International Economics

By Robert J. Carbaugh
8th Edition

Chapter 16:
Exchange-Rate Systems

Copyright 2002, 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

Exchange rate system alternatives

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
Carbaugh, Chap. 16

Exchange rate system alternatives

Key currencies: Share of national currencies in

total identified official holdings of foreign exchange, 1998

Key currency
US dollar
German mark
Japanese yen
British pound
French franc
ECU
Swiss franc
Netherlands guilder
Other

Carbaugh, Chap. 16

All
countries

Industrial
countries

Developing
countries

60.3%
12.1
5.1
3.9
1.3
0.8
0.7
0.4
15.4

64.3%
14.7
7.0
3.1
1.4
1.8
0.2
0.3
7.2

57.1%
10.1
3.7
4.6
1.2
1.0
0.4
21.9

Exchange rate system alternatives

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
Carbaugh, Chap. 16

Exchange rate system alternatives

Exchange rate stabilization under fixed rates

Carbaugh, Chap. 16

Exchange rate system alternatives

Exchange rate stabilization under fixed rates

Carbaugh, Chap. 16

Exchange rate system alternatives

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
currencys value relative to other
currencies, correcting a surplus

Carbaugh, Chap. 16

Exchange rate system alternatives

Devaluation and revaluation

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

Carbaugh, Chap. 16

Devaluation and revaluation

Devaluation/revaluation: legal and economic impact

Carbaugh, Chap. 16

10

Devaluation and revaluation

Devaluation/revaluation: legal and economic impact

Carbaugh, Chap. 16

11

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
Carbaugh, Chap. 16

12

Stabilizing developing country currencies

Currency boards vs. dollarization (contd)

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
Carbaugh, Chap. 16

13

Stabilizing developing country currencies

Currency boards vs. dollarization (contd)

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

Carbaugh, Chap. 16

14

Stabilizing developing country currencies

Currency boards vs. dollarization (contd)

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
Carbaugh, Chap. 16

15

Exchange rate system alternatives

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
Carbaugh, Chap. 16

16

Exchange rate system alternatives

Floating exchange rates (contd)

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

Carbaugh, Chap. 16

17

Exchange rate system alternatives

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

Carbaugh, Chap. 16

18

Exchange rate system alternatives

Adjustable pegged rates

Carbaugh, Chap. 16

19

Exchange rate system alternatives

Managed floating exchange rates

Carbaugh, Chap. 16

20

Exchange rate system alternatives

Exchange rate stabilization and monetary policy

Carbaugh, Chap. 16

21

Exchange rate system alternatives

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
Carbaugh, Chap. 16

22

Exchange rate system alternatives

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)
Carbaugh, Chap. 16

23