Chapter 3
Chapter Objective:
This chapter discusses:
1. alternative exchange rate systems
2. A brief history of the international monetary system
3. The European monetary system, and
4. The costs and benefits of a single
currency
Poorna Pal, MS MBA Ph.D.
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Evolution of the International Monetary System
Current Exchange Rate Arrangements
European Monetary System
Euro and the European Monetary Union
The Mexican Peso Crisis
The Asian Currency Crisis
Fixed versus Flexible Exchange Rate Regimes
Alternative Exchange Rate Systems
(Obvious but important point)
• People trade currencies for two primary reasons
• To buy and sell goods and services
• To buy and sell financial assets
There are an enormous number of
exchange rate systems, but generally
they can be sorted into one of these
categories
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Freely Floating
Managed Float
Target Zone
Fixed Rate
Important Note:
• Even though we may call it “free float” in fact the
government can still control the exchange rate by
manipulating the factors that affect the exchange
rate (i.e., monetary policy)
Under a floating rate system, exchange
rates are set by demand and supply.
• price levels
• interest rates
• economic growth
Alternate exchange rate systems: Managed
Float (“Dirty Float”)
• Market forces set rates unless excess volatility occurs,
then, central bank determines rate by buying or selling
currency. Managed float isn’t really a single system, but
describes a continuum of systems
• Smoothing daily fluctuations
• “Leaning against the wind” slowing the change to a
different rate
• Unofficial pegging: actually fixing the rate without
saying so.
• Target-Zone Arrangement: countries agree to maintain
exchange rates within a certain bound What makes
target zone arrangements special is the understanding
that countries will adjust real economic policies to
maintain the zone.
Fixed Rate System: Government maintains
target rates and if rates threatened, central
banks buy/sell currency. A fixed rate
system is the ultimate good news bad news
joke. The good is very good and the bad is
very bad.
• Advantage: stability and predictability
• Disadvantage: the country loses control of
monetary policy (note that monetary policy can
always be used to control an exchange rate).
• Disadvantage: At some point a fixed rate may
become unsupportable and one country may
devalue. (Argentina is the most dramatic recent
example.) As an alternative to devaluation, the
country may impose currency controls.
A Brief History of the International
Monetary System
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Pre 1875 Bimetalism
1875-1914: Classical Gold Standard
1915-1944: Interwar Period
1945-1972: Bretton Woods System
1973-Present: Flexible (Hybrid) System
The Intrinsic Value of Money and
Exchange Rates
At present the money of most countries has no
intrinsic value (if you melt a quarter, you don’t get
$.25 worth of metal). But historically many
countries have backed their currency with valuable
commodities (usually gold or silver)—if the U.S.
treasury were to mint gold coins that had 1/35th
ounces of gold and sold these for $1.00, then a
dollar bill would have an intrinsic value.
When a country’s currency has some intrinsic
value, then the exchange rate between the two
countries is fixed. For example, if the U.S. mints
$1.00 coins that contain 1/35th ounces of gold and
Great Britain mints £1.00 coins that contain 4/35th
ounces of gold, then it must be the case that £1 = $4
(if not, people could make an unlimited profit
buying gold in one country and selling it in another)
The Classical Gold Standard (1875-1914)
had two essential features
Nations fixed the value of the currency in
terms of Gold
Currencies were freely transferable between
the countries
This was essentially a fixed rate system:
Suppose the US announces a willingness to buy
gold for $200/oz and Great Britain announces a
willingness to buy gold for £100. Then £1=$2
Advantage of the Gold System
Disturbances in Price Levels would be offset
by the price-specie-flow mechanism. When a
balance of payments surplus led to a gold
inflow to the country with surplus, it led to
higher prices there which reduced surplus.
Likewise, gold outflow led to lower prices and
increased surplus.
Retail Price Index (Log values)
5
4
http://measuringworth.com/graphs/
Gold standard
collapsed during
World War I
US
3
UK
2
1
1800
1852
1904
1956
2008
http://www.measuringworth.com/datasets/gold/result.php
Gold price history
http://www.measuringworth.com/
http://www.research.gold.org/prices/monthly/
1,800
180
Right scale: 1000¥ per ounce
Left scale: all other currencies
per ounce
1,600
1,400
JPY
USD
160
140
1,200
120
1,000
100
800
80
EUR
600
60
400
40
200
0
Jan-70
GBP
20
0
Jun-75
Dec-80
Jun-86
Nov-91
May-97
Nov-02
May-08
http://www.gold.org/deliver.php?file=/value/stats/statistics/xls/monthly_prices.xls
The Interwar Period
Periods of serious chaos such as German
hyperinflation and the use of exchange rates
as a way to gain trade advantage.
Britain and US adopt a kind of gold standard
(but tried to prevent the species adjustment
mechanism from working).
The Bretton Woods
System (1946-1971)
British
pound
German
mark
US$ was key
currency
valued at $1 =
1/35 oz. of
gold
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
All currencies
linked to that
price in a
fixed rate
system.
In effect,
rather than
hold gold as a
reserve asset,
other
countries
hold the goldbacked US
dollars.
Collapse of Bretton Woods (1971)
high U.S. inflation rate
U.S.$ depreciated sharply.
Smithsonian Agreement (1971) US$ devalued to
1/38 oz. of gold.
1973 The US dollar is under heavy pressure,
European and Japanese currencies are allowed
to float
1976 Jamaica Agreement:
 Flexible exchange rates declared acceptable
 Gold abandoned as an international reserve
Current Exchange Rate Arrangements
The largest number of countries, about 49,
allow market forces to determine their
currency’s value.
Managed Float. About 25 countries combine
government intervention with market forces to
set exchange rates.
Pegged to another currency such as the U.S.
dollar or euro (through franc or mark). About
45 countries.
No national currency and simply uses another
currency, such as the dollar or euro as their
own.
Evolution of the
International Monetary System
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Bimetallism: Before 1875
Classical Gold Standard: 1875-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime: 1973Present
Bimetallism: Before 1875
• A “double standard” in the sense that both gold
and silver were used as money.
• Some countries were on the gold standard, some
on the silver standard, some on both.
• Both gold and silver were used as international
means of payment and the exchange rates among
currencies were determined by either their gold or
silver contents.
• Gresham’s Law implied that it would be the least
valuable metal that would tend to circulate.
Classical Gold Standard:
1875-1914
• During this period in most major countries:
• Gold alone was assured of unrestricted coinage
• There was two-way convertibility between gold and
national currencies at a stable ratio.
• Gold could be freely exported or imported.
• The exchange rate between two country’s
currencies would be determined by their relative
gold contents.
Classical Gold Standard:
1875-1914
For example, if the dollar is pegged to gold at
U.S.$30 = 1 ounce of gold, and the British pound is
pegged to gold at £6 = 1 ounce of gold, it must be
the case that the exchange rate is determined by
the relative gold contents:
$30 = £6
$5 = £1
Classical Gold Standard:
1875-1914
• Highly stable exchange rates under the classical
gold standard provided an environment that was
conducive to international trade and investment.
• Misalignment of exchange rates and international
imbalances of payment were automatically
corrected by the price-specie-flow mechanism.
Classical Gold Standard:
1875-1914
• There are shortcomings:
• The supply of newly minted gold is so restricted that
the growth of world trade and investment can be
hampered for the lack of sufficient monetary reserves.
• Even if the world returned to a gold standard, any
national government could abandon the standard.
Interwar Period: 1915-1944
• Exchange rates fluctuated as countries widely
used “predatory” depreciations of their currencies
as a means of gaining advantage in the world
export market.
• Attempts were made to restore the gold standard,
but participants lacked the political will to “follow
the rules of the game”.
• The result for international trade and investment
was profoundly detrimental.
Bretton Woods System:
1945-1972
• Named for a 1944 meeting of 44 nations at Bretton
Woods, New Hampshire.
• The purpose was to design a postwar international
monetary system.
• The goal was exchange rate stability without the
gold standard.
• The result was the creation of the IMF and the
World Bank.
Bretton Woods System:
1945-1972
• Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.
• Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par value
by buying or selling foreign reserves as necessary.
• The Bretton Woods system was a dollar-based
gold exchange standard.
The Flexible Exchange Rate Regime: 1973Present.
• Flexible exchange rates were declared acceptable
to the IMF members.
• Central banks were allowed to intervene in the
exchange rate markets to iron out unwarranted
volatilities.
• Gold was abandoned as an international reserve
asset.
• Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.
Current Exchange Rate Arrangements
• Free Float
• The largest number of countries, about 48, allow market
forces to determine their currency’s value.
• Managed Float
• About 25 countries combine government intervention with
market forces to set exchange rates.
• Pegged to another currency
• Such as the U.S. dollar or euro (through franc or mark).
• No national currency
• Some countries do not bother printing their own, they just
use the U.S. dollar. For example, Ecuador has recently
dollarized.
European Monetary System
• Eleven European countries maintain exchange
rates among their currencies within narrow bands,
and jointly float against outside currencies.
• Objectives:
• To establish a zone of monetary stability in Europe.
• To coordinate exchange rate policies vis-à-vis nonEuropean currencies.
• To pave the way for the European Monetary Union.
The Euro
• What is the euro?
• When will the new European currency become a
reality?
• What value do various national currencies have in
euro?
What Is the Euro?
• The euro is the single currency of the European
Monetary Union which was adopted by 11 Member
States on 1 January 1999.
• These member states are: Belgium, Germany,
Spain, France, Ireland, Italy, Luxemburg, Finland,
Austria, Portugal and the Netherlands.
Eurozone
Membership
THE
EURO
CONVERSION
RATES
1 Euro is Equal to:
40.3399 BEF
Belgian franc
1.95583 DEM
German mark
166.386 ESP
Spanish peseta
6.55957 FRF
French franc
.787564 IEP
Irish punt
1936.27 ITL
Italian lira
40.3399 LUF
Luxembourg franc
2.20371 NLG
Dutch gilder
13.7603 ATS
Austrian schilling
200.482 PTE
Portuguese escudo
5.94573 FIM
Finnish markka
3.0
300
JPY-USD
right scale
2.5
250
USD-GBP
left scale
2.0
200
1.5
150
1.0
100
0.5
1978-01-01
USD-EUR
left scale
1984-11-05
1991-09-10
1998-07-15
2005-05-19
50
2012-03-23
http://research.stlouisfed.org/fred2/series/EXUSUK/downloaddata?rid=15
What is the subdivision of the euro?
• During the transitional period up to 31 December
2001, the national currencies of the member states
(Lira, Deutsche Mark, Peseta, Franc. . . ) will be
"non-decimal" subdivisions of the euro.
• The euro itself is divided into 100 cents.
What is the official sign of the euro?

The sign for the new single currency looks like
an “E” with two clearly marked, horizontal
parallel lines across it.
It was inspired by the Greek letter epsilon, in reference to
the cradle of European civilization and to the first letter of
the word 'Europe'.
What are the different denominations of the
euro notes and coins ?
• There will be 7 euro notes and 8 euro coins.
• The notes will be: 500, 200, 100, 50, 20, 10, and 5
euro.
• The coins will be: 2 euro, 1 euro, 50 euro cent, 20
euro cent, 10, euro cent, 5 euro cent, 2 euro cent,
and 1 euro cent.
How will the euro affect contracts
denominated in national currency?
• All insurance and other legal contracts will continue in force
with the substitution of amounts denominated in national
currencies with their equivalents in euro.
• Euro values will be calculated according to the fixed
conversion rates with the national currency unit adopted on
1 January 1999.
• Generally, the conversion to the euro will take place on 1
January 2002, unless both parties to the contract agree to
do so beforehand.
The Mexican Peso Crisis
• On 20 December, 1994, the Mexican government
announced a plan to devalue the peso against the
dollar by 14 percent.
• This decision changed currency trader’s
expectations about the future value of the peso.
• They stampeded for the exits.
• In their rush to get out the peso fell by as much as
40 percent.
The Mexican Peso Crisis
• The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of portfolio
capital.
• Two lessons emerge:
• It is essential to have a multinational safety net in place
to safeguard the world financial system from such
crises.
• An influx of foreign capital can lead to an overvaluation
in the first place.
The Asian Currency Crisis
• The Asian currency crisis turned out to be far more
serious than the Mexican peso crisis in terms of
the extent of the contagion and the severity of the
resultant economic and social costs.
• Many firms with foreign currency bonds were
forced into bankruptcy.
• The region experienced a deep, widespread
recession.
Currency Crisis Explanations
• In theory, a currency’s value mirrors the fundamental
strength of its underlying economy, relative to other
economies. In the long run.
• In the short run, currency trader’s expectations play a much
more important role.
• In today’s environment, traders and lenders, using the most
modern communications, act by fight-or-flight instincts. For
example, if they expect others are about to sell Brazilian
reals for U.S. dollars, they want to “get to the exits first”.
• Thus, fears of depreciation become self-fulfilling prophecies.
Fixed versus Flexible
Exchange Rate Regimes
• Arguments in favor of flexible exchange rates:
• Easier external adjustments.
• National policy autonomy.
• Arguments against flexible exchange rates:
• Exchange rate uncertainty may hamper international
trade.
• No safeguards to prevent crises.