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International Finance and Investment

Topic 2: Evolution of Exchange Rate Systems


Finance 663
Ali Emami
Lundquist College of Business
Department of Finance
University Of Oregon
Contents
INTRODUCTION: HISTORY OF EXCHANGE RATE SYSTEMS ............................... 2
I.
THE CLASSICAL GOLD STANDARD SYSTEM: 1821-1914 ................................... 2
Trade Imbalances under Gold Standard................................................................................ 3
Problems with Gold Standard ................................................................................................. 3
Gold Standard: Statistics ......................................................................................................... 3
II.
POST WWI GOLD- EXCHANGE STANDARD: 1925-1931 ...................................... 4
III.
THE BRETTON WOODS AGREEMENT: 1944.......................................................... 4
IV.
The Fixed-Rate Dollar Standard, 1950-1970.................................................................. 5
V.
SMITHSONIAN AGREEMENT (Fixed Rates with Wider Bands), 1971................... 6
VI.
THE FLOATING-RATE DOLLAR STANDARD, 1973-1985..................................... 6
Major events during 1973-1985 that contributed to exchange rate volatility during 19731985............................................................................................................................................. 7
OPEC (Organization of Petroleum Exporting Countries) 1973-1974 ............................. 7
Dollar Crisis of 1977-1978 .................................................................................................... 7
The Rising U.S. Dollar: 1980-1985 ...................................................................................... 7
VII. THE PLAZA-LOUVRE INTERVENTION ACCORD AND THE FLOATINGRATE DOLLAR STANDARD (The Era of Managed Float), 1985-1995.................... 7
VIII. EUROPEAN MONETARY SYSTEM (EMS), 1979 ..................................................... 8
The European Currency Unit (ECU)...................................................................................... 8
The Exchange Rate Mechanism (ERM) ................................................................................. 8
The European Monetary Cooperation Fund (EMCF) .......................................................... 8
IX.
Nominal, Real, and Effective Exchange Rates ............................................................. 10
Nominal Exchange Rates........................................................................................................ 10
Real Exchange Rates............................................................................................................... 10
Nominal Efective Exchange Rates......................................................................................... 10
Real Effective Exchange Rate.11

Evolution of Exchange Rate Systems


INTRODUCTION: HISTORY OF EXCHANGE RATE SYSTEMS
During the last century, nations have developed systems to exchange their domestic currencies to
conduct international transaction such as import and exports of goods and services, and foreign
investment. The principal international financial systems may be classified as:
I.
II.
III.
IV.
V.
VI.
VII.

The Classical Gold Standard System: 1821-1914


The Gold Exchange Standard: 1925-1931
The Bretton Woods System: 1944
The Fixed-Rate Dollar Standard, 1950-1970
Smithsonian Agreement: 1971-1973
The Floating-rate Dollar Standard, 1973-1984
The plaza-Louvre Intervention Accord and the Floating-rate Dollar Standard,
1955-1995
VIII. European Monetary System, 1979

I.

THE CLASSICAL GOLD STANDARD SYSTEM: 1821-1914

Each country had to stand ready to convert its paper money to gold at a fixed price. Central
banks required to hold a minimum ratio of gold reserves to paper money (about 25%) for
emergency money-gold exchange purposes. Governments should allow free movements of gold
between countries.
Example: If the U.S. Fed agrees to buy and sell gold at $400 per ounce and the bank of England
agrees to buy and sell gold at 250 per ounce, the exchange rate between pound and dollar will
be:
S($/) = ($400/ 250) = $1.60/
Exercise 1: Given the gold prices in above, how one can profit if the market exchange rate is
S($1.5/).
Answer: If you exchange 1 in foreign exchange market for $, you get $1.50. If you convert 1
in U.K. into gold you get (1/250) oz of gold. Sell (1/250) oz of gold to Fed in U.S. for ($400 x
1/250) = $1.60. Exchange $1.60 for pound at the market rate of S ($1.5/), you get 1.066. Thus,
the latter method provides 0.066 profit. In this example people keep converting $ into pound.
The demand for pound increases which increases the $ price of pound to $1.60/ where there are
no further profitable arbitrage.

Trade Imbalances under Gold Standard:


Suppose U.K. had trade deficit, i.e., (X-M) UK <0, and U.S. had trade surplus, i.e., (X-M)US >0.
Under the gold standard, trade imbalances will be adjusted automatically. The mechanism under
which trade balances are reinstated is referred to as the price-specie flow automatic adjustment
mechanism. Where, specie means precious metal (gold), and adjustment mechanism occurs
through the flow of gold (specie) from deficit country (U.K.) to surplus country (U.S.), which
increases the reserves of gold in surplus country and reduces the reserves of gold in the deficit
country. Since according to the main rule of gold standard each country had to stand ready to
convert its paper money to gold at a fixed price, the deficit country (UK) who lost gold had to
reduce its money supply. Reduction of money supply in deficit country reduces the price level
(M9V=P9Q). The increase of gold reserves in the surplus country (U.S.) , increases the money
supply which in turn increases the price level, (M8V=P8Q). Reduction in prices in the deficit
country (UK) make U.K. goods cheaper than U.S. goods, therefore, U.K. exports to U.S.
increases and its imports from U.S. reduces, hence trade balance will be restored in both
countries through flow of gold-change in the money supplies-change in price levels-change in
exports and imports.
Problems with Gold Standard
If reduction in the money supply is not allowed by the government of the deficit country (say due
to possible raise in interest rate, decline in employment, reduction in growth), then the pricespecie flow automatic adjustment mechanism will be ineffective. The policy of not allowing
the decline in the reserves to change the money supply is referred to as sterilization
(neutralization). Because almost every nation is concern with full employment, at the beginning
of this century nations had to practice sterilization often and ultimately abandoned the gold
standard temporarily in 1914, and permanently in 1933.
Gold Standard: Statistics

Gold Standard operated during 1821-1914.


From 1821 to 1914, Great Britain maintained a fixed price of at 4.2474 per ounce.
The United States, during 1834-1933 (except for 1861-1878-Greenback period),
maintained the price of gold at $20.67.
Par exchange rate: The $/ exchange rate over 1834-1914 (except for 1861-1878) was
determines at [($20.67/ounce of gold)/ (4.2474)] = $4.8665/1.
Gold standard ensured long-run price stability (low inflation).

II.

POST WWI GOLD- EXCHANGE STANDARD: 1925-1931

The classical gold standard was abandoned during World War I. However, during 1925 to 1931
the Gold Exchange Standard was reestablished to combat the inflation and protectionism
generated during WWI, and to improve competitive advantage. According to this system,
Britain and U.S. could hold only gold, but other countries could hold both gold, and dollars or
pound as reserves. In 1926, France devaluated the franc that created problems for Britain. In
1928, French decided only to accepts gold and no foreign currency. In 1931, France refused too
accept British ponds and only demanded gold for their sterling pound holdings. British made
pound inconvertible into gold and other countries except U.S. follow the suit. Up to 1934, the
U.S. dollar could be converted to gold. This system officially ended in 1931. After this period
nations started devaluation of their currencies to take advantage of more exports. These beggarthy-neighbor devaluations ultimately led to great depression.
III.

THE BRETTON WOODS AGREEMENT: 1944

In post WWII, in a conference the allied countries introduced a new monetary system in Bretton
Woods (a town a New Hampshire) in 1944. To implement this new system, this conference also
created two new international institutions of International Monetary Fund (IMF) and
International Bank for Reconstruction and Development (World Bank). Under Bretton Woods
Agreement which was implemented in 1946, each nation accepted to set a fixed or pegged
exchange rate for its currency vis--vis the dollar or gold. One ounce of gold was set equal to
$35. Currency values were allowed to fluctuate within a one percent band in the short-run.
Long-run devaluations or revaluations beyond the band had to be approved by IMF.
According to Bretton Woods Agreement, to offset the short-term payments imbalances nations
could use their official reserves or borrowing credits from IMF to sterilize the impacts of
exchange market interventions on national money supply. The following figure shows the role
of international reserves in a pegged exchange rate system.

$/

E4
$2.814
$2.80

M
D

$2.786

E1
F

G
E2

K
S

J
D

D
Quantity of /time

The equilibrium central parity rate for in 1960 is given at a price of $2.80/ at point E1.
Assume that demand for falls to DD due to an increase in inflation (rise in price level) in
U.K. In the absence of British government interventions, the $ price of will fall to the new
equilibrium (intersection of DD & SS) at E2. According to Bretton Woods Agreement British
government may keep the exchange rate within 1% of its par value $2.80/ (i.e., at $2.80$0.028= $2.772).
If British government decides to maintain the exchange rate say at 0.5% below par value (i.e., at
$2.786) then Bank of England must buy up the excess supply of equal to fg units each period at
the cost of $2.786 x fg in order to keep the value of at $2.786 rather than allowing to drop
to point E2. Note that British government has to pay $ for its reserves to by back the excess
supply of . If British government runs out of $reserves or cannot borrow anymore, then it has
to devalue its currency.
If demand for increases to DD, then excess demand for and UK must supply MN units of
and accumulate $ ($2.814 x MN).
Exercise: Given DD and SS, what actions should be taken by Bank of England to keep the
value of at $2.786?

IV.

The Fixed-Rate Dollar Standard, 1950-1970

From 1950 to 1970, the Bretton Woods system operated in the form of a Fixed-Rate Dollar
Standard. That is, except for the United States, the industrial countries fixed their currencies at an
official par value in terms of the U.S. dollar, and kept the exchange rate within 1 percent of its
par value.
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According to this system U.S. faced the Redundancy Problem. That is its exchange rate was
determined by other countries. Thus the policies of other countries determined the U.S. policy.
Example: when France set a fixed exchange rate of 5 ff/$, then the United States must accept
$0.20/ff as its par value rate. Thus the United States had to stay passive in foreign exchange
market. During this 20- year period, the United States had to adopt monetary polices in
accordance with other countries macroeconomic objectives which provided worldwide price
stability.
By the 1960s, increase in U.S. liabilities abroad created the fear that the United States gold
reserves might not be sufficient for converting dollars into gold. Thus, SDR (special drawing
right, Paper gold) was introduced. Also, in 1960s, U.S. used expansionary monetary policy
which produced inflation. Hence, U.S. experienced trade imbalances. On August 1971, dollar
was devalued from $35 to $42 for one ounce gold, and simultaneously U.S. officially avoided the
exchange of dollar for gold.

V.

SMITHSONIAN AGREEMENT (Fixed Rates with Wider Bands),


1971

In December 1971, industrial countries tried to set new parities and return to pegging system.
The dollar was set to 1/38 of an ounce of gold and other currencies were revalued at fixed rates
vis--vis dollar. According to this agreement the currencies were to be allowed to fluctuate
within a wider band of "2.5% around parity rather tan "1%. But, not many countries adopted
this fixed system. Agreement was abandoned and currencies allowed to float against each other
by 1973.
VI.

THE FLOATING-RATE DOLLAR STANDARD, 1973-1985

IMF established new guidelines for foreign exchange markets for both U.S. and other industrial
countries:
For industrial countries:

Allow short-term fluctuation in the dollar exchange rate, but not pegging or
commitment to long-run exchange stability.

Allowing free conversion of currencies for current account transaction and


elimination of impediments on capital account transactions.

Use of the U.S. dollars for intervention purposes, and holding official reserves in
U.S. Treasury bonds

Using monetary policy for adjusting exchange rate: Increase money supply when
currency is strong, reduce money supply when currency is weak.

Allow money supply and price levels to be determined independent from U.S.
6

Let exchange rate adjustment to reflect difference in price level and money
supply.
For United States:
Conduct free trade independent from maintenance of balance of payments or
exchange rate targets.

No interventions in capital market.

Adopt monetary policies independent from exchange rate and price stabilization
policies of other countries.
Major events during 1973-1985 that contributed to exchange rate volatility during 19731985:

VII.

OPEC (Organization of Petroleum Exporting Countries) 1973-1974


OPEC was formed on October 1973 which raise the oil price in 1974. The
United State reacted by controlling the price of oil, increasing overall spending,
expansionary monetary policies which resulted in high inflation, and low
economic growth. Despite the downward pressure on dollar, U.S. maintained the
high overvalued dollar in foreign exchange market that resulted in balance-ofpayment deficit. Nations such as Japan who did not control the price of oil
(allowed to rise) and followed tight monetary policy along with OPEC countries
experienced balance of payment surplus. These surpluses were lend to debtor
nations which resulted in debt crises of the 1980s.

Dollar Crisis of 1977-1978


During 1977-1978, Carter administration allowed expansionary monetary policy,
which resulted in high inflation, and depreciation of U.S. dollar. In October 6,
1979 Fed pursued tight monetary policies, which help to reduce inflation and
increase in U.S. interest rates and the value of U.S. dollar.

The Rising U.S. Dollar: 1980-1985


As the result of the Feds controlled money supply policy, inflation declined and
U.S. dollar gained higher value during 1981-1985 (President Regans first term in
office). The higher valued dollar translated into higher economic growth and
higher real interest rate, which attracted foreign capital into U.S. causing
downward pressure on other countries currencies.

THE PLAZA-LOUVRE INTERVENTION ACCORD AND THE FLOATINGRATE DOLLAR STANDARD (The Era of Managed Float), 1985-1995

In 1981, expansive U.S. fiscal policy and controlled monetary policies supported by President
Regan, appreciated the U.S. dollar against other major currencies. Other countries conducted
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tight monetary policies to protect their currencies, but it only reduced their economic growth.
On September 2, 1985, the G-5 countries (U.S., France, Germany, Britain, and Japan) met in
Plaza Hotel in New York to find solutions for exchange rate crisis. They jointly decided to
intervene and depreciate the U.S. dollar. Dollar continued to fall till 1987. The fall in dollar
strengthen U.S. competitiveness and reduced European countries competitiveness, hence the G-5
countries plus Canada and Italy (G-7) held a meeting in February 1987 at Louver in Paris to slow
the dollars fall by pegging exchange rates within a "5% band around the central par value of
DM1.8250/$ and 153.50/$ which prevailed at that time. However, dollar appreciated during
1988-1989 against most major currencies, it fell in 1990, it was constant during 1991-1992, it fell
again against yen and DM, and fell during 1994-1995, appreciated again in 1996-1997.

VIII.

EUROPEAN MONETARY SYSTEM (EMS), 1979

In 1971 after the collapse of Bretton Woods system, the European countries member of the
European Community (EC) adopted a plan (Werner Plan) to form a monetary union with the
objective of creating smaller fluctuations for member countries against each other but greater
fluctuations for European currency against the U.S. dollar. In 1972, European countries
established an internal exchange rate variability band among the EC members at "2.25% (the
snake), and an external exchange rate variability band between the European currencies and the
U.S. dollar members at "4.5% (the tunnel). The time series chart of the exchange rate
movements thus looked liked a snake in the tunnel. In 1973, European countries abolished
the tunnel and allowed European currencies to freely float against the U.S. dollars, however
they maintained the snake.
In 1978-1979, led by Germany and France, the European Monetary System (EMS) was
introduced hoping that EMS eventually will bring about the European Monetary Union (EMU).
This EMS suggested creation of:
The European Currency Unit (ECU): A basket of certain amount of currencies of
each European member country. (see Table 2-2 page 37)
The Exchange Rate Mechanism (ERM): ERM limits the member countries
exchange rate fluctuations ("2.5%) around a central rate in terms of ECU across
Europe. (Box 2-6, rule 1 and II). ERM allows government intervention if
fluctuation exceeds the limit (the central bank of strong currency should lend to
country of weak currency) (Rule III). Realign the exchange rate par values with
majority (Rule IV). Countries should converge their macroeconomic policies
(Rule V).
The European Monetary Cooperation Fund (EMCF): The EMCF issued ECUs to
central banks of member countries in exchange for 20% of their gold and US
dollar reserves.
Macroeconomic Requirements for EU Members

EU Articles (Optional):
See the Special Issue of the Journal of Policy Modeling, on the Euro, the Dollar, and the
International Monetary System. 22(3): 275-415.
Uof O library provides link to this site. You can download all articles in this special issue of
JPM. (I posted these articles on the class site)
NOTE:
For more information on Europeans single currency see NBER site: nber.org

IX. Nominal, Real, and Effective Exchange Rates


Nominal Exchange Rates: Nominal exchange rates are rates quoted in the market daily.
Nominal exchange rates also are referred to as actual exchange rates or market exchange
rates.
Real Exchange Rates: Are nominal rates adjusted for relative rates of inflations in
countries. In empirical research, it is a customary practice to use relative inflation rates
reflected in consumer price indexes (CPIs), relative producer price indexes (PPIs), or
relative labor cost indexes (LCIs).

0.7812
Calculating Real Exchange Rate: Let StN
represent the nominal exchange rate
$

between dollar and euro at time t. Let CPI $,t = 104 and CPI ,t = 110 denote CPIs in

U.S. and EU respectively. The real exchange rate at time t , StR , is calculated as:
$

StN
R
$ = S N CPI$,t = 0.7812 104 = 0.738589
=
S

t
t $
110
$ CPI ,t
CPI ,t

CPI$,t
Nominal Effective (trade-weighted) Exchange Rate: A currency may appreciate
against one currency and depreciate against another currency. Thus on the basis of
bilateral exchange rates one can not judge whether or not the currency appreciated or
depreciate. An indicator of a currencys overall movements (on average) against other
currencies is referred to as Nominal Effective Exchange Rate (NEER). Thus, NEER
measures the dollars value relative to the currencies of the U.S. major trading partners.
The magnitude of NEER index depends on the weight given to each currency in the
basket of currencies of trading partner. Value of trade may be used to weight currencies
to produce trade weighted value of NEER index.
Effective exchange rate of a country is more stable than its bilateral exchange rates.
Sources for U.S. NEER: A nominal effective exchange rate, labeled U.S. dollar: J.P.
Morgan index against 19 currencies, is published daily in The Wall Street Journal on the
first page of Section C, Money and Investing. Also, see Economic Report of the
President.

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Example NEER:

The following table shows how the NERR is calculated for the United States and selected
major trading countries partners for 1990 and 1998.
Country
France
Germany
Italy
UK
Canada
Japan
Mexico
Total

Exchange Rate
1990
1998
Ff 5.4453 $
DM 1.6157 $
Lire1,198.1 $
0.5603 $
C $1.1668 $
144.79 $
Peso 2.81 $

Ff 5.8995 $
DM 1.7597 $
Lire1, 736.2 $
0.6037 $
C $1.4835 $
130.91 $
Peso 9.14 $

Index 1998
S98
S90
1.083
1.089
1.449
1.077
1.271
0.904
3.253

U.S. Trade, 1998


Exports and Weight
Imports
41.5
0.046
76.1
0.084
29.9
0.033
72.3
0.080
332.6
0.368
178.4
0.197
173.8
0.192
1,904.7
1.000

NEER1998 = (1.083)( 0.046 ) + (1.089 )( 0.084 ) + (1.449 )( 0.033) + (1.077 )( 0.080 ) +

(1.271)( 0.368) + ( 0.904 )( 0.197 ) + ( 3.253)( 0.192 )


= 1.546
Here, NERR indicates that the U.S. dollar appreciated 54.6% against this set of trade
partners over 1990-1998 period. Note that NERR is sensitive to the choice of countries
included in the sample.
Source:IMF, IFS Yearbook 1999 and Survey of Current Business, July 1999.
Real Effective Exchange Rate (REER)
Real effective exchange rate measures an effective (trade-weighted) exchange rate based
on real exchange rates rather than nominal rates. In this case, in the above example, the
exchange rate indexes are calculated using real exchange rates rather than nominal
exchange rates. These indexes then are weighted by trade shares.

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