Copyright ©2004, South-Western College Publishing International Economics By Robert J. Carbaugh 9th Edition Chapter 16: Exchange-Rate Systems

Copyright ©2004, South-Western College Publishing

International EconomicsBy Robert J. Carbaugh9th Edition

Chapter 16:

Exchange-Rate Systems

Carbaugh, Chap. 16 2

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)


Exchange rate system alternatives

Exchange rate arrangements ofIMF members, 2001

Exchange arrangements with no separate legal tender 39

Currency board arrangements 8

Conventional pegged (fixed) exchange rates 31

Pegged rates within horizontal bands 6

Crawling pegged exchange rates 4

Exchange rates within crawling bands 5

Managed floating exchange rates 33

Independently floating exchange rates 47

NumberExchange Arrangement of Countries



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



Key currencies: Share of national currencies in total identified official holdings of foreign exchange, 2000

US dollar 68.2% 73.3% 64.3%Japanese yen 5.3 6.5 4.4Pound sterling 3.9 2.0 5.2Swiss franc 0.7 0.2 1.1Euro 12.7 10.2 14.6Other 9.2 7.8 10.4

All Industrial DevelopingKey currency countries countries countries



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


Exchange rate stabilization under fixed rates



Exchange rate stabilization under fixed rates




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 currency’s value relative to other currencies, correcting a surplus



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


Devaluation/revaluation: legal and economic impact

Devaluation and revaluation


Devaluation/revaluation: legal and economic impact

Devaluation and revaluation


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



Currency boards vs. dollarization (cont’d)

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




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




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



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



Floating exchange rates (cont’d)

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



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


Adjustable pegged rates



Managed floating exchange rates



Exchange rate stabilization and monetary policy




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



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)

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Copyright ©2004, South-Western College Publishing International Economics By Robert J. Carbaugh 9th Edition Chapter 16: Exchange-Rate Systems