Exchange Rate Regimes
Lecture 4

 

Gold Standard

 

Exchange rate regime - nations agree to a currency exchange rate system and determine the flow of goods and financial investments between countries

  1. Gold standard - central banks convert their currency to gold on demand

    1. History

      • Greeks and Romans

      • 1876 to 1913

    2. The central banks set an exchange rate of their currency to gold

    3. Examples:

2,000 U.S. dollars = 1 ounce of gold

200,000 Japanese yen = 1 ounce of gold

4,000 British pounds = 1 ounce of gold

  1. If the U.S. central bank wants a money supply of $40 million, it must buy and hold 20,000 ounces of gold ( = $40 million / 2,000).

    1. The gold standard has fixed exchange rates

    2. Example:

1 ounce of gold = $2,000 = 200,000 yen = 4,000 pounds

$1 = 100 yens = 2 pounds

  1. If the U.S. has a balance-of-payments deficit with Japan

    1. current account + financial account < 0

    2. U.S. dollars flow out of the United States and into Japan

    3. Japan has a surplus of U.S. dollars, so U.S. central bank exchanges gold for dollars

    4. The United States ships gold to Japan

      • The U.S. central bank has less gold, so it must decrease the money supply

      • Remember - the money supply is tied to the amount of gold the government is holding.

      • When the money supply decreases, prices in the economy decrease

      • Creates deflation (i.e. negative inflation)

        • U.S. products become cheaper compared to other countries, so U.S. export increase

        • The lower U.S. prices cause foreign products to become more expensive, so U.S. imports decrease

        • The balance-of-payments deficit returns to zero

    5. The exact opposite will occur in Japan

  2. The gold standard has two benefits

    1. High inflation rates were rare under the gold standard

      • Central banks have little control over the money supply

      • If a central bank wants to increase the money supply, the central bank must buy gold.

      • The inflation rate averaged less than 1% in U.S. under the gold standard.

    2. The exchange rate risk is zero, which fosters trade and investment

  3. The gold standard has two problems

    1. The central bank has little power to influence the money supply

      • Monetary policy is weak

      • During the 2008 Financial Crisis, the Fed granted $2 trillion for emergency loans to banks

      • Difficult to do under a gold standard

    2. If one country experiences a recession, then the recession can easily spread to other countries

      • Other exchange-rate regimes have this problem; fixed exchange rates are the worse

      • Example

      • The United States enters a recession

      • Americans buy fewer imports, causing a trade surplus

      • U.S. accumulates gold from foreign countries

      • China experiences lower demand for its exports

      • Export industries lay off workers, decreasing the multiplier effect

      • China enters a recession

      • China's central bank would send gold to the U.S., causing deflation in China, worsening the recession

  4. Countries left the gold standard before the outbreak of World War I

 

Bretton Woods System

 

Bretton Woods System - established a fixed exchange rate regime

  1. Founded after World War II from 1945 to 1971

  2. Bretton Woods, New Hampshire

  3. The United States gov. promised to convert U.S. dollars into gold

    1. Official exchange rate, $35 = 1 ounce of gold

    2. U.S. government held the world's gold

    3. Europe bought military supplies from U.S. using gold

    4. Illegal for Americans to hold gold between 1933 and 1974

  4. The other countries fixed their exchange rates with the U.S. dollar

    1. The U.S. dollar became the international reserve currency

    2. Flexible gold standard

    3. Countries could adjust their exchanges rates relative to the U.S. dollar, especially if it has a balance-of-payments deficit

  5. The Bretton Woods system created two institutions

    1. International Monetary Fund (IMF) - created to enhance stability in international payments and promote international trade

      • IMF is the lender of the last resort

      • Similar to a central bank for its banks

      • Granted loans to countries that experienced balance-of-payment deficits

        • More money is leaving the country than amount entering

      • IMF collects and standardizes international economic data

      • A country wants to join the IMF

        • IMF uses a formula

        • One-fourth of the capital is gold

        • Three-fourths is the country’s own currency

        • IMF has financial capital: gold and a pool of foreign currencies

      • Example

        • Britain has a payments deficit and borrows from the IMF

        • Britain needs U.S. dollars, so the British give pounds and receive dollars from the IMF to finance its payments deficit (i.e. a swap)

        • U.S. dollars decrease and pounds increase in the IMF’s currency pool

        • Britain pays back the loan with interest to the IMF in an acceptable currency and Britain gets its pounds back

      • IMF created Special Drawing Rights (SDRs) in 1969

        • Belief of gold shortage and other reserve assets; originally a SDR was priced in a weight of gold

        • IMF disburses newly created SDRs to members

        • IMF issued 204 billion SDRs by 2010 (approximately worth $308 billion)

        • SDR value is equaled to a basket of currencies, the euro, British pound, Japanese Yen, and U.S. dollar

        • Countries can use SDRs to obtain foreign currencies from the IMF

        • IMF considers SDRs as a credit instrument

        • SDR defined as "unit of account," which is a function of money and has an exchange rate with the four currencies

      • The U.S. Treasury receives new SDRs

        • Treasury issues certificates that are claims to the SDRs

        • Treasury sells these certificates to the Federal Reserve

        • The Federal Reserve assets increase, causing the money supply to increase

    2. World Bank - grants long-term loans to developing countries

      • The loans are for economic development and help to build a country's infrastructure, such as highways, bridges, power plants, and water supply systems

      • World Bank sells bonds and receives donations

  6. President Nixon ended the Bretton Woods System in 1971

    1. Balance-of-payment deficits (i.e. trade deficits) would cause gold to leave the U.S.

    2. World Bank and IMF still live on

 

Current Exchange Rate Regime

1. Governments use a variety controls and measures

  1. Gov. imposes capital controls - the movement of money into and out of a country
  2. Gov. imposes controls on imports, exports, and foreign investment
  3. Gov. imposes restrictions on property ownership

2. Types

  1. Free float (or clean float) - a flexible exchange rate system
    • Supply and demand in the foreign exchange markets determine the exchange rates
    • No gov. interference
    • Canada, Eurozone, Japan, South Korea, and United States
  2. Managed float - government intervenes in the foreign exchange market in order to achieve its policy goals
    • Dirty float - if you are pessimistic; managed float if you are optimistic
    • Gov. keeps its currency too strong or too weak
    • Gov. does allow currency to move
    • Problems
      • If investors believe a country's currency will depreciate, then investors sell currency or short currency, creating the depreciation
      • Investors can overwhelm a government, and then government may devalue its currency
      • Self-fulfilling prophecy
  3. Pegged Exchange Rates - a country sets its currency exchange rate with another currency, usually the U.S. dollar or euro
    • Countries
      • United Arab Emirates, $1 = 3 Dirhams before 2008, and $1 = 3.67 after 2008
      • Bahamas, Barbados, and Hong Kong peg their currencies to the U.S. dollar, Bosnia and Herzegovina and Bulgaria peg their currencies to the euro
    • Gov. has to intervene to maintain that exchange rate
      • Some countries refuse to do this
      • Uzbekistan and some African countries
      • Black markets form for their currencies
      • The black markets reflect the true market value
      • The official gov. value tends to be over valued and its central bank is increasing the money supply
      • Gov. uses a pegged exchange rate to keep inflation in check from expanding money supply
  4. Dollarization - a country uses the U.S. dollar or euro as its currency
    • Countries
      • El Salvador, Ecuador, and Panama use the U.S. dollar
      • Guam, Marshall Islands, U.S. Virgin Islands, and Puerto Rico
      • Montenegro and Kosovo use the euro
    • Benefits
      • Integrate economy with United States or EU
      • Tie inflation rate to the United States or EU
      • Remove exchange rate risk
    • Problems
      • No monetary policy
      • No seignorage - gov. creates profit from printing money
        • Example - a $100 bill costs $0.14 to make
        • The $99.86 is a profit to the central bank or government
      • Severely limits a central bank

Note - free or managed exchange rate systems could lead to high inflation rates

  • One major trading partner has a high inflation, causing its currency to depreciate
  • The other country can increase its inflation rate, which maintains the exchange rate

Financing Balance-of-Payments Deficits and Surpluses

1. Fixed Rate Regime – government ensures balance-of-payments (BOP) is close to zero

  1. Weakens monetary policy
    • Changing the money supply changes the interest rates which could change the flow of money into and out of a country
    • Central bank has to maintain exchange rate; reduces focus on other goals
  2. If BOP < 0
    • Excess supply of currency on exchange markets
    • Government intervenes to bring BOP = 0
    • Government has to buy its currency back using official settlements reserves, such as foreign currencies, gold, SDRs, etc.
    • If government has no reserve assets, then it has to either devalue its currency or a black market forms
  3. If BOP > 0
    • Shortage of currency on exchange markets
    • Government sells it currency to buy foreign currencies
    • Government garners official reserves
    • Very easy to do

2. Floating exchange rate regime - government lets the exchange rate changes

  1. Balance-of-Payments deficit
    • Currency depreciates
    • Exports increase while imports decrease until BOP = 0
    • J-curve Effect - trade deficit get temporarily worse as currency depreciates
    • Usually t1 to t2 is 3 to 6 months

J-Curve Effect

  1. Balance-of-Payment surplus
    • Currency appreciates
    • Exports decrease while imports increase until BOP = 0

3. Managed floats - government changes the interest rates to intervene in the foreign exchange market

  1. Balance-of-Payments deficit
    • Central bank decreases the money supply
    • Interest rate increases
    • Investors want to invest in the country to earn higher interest rate
    • Financial account increases until BOP = 0
  2. Balance-of-Payments surplus
    • Central bank increases the money supply
    • Interest rate decreases
    • Investors reduce investments in the country, so financial account decreases until BOP = 0

 

Capital Flight

1. Capital Flight – foreign investors withdraw investments from a country

  • Massive financial account outflows
  • Causes problems for a government
  • Could cause a country's currency to depreciate rapidly
  • Examples - Argentina, Asian Financial Crisis 1997, Brazil, Italy 1992/1993, Mexico 1994/1995, Russia 1998, etc.

2. An event triggers a crisis

  • Example 1 - 1997 Asian Financial Crisis
  • Example 2 - France passed a new wealth tax in 2006
    • Collects $2.6 billion per year in new taxes
    • Lost over $125 billion in capital
  • Example 3 - gov. begins nationalizing industries
  • Example 4 - Mexico's Peso Crisis

3. Methods for countries to get investment out of the country

  1. International bank transfers until a government freeze international transfers
  2. Smuggle currency out of the country (illegal???)
  3. Convert currency to precious metals and smuggle metals outside of country
  4. Money laundering
  5. False invoices
    • Over price imports
    • Under price exports
 

FOLLOW ME