 2.0 5.2
Swiss franc 0.7 0.2 1.1
Euro 12.7 10.2 14.6
Other 9.2 7.8 10.4
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 can become
impossible to defend and must be changed
Exchange rate stabilization under fixed rates
Exchange rate stabilization under fixed rates
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

 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
Devaluation/revaluation: legal and economic impact
Devaluation/revaluation: legal and economic impact
Stabilizing developing country currencies
Currency boards vs. dollarization

 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
 Currency boards do not make loans or finance
government deficits
Currency boards vs. dollarization (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, which they sometimes replace)
 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

 Dollarization: residents of a country use the US
dollar with or instead of their local currency
 Unofficial dollarization: residents hold assets and bank
accounts denominated in dollars
 Official dollarization: US dollar replaces local currency
 Countries use dollarization to reduce risks for
investors and avoid problems with domestic
inflation and devaluations

 Dollarization implies acceptance of monetary
policy set in the US by the Federal Reserve
 Less subject to domestic politics
 Cannot respond to local problems, or run deficits
 US Federal Reserve would not be a lender of last
resort, however
 By holding dollars rather than US government
bonds, the country gives an interest-free loan to
the US
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
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
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
Adjustable pegged rates
Managed floating exchange rates
Exchange rate stabilization and monetary policy
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
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)

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International Economics

Copyright ©2004, South-Western College Publishing

Exchange rate practices

Exchange rate arrangements of

Exchange arrangements with no

Fixed exchange rates

Key currencies: Share of national currencies in

All Industrial Developing

US dollar 68.2% 73.3% 64.3%

Fixed exchange rate system

Exchange rate stabilization under fixed rates

Exchange rate stabilization under fixed rates

Devaluation and revaluation

Devaluation and revaluation

Devaluation/revaluation: legal and economic impact

Devaluation/revaluation: legal and economic impact

Currency boards vs. dollarization

Currency boards vs. dollarization (cont’d)

Currency boards vs. dollarization (cont’d)

Currency boards vs. dollarization (cont’d)

Floating exchange rates

Floating exchange rates (cont’d)

Bretton Woods and after

Adjustable pegged rates

Managed floating exchange rates

Exchange rate stabilization and monetary policy

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