Exchange-Rate Systems

and Currency Crises

Chapter 15

Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Exchange Rate Systems
1) fixed rate
a) also known as pegged exchange rate
b) anchored to the value of one other
currency or a group of currencies
2) floating rate
a) determined by market forces
b) float independently or with a group
of other currencies
IMF Principles
1) Member nations must avoid manipulating
exchange rates in order to impact balance of
payments
2) Members should intervene to counteract
disruptive short term exchange rate
movements
3) Members should take into account the
impact of intervention policies on other
members
Impossible Trinity
It is not possible for a country to maintain all
three of the following:

1) free capital flows

2) a fixed exchange rate
3) independent monetary authority
Impossible Trinity (continued)
A country can choose any two of the three:
Impossible Trinity (examples)
1) U.S. allows free flow of capital &
maintains monetary authority but does not
have a fixed exchange rate
2) Hong Kong has a fixed exchange rate &
allows free flow of capital but does not have
independent monetary authority
3) In the past, China had a fixed and
maintained monetary authority but did not
allow the free flow of capital
Fixed Exchange Rates
Fixed exchange rates are the norm for
developing economies. By tying their
currencies to a key currency – that of a
larger, more developed nation they promote
1)a means of international settlement
2)stabile prices for imports/exports
3)limits on inflationary pressure
Fixed Exchange Rates (continued)
Under a fixed exchange rate system
governments maintain
o par value for their currencies
o an official exchange rate determined by
comparing par values
o an exchange rate stabilization fund to buy
and sell foreign currencies in order to
preserve the official exchange rate
 Preventing Depreciation
If the demand for
the euro P Market for Euros
increased, the S1
value of the euro S2
$1.70
would rise and
the value of the
dollar would fall. $1.50

In order to
maintain the fixed D2
exchange rate,
D1
the U.S. would
Q
use its reserve of
euros to buy
dollars.
 Preventing Appreciation
If the supply of
the euro P Market for Euros
increased, the S1
value of the euro S2
would fall and the
value of the dollar
would rise. $1.50

In order to
$1.25
maintain the fixed D2
exchange rate,
D1
the U.S. would
Q
use dollars to buy
euros.
Devaluation & Revaluation
Devaluation
o legal reduction of a currency’s par value
o market impact termed depreciation
o counters a balance of payment deficit by making
exports less expensive
Revaluation
o legal increase of a currency’s par value
o market impact termed appreciation
o counters a balance of payment surplus by
making imports less expensive
Bretton Woods System
1) response to crises of Great Depression when
floating exchange rates had been unsuccessful
2) Bretton Woods created a semi-fixed system
known as adjustable pegged exchange rates
3) currencies values tied to each other
4) nations to use fiscal and monetary policies first
to address balance of payments disequilibria
5) last resort was to re-peg currencies; greater than
10% change required IMF permission
Floating Exchange Rates
o also known as flexible exchange rates
oequilibrium exchange rate determined by
demand for and supply of home currency
ochanges in exchange rate correct payments
imbalance by changing the effective cost of
imports and exports
owill not fluctuate erratically unless there is
significant instability in financial markets
 Depreciation & Exports
If real income in Market for Euros
P
the U.S.
S1
increased, then
demand for $1.70
imports and
demand for the $1.50
euro would
increase. The
value of the euro D2
would rise and D1
the value of the
Q
dollar would fall.
 Depreciation & Exports (cont.)
Since more dollars are required to purchase a euro,
the dollar has depreciated.
1)As a result, U.S. goods will become less
expensive to European citizens leading to more
exports from the U.S.
2)European goods will become more expensive to
U.S. citizens leading to fewer imports to the U.S.
$150 U.S. auto part 100€ French wine
before $150 = 100 € before 100 € = $150
after $150 = 88.2 € after 100 € = $170
(150÷170)
 Appreciation & Imports
If real income in P Market for Euros
the U.S. declined,
then demand for S1
imports and
demand for the
euro would also $1.50
decrease. The
value of the euro $1.25
D1
would fall and the
value of the dollar D2
would rise. Q
 Appreciation & Imports (cont.)
Since fewer dollars are required to purchase a
euro, the dollar has appreciated.
1)As a result, U.S. goods will become more
expensive to European citizens leading to fewer
exports from the U.S.
2)European goods will become less expensive to
U.S. citizens leading to more imports to the U.S.
$150 U.S. auto part 100€ French wine
before $150 = 100 € before 100 € = $150
after $150 = 120 € after 100 € = $125
(150/125)
 Arguments on Floating Exchange
Advantages Disadvantages

Fixed • simplicity and clarity of • loss of independent

exchange-rate target monetary policy
• automatic rule for • vulnerable to
monetary policy speculative attacks
• controls inflation
Floating • continuous adjustment • conducive to
in balance of payments inflation
• simplified institutional
• disorderly markets
arrangements can disrupt trade and
investment patterns
• independent monetary • reckless financial
and fiscal policies policies by government
Managed Floating System
o intervention to stabilize rates in short run with
market forces determining rates in long run
o informal guidelines established by IMF
o clean float – free-market forces of supply and
demand determine equilibrium
o dirty float – central banks intervene to promote
depreciation of their currencies
o leaning against the wind – intervention to reduce
fluctuations in the short run only
 Managed Float Example

permanent change in demand temporary increase in demand -

to D1 – exchange rate allowed central bank sells francs while
to increase demand is D1 until return to D0
 Monetary Policy

if demand for pounds decreases if demand for pounds increases

Fed increase MS lowering rates Fed decrease MS raising rates
decreasing demand for dollars increasing demand for dollars
Crawling Peg
o uses small, frequent changes in par value
to correct balance of payments disequilibria
oprimarily nations with high inflation
odiffers from adjustable pegged rates under
which par values change infrequently
ocrawling peg is appropriate for developing
nations but not for industrialized nations
whose currencies provide international
liquidity
Currency Crises
o also known as speculative attacks
oweak currency depreciates significantly as
a result of selling
ocan substantially reduce economic growth
ousually ended by official devaluation or
adoption of a floating rate
oextreme cases => currency crashes
Causes of Currency Crises
1) speculation
2) deficit financed by inflation
3) weak financial systems
4) recent deregulation of financial markets
5) weak economic performance
6) political factors
7) external factors such as interest rates
8) choice of exchange rate system
Capital Controls
1) also known as exchange controls
2) barriers to foreign savers investing in
domestic assets
3) pro: government can control its balance of
payments position and possibly prevent
speculative attacks
4) con: weakened confidence in the
government may actually cause an
increase in capital outflows
Question of Foreign Exchange Tax
1) volatile capital movements lead to severe
repercussions across economies
2) a tax on inflows or outflows would reduce
the number of transaction based on short
term speculation
3) such a tax would still allow market forces
to influence investment and exchange
rates over the long term
4) how much volatility is acceptable
Currency Board
1) monetary authority that issues notes
convertible into a foreign anchor currency
at a fixed rate
2) anchor currency chosen for stability and
acceptability
3) government finance only by taxation and
borrowing – not by printing money
4) implies elimination of discretionary
monetary policy by domestic government
Case Study – Hong Kong
1) Hong Kong adopted a currency board
system in 1983
2) U.S.$ = 7.75 to 7.85 HK$
3) reversed lack of confidence in the
economy despite anticipation of control
shifting from the U.K. to China
4) contributed to significant economic growth
in Hong Kong; per capita real GDP of
$37,300 ranks 13th of 216 nations
Case Study – Argentina
1) adopted currency board in 1991 to limit
inflation
2) 1 U.S.$ = 1 Argentine Peso
3) issues: dollar appreciated, U.S. interest
rates rose, domestic commodity prices
fell, and Brazil’s currency depreciated
4) U.S. fiscal & monetary policy ill suited to
conditions in Argentina
5) results: deficits, borrowing, default and
economic chaos
Dollarization
1) partial dollarization indicates use of the
U.S. dollar alongside domestic currency
2) full dollarization indicates use of the dollar
and elimination of domestic currency
3) benefits:
a) lower inflation
b) decreased transactions costs
c) greater openness
Effects of Dollarization
o U.S. monetary policy would not
necessarily be appropriate for a foreign
economy
o Federal Reserve is not the lender of last
resort for that economy
o loss of seigniorage which is the income
that would have been derived from
interest bearing foreign reserves