Transcript Floating exchange rates

Chapter 34
Exchange rate regimes
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
7th Edition, McGraw-Hill, 2003
Power Point presentation by Alex Tackie
©The McGraw-Hill Companies, 2002
Key issues
• Exchange rate regimes and their
implications for the world economy
• International policy co-ordination
• Policy co-ordination in Europe
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Exchange rate regimes
Exchange rate
Fixed
Floating
Forex
intervention
Free
float
None
Gold standard
currency board
Adjustable peg
Automatic
Managed
float
Some discretion
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The gold standard
• Characteristics of the gold standard:
– The government of each country fixes the price of
gold in terms of its domestic currency.
– The government maintains convertibility of
domestic currency into gold.
– Domestic money creation is tied to the
government's holding of gold.
• Adjustment to full employment is via
domestic wages and prices
– creating vulnerability to long and deep recessions.
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The adjustable peg and the dollar
standard
• In an adjustable peg regime, exchange
rates are normally fixed, but countries
are occasionally allowed to alter their
exchange rate.
• Under the Bretton Woods system, each
country announced a par value for their
currency in terms of US dollars
– the dollar standard.
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The dollar standard
• Faced with a balance of payments deficit
under the dollar standard
• countries could try to avoid monetary
contraction by running down foreign
exchange reserves
• but devaluation could not be postponed for
ever, given finite reserves
• expansion of US money supply began to
spread inflation world-wide
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Floating exchange rates
• Under pure/clean floating, forex markets are
in continuous equilibrium
• the exchange rate adjusts to maintain
competitiveness
• but in the short run, the level of floating
exchange rates is determined by speculation
– given that capital flows respond to interest rate
differentials.
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Fixed versus floating exchange rates
• Robustness
– Bretton Woods system was abandoned because it could not
cope with real and nominal strains
– a flexible rate system is probably more robust
• Volatility
– fixed rate system offers fundamental stability
– flexible rate system is potentially volatile
– but instability must be accommodated in other ways under a
fixed rate system
• Financial discipline
– fixed rate system imposes discipline and policy
harmonization.
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International policy co-ordination
• Can a concerted attempt by a group of
countries to co-ordinate their policy bring
benefits to the group?
• Externality argument:
– non-co-operative policy can impose costs that can
be avoided by agreement between governments
• Reputation argument
– co-ordination may allow individual governments to
pre-commit to policies that would otherwise not
be credible
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The European Monetary System
• Established by members of the European Community (including
the UK) in 1979
• A system of monetary and exchange rate cooperation.
• Included the Exchange Rate Mechanism (ERM)
– which the UK did not join until 1990
– and it left again in 1992.
• The system had some success in reducing exchange rate
volatility
– through co-ordination of monetary policy
– plus exchange rate controls
– even if it did not work for the UK.
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