Dr Marek Porzycki
Chair for Economic Policy
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basic concepts
exchange rate regimes
evolution of the international currency system
Special Drawing Rights (SDR)
currency unions
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Currency
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synonym of money
system of monetary units in use in a country or an area
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Foreign exchange
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foreign currency (in: foreign exchange reserves)
market for trading currencies (in: FX market, i.e. global
decentralized market for the trading of currencies)
Exchange rate – value (price) of one currency
expressed in another currency
spot and forward exchange rate
buying and selling rate, mid-market rate
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Convertibility
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full convertibility
- currency of a country can be freely converted into foreign exchange at
market determined rate of exchange as determined by demand for and
supply of a currency
- no restrictions on currency trade on the foreign exchange market. E.g.
USD, EUR, PLN
- convertibility on current account- exports and imports of merchandise
(goods) and invisibles
- capital account convertibility - in respect of capital flows (flows of
portfolio capital, direct investment flows, of borrowed funds, capital gains
like dividends and interests)
- advantages:
- greater trade and capital flows, better living standard,
- improved access to international financial markets and reduction in
cost of capital.
- greater confidence of global investors
- disadvatages: volatility of exchange rates, vulnerability to reversals in
capital flows (outflows of foreign capital – e.g., Asian crises in 90’s)
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Convertibility
partial convertibility – control on cross-border capital flows, some
restriction on currency conversion (permissicion of central bank).
E.g. CNY, INR
- India : „Liberalised Exchange Rate Management” scheme in which
60% of all receipts on current account (i.e., merchandise exports
and invisible receipts) could be converted freely into rupees at
market determined exchange rate quoted by authorised dealers,
while 40% of them was to be surrendered to Reserve Bank of India
at the officially fixed exchange rate, for meeting Government
needs for foreign exchange and for financing imports of essential
commodities.
no convertibility – currency conversion is generally banned, currency
is not traded on the FX market. E.g. Eastern Bloc currencies before
1989, Cuban „national” peso, North Korean won.
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appreciation / depreciation - an increase/loss (decrease) of value
(exchange rate) of a currency with respect to one or more foreign
reference currencies due to market forces,
Appreciation: if the Polish PLN appreciates relative to the euro, the
exchange rate falls: it takes fewer PLN to purchase 1 euro (1 EUR=
4.20 PLN → 1 EUR=4.10 PLN).
When the PLN appreciates relative to the Euro, the PLN becomes less
competitive. This may lead to larger imports of European goods and
services, and lower exports of Polish goods and service.
Depreciation: if the Polish Zloty (PLN) depreciates relative to the
euro, the exchange rate (the PLN price of euros) rises: it takes more
PLN to purchase 1 euro (1 EUR=4.15 PLN → 1 EUR=4.25 PLN)
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Reasons for appreciation:
increased demand for that currency on world markets
High exports (the buyers of these exports need its currency to pay
for those exports)
increase of interest rates by country's central bank (people will want
that currency to deposit in the banks to earn that higher interest
rate)
Increase of employment and per capital income in a country
increase, the demand for its goods and services increases, along
with demand for that country's currency in the local market
Loosening fiscal policy by the government (borrowing money)
Effects of appreciation:
imports cheaper
lower inflation
Balance of trade deficit (because our currency is strong, our own
goods we look to export appear expensive to other countries)
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Reasons for depreciation:
inflationary pressure (inflation reduces the value of money)
collapse of confidence in an economy or financial sector (outflow of
capital)
lower growth and lower interest rates
current account deficit (a country imports more goods and services
than it exports)
price of commodities (If an economy depends on exports of raw
materials, a fall in the price of this raw material can cause a fall in
export revenue and a depreciation in the exchange rate. E.g. Russia
is suffering from a fall in price of oil).
speculation
Effects of depreciation:
Exports cheaper, imports more expensive, demand for imports will
be reduced
inflation is likely to occur (in particular cost push inflation)
Improvement in the current account
devaluation vs. revaluation
- an official lowering (reduction)/increasing of the value of a
country's currency within a fixed exchange rate system, by
which the monetary authority formally sets a new fixed rate
with respect to a foreign reference currency.
Devaluation – in order to reduce a country's trade deficit by
improving competitiveness of country’s commodities and
help to increase its export volume.
Sometimes devaluation is caused by impossibility of
maintaining a previous fixed exchange rate due to
downwards pressure on the currency.
Example: Argentinian peso in 2002
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Fixed exchange rate (currency peg) - rates are centrally determined
(usually by the Central Bank or by the Currency Board)
In order to maintain the local exchange rate, the central bank buys
and sells its own currency (interventions) on the foreign exchange
market in return for the currency to which it is pegged (more
vulnerable)
In order to maintain the rate, the central bank must keep a high level
of foreign reserves. This is a reserved amount of foreign currency
held by the central bank that it can use to release (or absorb) extra
funds into (or out of) the market.
currency board – currency reserves in the anchor currency need to
cover all local currency cash and reserves held with central bank (all
M0 monetary aggregate). New money in local currency can be issued
only in return for anchor currency.
a further step: currency substitution- citizens of a country officially
or unofficially use a foreign country's currency as legal tender for
conducting transactions.
dollarization (El Salvador, Ecuador, Panama), euroization (Kosovo,
Montenegro)
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Fixed exchange rate (currency peg) Advantages:
avoids currency fluctuations – decrease of costs of
international trade
stability encourages investment
keeps inflation low
Disadvantages:
less flexibility – it is difficult to respond to temporary shocks
(e.g. on the oil market)
„join at the wrong rate” – it is difficult to set the right rate for
fixing the exchange rate. If the rate is too high, it will make
exports uncompetitive. If it is too low, it could cause inflation.
current account imbalances
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Flexible (floating) exchange rate – exchange rate results from
supply and demand on the foreign exchange market
Advantages:
No need for international management of exchange rates
No need for frequent central bank intervention, lower foreign
exchange reserves needed
Automatic balance of payments adjustment - Any balance of
payments disequilibrium will tend to be rectified by a change in the
exchange rate
Greater insulation from other countries’ economic problems
Disadvantages
Higher volatility in exchange rates
Speculation which can be destabilising for the economy
Uncertainty into trade that can be reduced by hedging the foreign
exchange risk on the forward market
risk of inflation
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hybrid regimes, e.g.:
managed float - exchange rates fluctuate from day to day,
but central banks attempt to influence their countries'
exchange rates by buying and selling currencies
pegged float - a central bank keeps the rate from deviating
too far from a target band or value (e.g. ERM II),
crawling peg - a part of fixed exchange rate regimes that
allows depreciation or appreciation in an exchange rate
gradually, frequent but moderate exchange rate changes
exchange rate floor or ceiling
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Constraints on monetary policy resulting from a fixed
exchange rate. Impossibility of maintaining three
features simultaneously:
fixed exchange rate,
free flow of capital
independent monetary policy
Examples:
China (tightly managed float similar to a currency peg,
capital controls, some degree of independence in
monetary policy)
Bulgaria (currency peg, free flow of capital under EU
law, no independent monetary policy)
Poland (floating exchange rate, free flow of capital
under EU law, independent monetary policy)
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‘gold standard’ until WWI – effectively a system of fixed exchange rates with
gold as a measure of reference
Advantage: it prevented inflation, stabilized world trade; disadvantage:
danger of deflation crisis; it restricted monetary policy
Bretton Woods system (after WWII)
system of fixed exchange rates: currencies were pegged to USD
USD became international reserve currency that was linked to the price of
gold ($35 = 1 oz.), convertibility of the USD to gold
IMF (goal: to bridge temporary imbalances of payments) and World Bank
(International Bank for Reconstruction and Development)
Crisis of the Bretton Woods system: growing dollar overhang—the difference
between the dollars in international circulation and the value of the gold
backing held in Fort Knox - as a result of increased US investment abroad
and military spending (1960s).
1971: United States unilaterally terminated convertibility of the US dollar to
gold
Since 1970s – a system of flexible exchange rates, with several mutual or
regional arrangements
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an accounting unit created by the IMF in 1969 to facilitate
management of foreign exchange reserves and international
settlements
represents a claim on currency held as reserves by IMF member
states
value based on a weighted basket of 4 currencies (EUR, USD, JPY,
GBP)
allocated by the IMF Board of Governors to IMF Member States
(current total allocation at ca. 204 bn SDRs, average rate 1 SDR =
1,50 USD)
used as supplementary foreign exchange reserve asset (relatively
minor importance) and unit of account
XDRs are allocated to countries by the IMF Private parties do not
hold or use them
a 2009 proposal by Zhou Xiaochuan, chairman of the People’s Bank
of China, to increase the role of SDR as global reserve currency
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use of the same currency in more than one
country
usually result from a formal arrangement
(treaty) but may also result from de-facto
usage of a currency of another country (see
also  dollarization/euroization)
need for a common monetary policy (see 
optimum currency area), loss of monetary
sovereignty
historical: Latin Monetary Union (1865-1914/1927),
Scandinavian Monetary Union (1873-1914)
 existing:
- West African and Central African CFA Franc zones (CFA
Franc, pegged to EUR)
- East Carribean Currency Union (East Caribbean dollar,
pegged to USD)
- Singapore-Brunei currency interchangeability agreement
- Common Monetary Area, South Africa (South African rand)
- Economic and Monetary Union (euro area) [see  further
courses]
 planned:
- initiative of the Gulf Cooperation Council (currency:
Khaleeji)
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Additional (facultative):
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F. Mishkin, The Economics of Money, Banking, and Financial
Markets, Pearson, 10th ed. 2013, p. 506-513
Ch. Proctor, Mann on the Legal Aspect of Money, 7th ed.
2012: Chapter 33, Other Forms of Monetary Organization, pp.
861-891
Zhou Xiaochuan, Reform the International Monetary System,
March 2009,
http://www.pbc.gov.cn/publish/english/956/2009/2009122
9104425550619706/20091229104425550619706_.html