Documente Academic
Documente Profesional
Documente Cultură
I.
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.
II.
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.
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 $2.786?
IV.
From 1950 to 1970, the Bretton Woods system operated in the form of a Fixed-Rate Dollar
Standard. That is, except for the United States, the industrial countries fixed their currencies at an
official par value in terms of the U.S. dollar, and kept the exchange rate within 1 percent of its
par value.
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According to this system U.S. faced the Redundancy Problem. That is its exchange rate was
determined by other countries. Thus the policies of other countries determined the U.S. policy.
Example: when France set a fixed exchange rate of 5 ff/$, 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.
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.
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.
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.
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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.
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.
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.
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
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
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