Chapter Three 31
CHAPTER 3
Exchange Rate Systems, Past to Present
CHAPTER OVERVIEW
Chapter 3 begins with a general discussion of the idea of an exchange rate system, and then discusses in detail the historical experience under three different systems: (1) the gold standard system which lasted from the mid 1870’s to World War I, as well as the subsequent brief return to the system after the war, (2) the Bretton Woods pegged exchange rate system, which lasted from World War II through the early 1970’s, and, (3) the current post-Bretton Woods floating exchange rate system.
For each of the three major systems, the chapter reviews the historical conditions that led to the development of the system, as well as the events that culminated in the eventual collapse of the first two. The treatment of the post-Bretton Woods system includes discussions of several of the prominent accords and agreements that were reached among the industrialized countries during this period, including the Smithsonian Agreement of 1971, the Jamaica Accords of 1976, the Plaza Agreement of 1985 and the Louvre Accord of 1986.
The chapter also provides important details about the practical functioning of various types of exchange rate arrangements currently in place as part of the post-Bretton Woods system, including crawling pegs, currency basket pegs, and the role of currency boards. The chapter concludes with a brief discussion of the pros and cons of fixed versus flexible exchange rate systems and highlights the importance of sound macroeconomics policy making under either type of system.
Throughout the chapter, frequent references are made to present-day issues as they relate to the different types of exchange rate arrangements that have been practiced over time. The chapter begins with a discussion of various emerging economies’ techniques for dealing with exchange rate instability. These techniques range from adopting the U.S. dollar as a currency to allowing a currency to freely float once inflation targets are met. The section on crawling peg exchange rates describes the Nicaraguan experience in which the government, having noted the inflation differential between Nicaragua and the U.S., adopted a crawling peg, and slowed the rate of the crawl as inflation was brought under control. Even the section on the historical gold standard era includes a discussion of recent arguments that have been made for a return to a commodity based gold standard system, most notably by conservative politicians such as Jack Kemp and Steve Forbes during the 1996 U.S. presidential election. These topical case studies can serve as valuable pedagogic devices that will help to engage rate systems that have been in place both in the present and in the past.
OUTLINE
I. The Gold Standard
A. Currencies Convertible to Gold
1. Individually
2. Implied Cross Rates
B. Performance
1. Positive Aspect in Money Stock Stability
2. Negative Aspect in Resource Costs
C. Collapse
1. Over- and Undervalued Currencies
2. Changing Trade Flows
II. Bretton Woods System
A. Bretton Woods Agreement
1. Establishment of IMF
2. Pegged Exchange Rate System
a. Dollar Standard
b. Dollar Tied to Gold
c. Devaluation and Revaluation
B. Performance
1. Gold Pool in 1960
2. Nixon Closes Gold Window in 1971
C. Smithsonian Agreement
1. New Par Values
2. 1973 Collapse
III. Flexible Exchange Rates
A. Jamaica Accord
B. Performance
1. Economic Shocks
2. Trends in Value of U.S. Dollar
C. Plaza Agreement and Louvre Accord
IV. Other Exchange Rate Arrangements
A. Crawling Pegs
1. Peg With Adjustable Value
2. Parity Band
B. Currency Baskets
1. Selection
2. Maintenance
C. Independent Monetary Authorities
V. Fixed vs. Floating Exchange Rates
VI. Summary
FUNDAMENTAL ISSUES
1. What is an exchange rate arrangement or exchange rate system?
2. How does a gold standard standard constitute and exchange rate system?
3. What was the Bretton Woods system of “pegged” exchange rates?
4. What post-Bretton Woods system of “flexible” exchange rates prevails today?
5. What are crawling peg and basket-peg exchange rate arrangements?
6. What is a currency board or an independent currency authority?
7. Which is best, a fixed or flexible exchange rate system?
CHAPTER FEATURES
1. Policy Notebook: “The International Monetary Fund: Dismantle or Reform?”
This notebook addresses the changing role of the IMF over time. Though the IMF started out as an institution to make short-term loans to nations experiencing external payment problems, it has become an institution providing long-term loans with policy prescriptions to help developing and transitional economies advance. Given some of the recent problems the IMF has experienced, a commission was formed in the U.S. to assess what direction the IMF should take in the future. It was recommended that the IMF return to focus on its initial role as a short-term lender, citing that the IMF was “cracking under the pressure of trying to do too much.”
For Critical Analysis: This may be addressed in the context of various goals of “financial stability”. The notebook makes the case that the IMF has been criticized for trying to accomplish too many goals. It may be best to have the IMF in charge of making short term loans, but to also communicate with another agency which is in change of making long-term loans which promote developing and emerging economies’ continued long term economic growth.
2. Policy Notebook: “Should Argentina Dollarize?”
This notebook examines the case of Argentina’s monetary reforms. In the early 1990s, Argentina suffered from hyperinflation; witnessing at one point a 20,266 percent increase in prices. This led Argentine leaders to adopt a currency board arrangement to curb inflation and provide macroeconomic stability through low inflation rates. Of course, the formation of this monetary arrangement eliminated the government’s ability to use an independent monetary policy to influence the economy. Though some have argued that the currency board also eliminated a “lender of last resort” role for the government, the fact that the arrangement features the contingent repurchase facility partially fulfills a “lender of last resort” role.
For Critical Thinking: If Argentina were to fully dollarize, it would sell a significant portion of its limited reserves. This places an additional restriction on the influence the government would have over domestic stabilization policies to offset exogenous shocks.
ANSWERS TO END OF CHAPTER QUESTIONS
1. Ranking the various exchange rate arrangements by flexibility is not so clear cut. Nonetheless the
arrangements described in this chapter are ( from fixed to flexible): currency board, commodity
(standard) peg, dollar (standard) peg, currency basket peg, crawling peg, managed float, flexible.
2. The two primary functions of the International Monetary Fund are: surveillance of member nations’
macroeconomic policies, to provide liquidity to member nations experiencing payments imbalances.
3. The value of the Canadian dollar relative to gold is CAN$69 and the value of the British pound relative
to gold is £33.33.
4. The exchange rate between the Canadian dollar and the British pound is CAN$/£2.07.
5. The currency equivalent of the Newbill is $0.6625+£0.255=1NB. The exchange rate between the
dollar and the pound can be used to convert the pound value to $0.375. Hence $1=1 Newbill and
the exchange rate between the dollar and the Newbill is 1. Using the exchange rate between the
dollar and the pound again, the exchange rate between the pound and the Newbill is £0.667.
6. Since the weight assigned to the dollar times the exchange rate between the dollar the and Newbill
must equal the currency equivalent amount of $0.625, the weight assigned to the dollar must be
62.5 percent. Because the weights must sum to unity, the weight assigned to the pound must be 37.5
percent.
MULTIPLE CHOICE EXAM QUESTIONS
1. The principle function of the International Monetary Fund was originally to
A. lend to member nations experiencing a shortage of foreign exchange reserves.
B. finance postwar reconstruction, particularly in Europe and Japan.
C. reduce trade barriers and settle disputes among countries relating to currency negotiations.
D. act as a supranational regulatory agency for domestic central banks.
Answer: A
2. The U.S. dollar today is an example of a
A. commodity money.
B. fiat money.
C. commodity-backed money.
D. currency basket.
Answer: B
3. The gold standard was in place for most major economics of the world during the period
A. from the beginning of the Great Depression until World War II.
B. from 1973 until the present.
C. from the mid-1870s until World War I.
D. since the end of World War II.
Answer: C
4. Under the gold standard, if the mint parity condition for the French franc was set at Ffr107.008
per ounce of gold, and the German mark was set at DM886.672 per ounce of gold, then it is possible to
compute the exchange rate between the German mark and the French franc as approximately
A. 0.81.
B. 1.23.
C. 0.67.
D. It is not possible to compute the exchange rate between the mark and the franc with these values, since these values are relative to the price of gold.
Answer: A
5. Under the Bretton Woods system, most of the major currencies of the system
A. pegged their values against the value of an ounce of gold.
B. pegged their values against the value of the dollar.
C. allowed their currencies to float.
D. pegged their values against the value of the Euro.
Answer: B
6. Which of the following is not an institution that arose under the Bretton Woods Agreement?
A. The International Monetary Fund
B. The International Bank for Reconstruction and Development
C. The League of Nations
D. The General Agreement on Tariffs and Trade
Answer: C
7. In the Plaza Agreement of September, 1985, the “Group of Five” or “G5” countries announced that
they believed that
A. the “G5” needed to be expanded to include an additional five major industrialized countries to make up what is now referred to as the “G10”.
B. the Bretton Woods system would no longer be sustainable.
C. it was necessary to “float” the dollar relative to gold.
D. the exchange value of the dollar was too strong and that they would coordinate their central bank
interventions in order to drive down the value of the dollar.
Answer: D
8. Which of the following is not a member of the “Group of Ten” industrialized countries?
A. Japan
B. Belgium
C. Switzerland
D. Sweden
Answer: C
9. An example of a country that maintained a crawling peg arrangement during the early 1990s is
A. the United States.
B. Canada.
C. France.
D. Mexico.
Answer: D
10. A currency board is an
A. exchange market in which the major currencies of the world are exchanged on the open market among private banks at prevailing rates.
B. independent monetary agency that substitutes for a central bank by pegging the growth of the domestic money stocks to the foreign exchange holdings of the board.
C. independent monetary agency which is responsible for setting bank reserve requirements for the
domestic currency.
D. exchange market in which the notes and bills issued by the domestic government are traded on the
open market among private banks.
Answer: B
11. Which of the following countries currently does not fix its exchange rate to any other currencies?
A. The Czech Republic
B. France
C. Japan
D. Germany
Answer: C
12. If the Italian lira is revalued relative to the German mark, then
A. for each lira, one can expect to buy fewer German marks.
B. for each lira, one can expect to buy more German marks.
C. the exchange rate between the lira and the mark will depreciate.
D. it is impossible to tell what will happen to the exchange rate or the number of marks that one can buy for each lira, since this depends on the supply and the demand for the lira relative to the mark.
Answer: B
13. Currency basket pegs usually involve pegging the domestic currency to
A. each of the major currencies of the world.
B. the relative price of a chosen basket of consumer goods.
C. a weighted average of only a small selected number of different currencies.
D. within an upper and lower limit of a band relative to either the U.S. dollar or the Japanese yen.
Answer: C
14. A “dirty float” exchange rate system refers to
A. a dual exchange rate system wherein there is both an official exchange rate and a black market
exchange rate.
B. an exchange rate system whereby each of the members of the system peg their currency against one of the major currencies, such as the U.S. dollar, which is in turn pegged against a commodity, such as gold.
C. and exchange rate arrangement in which the domestic currency is primarily managed by the central bank of a foreign country, which is typically the major trading partner.
D. and exchange rate arrangement in which a nation allows the international value of its currency to be primarily determined by market forces, but intervenes occasionally to stabilize its currency.
Answer: D
15. The Bundesbank is the central bank for
A. the Netherlands.
B. Austria.
C. Germany.
D. Belgium.
Answer: C
16. The Smithsonian agreement refers to
A. the understanding that most of the major industrialized countries came to at the end of the
depression era regarding the non-sustainability of the gold standard as it was currently practiced.
B. an agreement that was made to establish new par values for the G10 countries that had participated in the Bretton Woods system.
C. the agreement that President Nixon came to vis a vis the other G10 members to suspend temporarily the convertibility of the dollar into gold or other reserve assets.
D. the initial agreement that set forth for future cooperation under the North American Free Trade
Association.
Answer: B
17. Which of the following did not contribute to the eventual collapse of the Bretton Woods system?
A. increased federal spending for social programs termed the “Great Society” under the Johnson
administration
B. heightened U. S. involvement in Vietnam
C. the conditions set forth in the Louvre Accord
D. U.S. balance of payments deficits with Germany and Japan
Answer: C
18. A Monetary Order is
A. a set of rules that determine the international value of a currency.
B. a set of laws and regulations that establishes the framework within which individuals conduct and
settle transactions.
C. an exchange rate arrangement in which a country pegs the international value of the domestic currency
relative to the currency of another nation.
D. a specialized form of a currency board.
Answer: B