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EXCHANGE RATE REGIMES Learning Objectives International Finance EXCHANGE RATE REGIMES Learning Objectives After completing this chapter, you should be able to understand: What do you mean by exchange rate and its regime. Gold Standard System Flexible exchange rate system. Central bank measures to balance the exchange rate. Exchange Rate Regimes Structure 7.1 Exchange RateRegimes 7.2 The Gold Standard System 7.3 Mint Par of Exchange 7.4 Gold Points 7.5 Bretton Woods System 7.6 Triffin’s Paradox 7.7 Smithsonian Agreement 7.8 Snake in the Tunnel System 7.9 Special Drawing Rights 7.10 Fixed Exchange Rate System 7.11 Flexible Exchange Rate System Exchange Rate Regimes Structure 7.12 Currency Intervention 7.13 Methods of Control 7.14 Clean Float 7.15 Dirty Float 7.16 Adjustable Peg System 7.17 Crawling Peg System 7.18 Neutralization of Reserves 7.19 Fixed vs. Flexible Exchange System 7.20 The Gold Standard vs. Bretton Woods System 7.21 Summary 7.22 Self Assessment Questions Exchange Rate Regimes 7.1 Exchange Rate Regimes Over the past 140 years several systems have been used for valuing currencies. Four such systems were used universally for significant periods and had a profound impact on how exchange rates between currencies were to be established. These systems are called “Exchange Rate Regimes” 1. Barter System: which provided valuation based on goods against goods. 2. The Gold Standard (1870 – 1932) provided for valuation against gold on fixed basis. 3. The Bretton Woods System (1946 – 1971) provided valuation against US $ on fixed basis. 4.TheFlexibleExchangeRateSystem(1978–tilltodate) provided valuation through supply & demand forces. Exchange Rate Regimes 7.2 The Gold Standard System The Gold Standard was the first universally implemented exchange rate system. It was promoted by the Bank of England and established world wide in 1870. Main Features: 1. Every country was required to establish Central Bank to function as the custodian of the country’s monetary gold reserves. 2. Every Central Bank was to be provided the sole authority to issue paper money (Bank Notes) within the area under its jurisdiction. Exchange Rate Regimes 7.2 The Gold Standard System 3. Each Central bank was required to establish a fixed official price for gold in terms of the domestic currency. 4. Every Central Bank was required to provide an irrevocable promise on each paper note to redeem thesameondemandintermsofspecifiedquantity of gold. 5. Each Central Bank was required to provide unconditional guarantee to buy and sell unlimited quantity of gold at the fixed official price. 6. The total supply of money supply in circulation to be limited to the value of gold reserves with the Bank. Exchange Rate Regimes 7.3 Mint Par of Exchange The mechanism for establishing exchange rates between currencies under the Gold Standard was called the ‘Mint Par of Exchange’. The exchange rates between two currencies were represented by the ratio of the official gold prices for the two currencies. Exchange Rate Regimes 7.4 Gold Points TheGoldStandardprovidedforfixedexchangerates. However, imbalance of trade between two countries on a day-to-day basis resulted in the exchange rate in the domestic market moving on either side of the central exchange rate, providing opportunities for arbitrage between the two rates . The extreme points of this zone are called the upper and lower gold points. Each currency pair had a unique set of gold points . Thus the in built mechanism for balancing trade in the Gold Standard was called as Price Specie Adjustment Mechanism. Exchange Rate Regimes 7.4 Gold Points Gold Standard Advantages: 1. It was an easy system to introduce and operate. 2. It provided for a very high level of stability in exchange rates. 3.The‘PriceSpecieAdjustmentMechanism’provides in built system for achieving trade equality. 4. It provided a fully secured system for settlement on international transactions. Exchange Rate Regimes 7.4 Gold Points Gold Standard Disadvantages: 1. The cost of manufacturing gold gradually increased to levels beyond official prices. 2. Countries with persistent trade deficit suffered from recessions resulting in reduced investments accompanied by unemployment. 3. The system had no flexibility to adjust money supply in times of economic crisis. 4. To avoid the negative effects of reduced money supply, countries would break the equality between gold reserves and money supply, thereby diluting the system. This is neutralization of reserves. It resulted in the failure of the system in 1932. Exchange Rate Regimes 7.5 Bretton Woods System also known as IMF’s exchange rate system. A) Bretton Woods System The continuing second world war made any cooperation on the economic front impossible. There was a need for an economic system which would again make international trade and investments possible. To make this possible, it was necessary to have a stable exchange rate accompanied by an arrangementthatwouldhelpcountriesovercome their short term balance of payments problems . Exchange Rate Regimes 7.5 Bretton Woods System A) Bretton Woods System –contd. Post world war, the trends in international monetary system had gradually started revealing imbalances in monetary resources. Representatives of forty five major economies met at Bretton Woods, USA, in July 1944 to finalize a new exchange rate system based on stability and flexibility to be universally implemented after the second world war. Exchange Rate Regimes 7.5 Bretton Woods System A) Bretton Woods System –contd. The conference in 1945 saw the birth of two leading world institutions – International Monetary Fund (IMF) International Bank of Reconstruction and Development (IBRD) With the objective of financing and assisting the need based nations to overcome their balance of payments deficits. Exchange Rate Regimes 7.5 Bretton Woods System A) Bretton Woods System –contd. The IMF was given the mandate to establish a suitable exchange rate system. The fixed exchange rate system proposed by IMF was implemented in 1946. In this system, all members were to fix par value of their currency either in terms of Gold or in US Dollar. TheparvalueofGoldindollarwasfixedat$35per ounce. Exchange Rate Regimes 7.5 Bretton Woods System A) Bretton Woods System-contd. The monetary authorities (US Federal Reserve bank) provided an unconditional guarantee to buy and sell unlimited quantity of gold at this price and thus support their exchange rate. This system was called ‘Gold Convertibility Clause’ Even though the member countries had an option of pegging their currencies to either gold or to US dollar, the only reserve mentioned in the agreement establishing the system was gold. Thus effectively, each currency was redeemable in US dollars, and US dollars were redeemable in gold. Exchange Rate Regimes 7.5 Bretton Woods System A) Bretton Woods System –contd. US dollar thus became the means of international settlements. Variations in the exchange rates were permitted on either side of the parity in the range (+/-) 1%. The end points of the variation zone were called ‘Support Points’ or ‘Intervention Points’. The system introduced the concept of Central bank intervention as a means of ensuring protection of parity values. Exchange Rate Regimes 7.5 Bretton Woods System A) Bretton Woods System –contd. The IMF also provided a commitment to the member countries to provide financial assistance to countries facing temporary balance of payments deficits. In case there are some structural imbalances , the member countries could devalue the currencies in consultation with IMF. Thus the system was also called ‘The Adjustable Peg System’. Finally, IMF’s supervisory authority was accepted by all members for 1) Exchange rate management & 2) The domestic foreign exchange market. Exchange Rate Regimes 7.5 Bretton Woods System B) Reasons for the failure of Bretton Woods System There was an excessive demand for US dollars in the international financial markets. There was a continuous deficit on USA’s Balance of Payment (trade deficit) as countries such as Japan and West Germany enjoyed export benefits against US economy. The system did not provide for a revision in the price of gold in terms of US dollars. Hence, it was not possible to devalue US dollar despite continuous trade deficit. Exchange Rate Regimes 7.5 Bretton Woods System B) Reasons for the failure of Bretton Woods System – contd. The system was too rigid. In 1967, Britain devalued its Pound. In 1968, there was an outflow of capital from France due to political disturbances. In 1969, Germany devalued its Franc. All these had compelling effect in the form of either creating worldwide ill-liquidity or devaluation of dollar thereby leading to break down of Bretton Woods System by 1970. Exchange Rate Regimes 7.6 Triffin’s Paradox Prof. Triffin, an economist, predicted that the continuous deficit in balance of trade incurred by the US would reduce its acceptability in the international markets since supply would keep increasing without a downward revision in the value of USD. He predicted that the system would disintegrate due to this basic weakness in the system that it did not provide periodic review of the value of USD In 1968 Gold Convertibility Clause was invoked but the US Federal Reserve Bank could not honor its commitment. A formal withdrawal from the system was announced by the US inExchange 1971. (as Rate predicted Regimes by Prof. Triffin) 7.7 Smithsonian Agreement 1. The G 10 countries (USA, UK, West Germany, France, Japan, Canada, Italy, Sweden, Belgium and Holland) met at the Smithsonian Institute in Washington in December 1971 and reached an agreement to re-introduce the Bretton Woods System with certain modifications. 2. The main amendments: e)All other countries fixed new parities against USD Exchange Rate Regimes 7.7 Smithsonian Agreement – contd. 3. The basic idea behind these amendments was to provide greater export competitiveness to the US economy to help them to reduce their trade deficit andre-introduceafixedpriceforgoldfor conversion.
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