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Chapter 6
Government Policies toward the
Foreign Exchange Market
Tutor: X. Zhang
Topics covered
• Why governments intervene?
• Two aspects: Rate Flexibility and
Restrictions on Use
• Defense through official intervention
• Exchange control
• International currency experience
Why governments intervene?
• Exchange rates, if left to private market
forces sometimes fluctuate a lot. They are
prone to overshoot and may occasionally also be
influenced by bandwagons among investors or
speculators.
• Exchange rates are very important prices—they
can affect the entire range of a country’s
international transactions. Therefore, one
objective for government policy is to reduce
variability in exchange rates.
Why governments intervene?
• A government may want to keep the exchange rate value
of its currency low, preventing appreciation or
promoting depreciation, which could benefits the
country’s exporters and import-competing businesses.
• Or a government may want to keep the exchange rate
value of its currency high, preventing depreciation or
promoting appreciation, which could benefit buyers of
imports. Meanwhile it can be used as part of an effort
to reduce domestic inflation by using the competitive
pressure of low import prices.
• In addition, a government policy may reflect other
noneconomic goals. For example, by maintaining a steady
exchange rate or a strong currency internationally, the
government may believe it is defending national honour
or encouraging national pride.
Two aspects of government policies
• Rate flexibility—those polices that are
directly applied to the exchange rate
itself.
• It directly acts on price (the exchange
rate), similar as the tariff imposed on a
country’s imports.
• Government policies toward the exchange
rate itself are usually categorized
according to the flexibility of the
exchange rate—the amount of movement in
the exchange rate that the policy permits.
• In the simplest terms, governments choose
between floating and fixed exchange rates.
Two aspects of government policies
• Restrictions on use—those policies that directly
state who may use the foreign market and for what
purposes.
• It acts directly on quantity (by limiting people’s
ability to use the foreign exchange market),
similar as the quota of a country’s imports.
• Government policies can also restrict access to
the foreign exchange market.
• One type of policy is no restriction—everyone is
free to use the foreign exchange market. The
country’s currency is fully convertible into
foreign currency for all uses.
Two aspects of government policies
• The other type of policy is exchange control—the
country’s government places some restrictions on use of
the foreign exchange market.
• In the most extreme form of exchange control, all
foreign exchange proceeds (for instance, proceeds from
foreign payments for the country’s exports) must be
turned over to the country’s monetary authority. Anyone
wanting to obtain foreign exchange must request it from
the authority, which then determines whether to approve
the request.
• Less extreme forms of control limit access for some
types of transactions, while permitting free access for
other types of transactions. For example, the currency
is convertible for current account transaction but
placing limits or requiring approvals for payments
related to some international financial activities.
Floating Exchange rate
• Definition: Currency exchange rate which is determined by
free market forces, rather than being fixed by a
government. Value of the currency is determined solely by
market demand for and supply of the currency in the foreign
exchange market. Trade flows and capital flows are the main
factors affecting the exchange rate. In the long run it is
the macro economic performance of the economy (including
trends in competitiveness) that drives the value of the
currency. No pre-determined official target for the
exchange rate is set by the Government.
• If the government policy lets the market determine the
exchange rate and the rate is free to go wherever the
market equilibrium is at that time, this policy choice
results in a clean float. Market supply and demand are
nonofficial activities. A clean float is the polar case of
complete flexibility.
Floating Exchange Rate
• It is rare for clean float to exist - most
governments at one time or another seek to
"manage" the value of their currency through
official intervention. That is the monetary
authority enters the foreign exchange market
to buy or sell foreign currency or the
government would change its interest rates to
impact its exchange rate.
• This policy approach means a generally
floating exchange rate but with government
willing to intervene to attempt to influence
the market rate, which is called a managed
float or a dirty float.
Advantages of floating
exchange rates
1. Fluctuations in the exchange rate can provide an automatic
adjustment for countries with a large balance of payments
deficit. If an economy has a large deficit, there is a net
outflow of currency from the country. This puts downward
pressure on the exchange rate and if a depreciation occurs,
the relative price of exports in overseas markets falls
(making exports more competitive) whilst the relative price
of imports in the home markets goes up (making imports
appear more expensive). This should help reduce the overall
deficit in the balance of trade provided that the price
elasticity of demand for exports and the price elasticity
of demand for imports is sufficiently high.
2. A second key advantage of floating exchange rates is that
it gives the government / monetary authorities flexibility
in determining interest rates. This is because interest
rates do not have to be set to keep the value of the
exchange rate within pre-determined bands.
Fixed Exchange rate
• In a fixed exchange rate system, the
government (or the central bank acting on
the government's behalf) intervenes in
the currency market so that the exchange
rate stays close to an exchange rate
target.
• Often some flexibility is permitted
within a range, called a band, around
this chosen fixed rate, called the par
value or central value.
Advantages of Fixed Exchange
Rates (disadvantages of
floating rates)
1. Fixed rates provide greater certainty for exporters and
importers and under normally circumstances there is less
speculative activity - although this depends on whether
the dealers in the foreign exchange markets regard a
given fixed exchange rate as appropriate and credible.
Sterling came under intensive speculative attack in the
autumn of 1992 because the markets perceived it to be
overvalued and ripe for a devaluation.
2. Fixed exchange rates can exert a strong discipline on
domestic firms and employees to keep their costs under
control in order to remain competitive in international
markets. This helps the government maintain low inflation
- which in the long run should bring interest rates down
and stimulate increased trade and investment.
Fixed Exchange Rate
• In implementing its choice of a fixed
exchange rate, the government actually
faces three specific major questions:
1.To what does the government fix the
value of its currency?
2.When or how often does the country
change the value of its fixed rate?
3.How does the government defend the fixed
value against any market pressures
pushing toward some other exchange rate
value?
What to fix to
1. It can be fixed to a commodity such as gold. If several
countries all fix the values of their currencies to specific
amounts of a commodity, then arbitrage ensures that the
exchange rates among the currencies will also be fixed at the
rates implied by the commodity’s values. That is currencies
tied to the same thing are all tied to each other.
2. The country could choose to fix the value of its currency to
some other currency, rather than to a commodity. For example,
US dollar after World War II
3. The country could choose to fix the value of its currency to
the average value of a number of other currencies. The logic
behind this is the same as that of diversifying a portfolio
(not putting all eggs in one basket). If the country fixes to
one single other currency, then it will ride along with this
other currency if the other currency’s value experiences
extreme changes against any third-country currencies. Fixing
to a basket of currencies moderates this effect, in that the
average value is kept steady.
What basket of currencies
might the country fix to?
There is one ready-made basket—the special drawing
right (SDR), a basket of four major currencies in the
world. In 2002, one SDR equals the collection of
US$0.577 plus 21 Japanese Yen plus 0.426 euros plus
British pound 0.0984. Market exchange rates can then
be used to compute the SDR’s value in terms of any
specific single currency.
Or a country can create its own basket. For instance,
the country might be interested in maintaining a
steady exchange rate value to facilitate its
international trade activities. In this case the
basket would include the currencies of its major
trading partner.
When to Change the fixed rate?
• Once the country has chosen what to fix to, it establishes a
specific value for its currency in terms of the item chosen.
As the government attempts to maintain this fixed value over
time, it faces the question of when to change the fixed rate.
1. The government may never change the fixed rate. A permanently
fixed exchange rate is useful as a polar case—the opposite
of a clean float. But nothing is fixed forever. On this
basis, the term pegged exchange rate in place of fixed
exchange rate is used, in recognition that the government has
some ability to move the peg value.
2. Although the fixed rate may not be fixed forever, the
government may try to keep the value fixed for long periods
of time. Nonetheless, in the face of a substantial or
fundamental disequilibrium in the country’s international
position, the government may change the pegged-rate value.
This approach is called an adjustable peg.
When to Change the fixed rate?
3. In other situations, the government may recognize that a
specific pegged-rate value cannot maintained for long and
it would change the peg value according to a set of
indicators or according to the judgment of the government
monetary authority.
For example, the difference between the country’s inflation rate
and the inflation rate of the country whose currency it pegs to.
If the inflation difference is used, the nominal pegged rate
will track purchasing power parity over time, and this bilateral
real exchange rate will be stabilized. Other indicators that
might be used include the country’s holdings of official
international reserve assets (indicating pressure from the
country’s balance of payments), the growth of the country’s money
supply (indicating underlying inflation pressure), or the
current actual market exchange rate relative to the central par
value of the pegged rate (indicating within the allowable band,
the foreign exchange market pressure away from the par value.
Defending a fixed exchange rate
• The pressures of a private or nonofficial supply and demand in
the foreign exchange market may sometimes drive the exchange
rate toward values that are not within the permissible band
around the par value. The government then must use some means to
defend the pegged rate—to keep the actual exchange rate within
the band. There are four basic ways:
1. The government can intervene in the FX market, buying or selling
foreign currency in exchange for domestic currency, to maintain
or influence the actual exchange rate in the market.
2. The government can impose some form of exchange control to
maintain or influence the exchange rate by constricting demand
or supply in the market. (a closely related approach would use
trade controls such as tariffs or quotas to attempt to
accomplish this result)
3. The government can alter domestic interest rates to influence
short-term capital flows, thus maintaining or influencing the
exchange rate by shifting the supply-demand position in the
market.
Defending a fixed exchange rate
4. The government can adjust the country’s whole macroeconomic
position to make it fit the chosen fixed exchange rate
value. Macroeconomic adjustments driven by changes in
fiscal or monetary policy can alter the supply demand
position in the foreign exchange market, for instance by
adjusting export capabilities, the demand for imports, or
international capital flows.
5. The country can alter its fixed rate (devaluing or
revaluing its currency) or switch to a floating exchange
rate (in which case the currency will immediately
depreciate or appreciate).
• The four ways of defending a fixed rate are not mutually
exclusive—a country can use several methods at the same
time. Indeed they are often closely interrelated. For
instance, changing interest rates to influence short-term
capital flows relates to overall macroeconomic management.
Defense through official
intervention-against Depreciation
• Suppose a Latin American country’s currency is tending toward
depreciation, say this country is attempting to maintain a fixed
rate of 25 pesos per dollar, with a band of plus or minus 4% (plus
or minus one peso).
• Nonofficial (private) supply and demand are attempting to push the
exchange rate to 28 pesos per dollar. If the country’s monetary
authority is committed to defending the fixed rate within its band
using intervention, then the authority must enter into the foreign
exchange market in its official role. It must sell dollars and buy
pesos. To keep the currency in the allowable band, it must sell 3
billion dollars into the FX market at the rate of 26 pesos per
dollar (the top of the band), so it is buying 78 billion pesos from
the foreign exchange market.
• The relatively strong demand for dollars is generally related to
strong demand by the country for purchases of foreign goods,
services, and financial assets. This results in an official
settlements balance deficit if the country’s monetary authority
intervenes to defend the fixed rate. Through intervention the
monetary authority is financing the country’s deficit in its
official settlement balance.
Figure 6-1: Intervention to Defend a Fixed
Rate: Preventing Depreciation of
the Country’s Currency
Exchange rate
pesos per $r
S$
Official par
28
value = 25
26
Allowable
band
{ 25
24
D$
20 23 $
(billions)
Defense through official
intervention-Against Depreciation
• Where does the country’s monetary authority get
the dollars to sell into the FX market?
• The authority either uses its own official
international reserve assets to obtain dollars from
some foreign source, or it borrows the dollars.
• There are four major components to a country’s
official reserve assets: the country’s holdings of
foreign exchange assets denominated in the major
currencies of the world, the country’s reserve
position with the IMF, the country’s holdings of
SDR and the country’s holdings of gold.
A country’s official reserve
assets
• Most official reserve assets are in the form of foreign exchange
assets, typically invested in safe, highly liquid interest-
earning debt securities such as government bonds.
• If the country has a reserve position in IMF, then it can obtain
dollars from the IMF on request. If the country is holding SDRs,
then it can use these SDRs to obtain dollars from the US
monetary authority or from the IMF.
• In addition to using its reserve assets to obtain dollars, the
country’s monetary authority can borrow dollars, either from the
monetary authorities of other countries, or from nonofficial
sources.
• If the country’s currency is a reserve currency, then the
country can effectively borrow through official channels by
issuing assets that will be held as reserves by the central
banks of other countries. It is called “deficit without tears”
Defense through official
intervention-against appreciation
• An Asian country attempting to maintain a fixed rate of 100
locals per dollar, with a band of plus or minus 5%. Nonofficial
supply and demand are attempting to push the exchange rate to
85 locals per dollar.
• If the country’s monetary authority is committed to defending
the fixed rate within its band using intervention, then the
authority must enter into the foreign exchange market in its
official role. It must buy dollars and sell domestic currency.
To keep the currency in the band, it must buy 2 billion dollars
from the foreign exchange market at the rate of 95 locals per
dollar, so it is selling 190 billion locals into the foreign
exchange market.
• The relatively strong demand for locals is generally related to
relatively strong demand by foreigners for the country’s goods
services and financial assets. This results in an official
settlements balance surplus if the country’s monetary authority
intervenes to defend the fixed rate. The intervention provides
the local currency for the foreigners to buy more from the
country than they are selling to the country.
Figure 6-2: Intervention to Defend a Fixed
Rate: Preventing Appreciation of
the Country’s Currency
Exchange rate
locals per $r
S$
Allowable
band
{ 105
100 Official par
95
value = 100
85
D$
16 18 $
(billions)
Defense through official
intervention-appreciation
• What does the country’s monetary authority
do with the dollars that it obtains from
the foreign exchange market?
• It adds these dollars to its official
international reserve holdings. Most
likely the authority will use the dollars
to obtain US dollar denominated foreign
exchange assets, i.e. US government bonds.
The country’s holdings of official reserve
assets increase. The selling of domestic
currency will expand the domestic money
supply.
Exchange control
• Although exchange control is inferior to
other options, it is still widely used by
most of countries both developed and
developing.
• It includes requirement to surrender export
proceeds and restrictions on international
portfolio investments as well as capital
transaction which restrict the ability of
residents to buy foreign goods or services,
to travel abroad, or to invest abroad.
• Exchange controls are closely similar to
quantitative restrictions (quotas) on
imports.
Exchange control
• For example, imaging that the US government has become
committed to maintaining a fixed exchange rate that
officially values foreign currencies less and the
dollar more, than would a free market equilibrium
rate. This official rate is $1.00 for the pound
sterling.
• The exchange control laws require exporters to turn
over all their revenues from foreign buyers to the US
government. The US government in turn gives them $1.00
in domestic bank deposits for each pound sterling they
have earned by selling abroad. At this exchange rate,
exporters are earning and releasing to authorities
only £30 billion per month.
Exchange control
• This figure is well below the £63.3 billion per
month that residents of the US want to buy at
this exchange rate to purchase foreign goods,
services and assets.
• If the US government is committed to the $1.00
rate, yet is not willing to intervene or to
contract the whole US economy enough to make
the demand and supply for foreign exchange
match at $1.00 then it must ration（配给） the
right to buy foreign exchange.
Exchange control
• Imagine on Jan. 21, US officials announce that
anyone wanting sterling for March must send in bids
by Feb. 15. Receiving all the bids, the government’s
computers would rank them by the price willingly
pledged, and the totals pledged would be added up at
each price.
• The government would announce on Feb. 20 that the
price of $1.50 per pound was the price that made
demand match the available £30 billion. Thus, all
who were willing to pay $1.50 or more for each pound
would receive the pounds they applied for, at the
price of $1.50 a pound. Anyone who did not submit
bids with prices as high as $1.50 would be denied
the right to buy pounds during Mar.
Exchange control
• This system would give the government a large amount
of revenues earned from the exchange control
auctions. Collecting $1.50/£ x £30 billion = $45
billion while paying exporters only $1.00/£ x £30
billion = $30 billion, the government would make a
net profit of $15 billion, minus its administrative
costs.
• This government profit could be returned to the
general public either as a cut in other kinds of
taxes or as extra government spending.
• The exchange control described does impose a loss of
well-being on society as a whole. When the exchange
controls are in effect and only £30 billion is
available, some mutually profitable trades are being
prohibited.
Exchange Control
• Actual exchange control regimes are likely to have several other
effects and costs:
• One is that the actual controls often incur greater administrative
costs to enforce the controls, as well as greater private resource
costs in dealing with them. Another difference is that some lower-
valued users may be approved in place of higher-valued users.
Therefore, the net loss may be larger.
• Another effect of exchange controls-efforts to evade them-is
predictable. People are frustrated when they are not allowed to buy
foreign exchange, even though they are willing to pay more than the
recipients of foreign exchange. The frustrated demanders will then
look for other ways to obtain foreign exchange.
• One way is to bribe the government functionaries in charge of
determining the official approvals.
• Another is to offer more to the recipients of foreign exchange than the
government is offering, thus making it worthwhile for the recipients to
sell direct in violation of the exchange controls. In this way a second
foreign exchange market—a parallel market or black market develops as a
way for private demanders and sellers of foreign exchange to evade the
exchange controls.
Macroeconomic Policy Goals
in an Open Economy
• In open economies, policymakers are
motivated by two goals:
• Internal balance
• It requires the full employment of a
country’s resources and domestic price level
stability.
• External balance
• It is attained when a country’s current
account is neither so deeply in deficit nor
so strongly in surplus.
Macroeconomic Policy Goals
in an Open Economy
• Internal Balance: Full Employment
and Price-Level Stability
• Under-and over employment lead to price
level movements that reduce the
economy’s efficiency.
• To avoid price-level instability, the
government must:
• Prevent substantial movements in aggregate
demand relative to its full-employment
level.
• Ensure that the domestic money supply does
not grow too quickly or too slowly.
Macroeconomic Policy Goals
in an Open Economy
• External Balance: The Optimal Level
of the Current Account
• External balance has no full employment
or stable prices to apply to an economy’s
external transactions.
• An economy’s trade can cause
macroeconomic problems depending on
several factors:
• The economy’s particular circumstances
• Conditions in the outside world
• The institutional arrangements governing its
economic relations with foreign countries
Macroeconomic Policy Goals
in an Open Economy
• Problems with Excessive Current
Account Deficits:
• They sometimes represent temporarily high
consumption resulting from misguided
government policies.
• They can undermine foreign investors’
confidence and contribute to a lending
crisis.
Macroeconomic Policy Goals
in an Open Economy
• Problems with Excessive Current
Account Surpluses:
• They imply lower investment in domestic
plant and equipment.
• They can create potential problems for
creditors to collect their money.
• They may be inconvenient for political
reasons.
Macroeconomic Policy Goals
in an Open Economy
• Several factors might lead policymakers
to prefer that domestic saving be devoted
to higher levels of domestic investment
and lower levels of foreign investment:
• It may be easier to tax
• It may reduce domestic unemployment.
• It can have beneficial technological
spillover effects
Standard Era,
The Gold 金币本位制的基本特征是：以一
1870-1914
定量的黄金为货币单位铸造金币
，作为本位币；金币可以自由铸
• 造，自由熔化，具有无限法偿能
The international gold standard emerged by 1870. Under
the gold standard each country’s government fixed its
力，同时限制其它铸币的铸造和
currency to a specified quantity of gold.
偿付能力；辅币和银行券可以自
• The government also freely permitted individuals to
由兑换金币或等量黄金；黄金可
exchange domestic currency for gold and to export and
import gold. 以自由出入国境；以黄金为唯一
• 准备金。
Through gold arbitrage the exchange rates between
currencies remained within a band whose width reflected
the transactions costs of gold movements between
countries.
• Furthermore, changes in the government’s gold holdings
were linked to changes in the country’s money supply-and
thus to the country’s average price level, its inflation
rate and other aspects of its macroeconomic performance.
The Gold Standard Era,
1870-1914
• External Balance Under the Gold Standard
• Central banks
• Their primary responsibility was to preserve the official
parity between their currency and gold.
• They adopted policies that pushed the nonreserve component of
the financial account surplus (or deficit) into line with the
total current plus capital account deficit (or surplus).
• A country is in balance of payments equilibrium when the sum of
its current, capital, and nonreserve financial accounts equals
zero.
• Many governments took a laissez-faire( 放 任 主 义 ）
attitude toward the current account.
The Gold Standard Era,
1870-1914
• The Price-Specie-Flow Mechanism 金币本位制消除
了复本位制下存
• The most important automatic
powerful 在的价格混乱和
货币流通不稳的
mechanism that contributes to the simultaneous
弊病，保证了流
achievement of balance of payments equilibrium
通中货币对本位
币金属黄金不发
by all countries 生贬值，保证了
世界市场的统一
• The flows of gold accompanying deficits and
和外汇行市的相
surpluses cause price changes that reduce current
对稳定，是一种
account imbalances and return all countries to
相对稳定的货币
external balance 制度。
The Gold Standard Era,
1870-1914
崩溃的原因：
successful before
• The fixed-rate gold standard seemed 第一，黄金生产量的增长幅度
1914 largely because the world economy itself was more
远远低于商品生产增长的幅度
stable than in the period that followed.
，黄金不能满足日益扩大的商
品流通需要，这就极大地削弱
• Many countries were able to keep their exchange rates
fixed because they were lucky enough to be running
第二，黄金存量在各国的分配
surpluses at established exchange rates without having
不平衡。1913年末，美、英、
德、法、俄五国占有世界黄金
to generate those surpluses with any contractionary
存量的三分之二。黄金存量大
macroeconomic policies. 部分为少数强国所掌握，必然
导致金币的自由铸造和自由流
• The main deficit running country Britain could control
通受到破坏，削弱其他国家金
international reserve flows in the short run by
was never called
controlling credit in London, but it第三，第一次世界大战爆发，
upon to defend sterling against sustained attack.
黄金被参战国集中用于购买军
火，并停止自由输出和银行券
兑现，从而最终导致金本位制
Activity
• Under the gold standard the fixed price of
gold was $20.67 per ounce in the US. The
fixed price of gold was #4.2474 per ounce
in Britain.
1. What is the “fixed” exchange rate (dollar per
pound) implied by these fixed gold prices?
2. How would you arbitrage if the exchange rate
quoted in the foreign exchange market was $4.00
per pound? (under the gold standard, you could
buy or sell gold with each central bank at the
fixed price of gold in each country.)
3. What pressure is placed on the exchange rate by
this arbitrage?
Activity-Answers
1. The implied fixed exchange rate is about £4.87/pound
2. You would engage in triangular arbitrage. If you start
with dollars, you buy pounds using the foreign exchange
market (because as quoted the pound is cheap). You then
use gold to convert these pounds back into dollars. If
you start with $4, you can buy one pound. You turn in
this one pound at the British central bank, receiving
about 0.2354 (or 1/4.2474) ounces of gold. Ship this gold
to the United States, and exchange it at the US central
bank for about $4.87 (or 0.2354 x 20.67). Your arbitrage
gets you (before expenses) about 87 cents for each $4
that you commit.
3. Buying pounds in the foreign exchange market tends to
increase the pound’s exchange rate value so the exchange
rate tends to rise above $4.00/pound (and toward
$4.87/pound).
The Interwar Years, 1918-1939
• With the eruption of WWI in 1914, the
gold standard was suspended.
• The interwar years were marked by severe
economic instability.
• The reparation （ 赔 偿 ） payments led to
episodes of hyperinflation in Europe.
• The German Hyperinflation
• Germany’s price index rose from a level of
262 in January 1919 to a level of
126,160,000,000,000 in December 1923 (a
factor of 481.5 billion).
The Interwar Years, 1918-1939
• The Fleeting Return to Gold
• 1919
• U.S. returned to gold
• 1922
• A group of countries (Britain, France, Italy,
and Japan) agreed on a program calling for a
general return to the gold standard and
cooperation among central banks in attaining
external and internal objectives.
The Interwar Years, 1918-1939
• 1925
• Britain returned to the gold standard
• 1929
• The Great Depression was followed by bank
failures throughout the world.
• 1931
• Britain was forced off gold when foreign
holders of pounds lost confidence in
Britain’s commitment to maintain its
currency’s value.
Bretton Woods system
• At the end of World War II, the conference
at Bretton Woods, in an effort to generate
global economic stability and increased
volumes of global trade, established the
basic rules and regulations governing
international exchange.
• As such, an international monetary system,
embodied in the International Monetary
Fund (IMF), was established to promote
foreign trade and to maintain the monetary
stability of countries and therefore that
of the global economy.
Bretton Woods system
• It was agreed that currencies would once again be
fixed, or pegged, but this time to the U.S.
dollar, which in turn was pegged to gold at USD
35/ounce.
• What this meant was that the value of a currency
was directly linked with the value of the U.S.
dollar. So if you needed to buy Japanese yen, the
value of the yen would be expressed in U.S.
dollars, whose value in turn was determined in
the value of gold.
• If a country needed to readjust the value of its
currency, it could approach the IMF to adjust the
pegged value of its currency. The peg was
maintained until 1971, when the U.S. dollar could
no longer hold the value of the pegged rate of
USD 35/ounce of gold.
Internal and External Balance
Under the Bretton Woods System
• The Changing Meaning of External
Balance
• The “Dollar shortage” period (first
decade of the Bretton Woods system)
• The main external problem was to acquire
enough dollars to finance necessary purchases
from the U.S.
• Marshall Plan (1948)
• A program of dollar grants from the U.S. to
European countries.
• It helped limit the severity of dollar shortage.
Internal and External Balance
Under the Bretton Woods System
• Speculative Capital Flows and Crises
• Current account deficits and surpluses
took on added significance under the new
conditions of increased private capital
mobility.
• Countries with a large current account deficit
might be suspected of being in “fundamental
disequilibrium”under the IMF Articles of
Agreement.
• Countries with large current account surpluses
might be viewed by the market as candidates
for revaluation.
The External Balance
Problem of the United States
• The U.S. was responsible to hold the dollar
price of gold at $35 an ounce and guarantee
that foreign central banks could convert
their dollar holdings into gold at that
price.
• Foreign central banks were willing to hold on
to the dollars they accumulated, since these
paid interest and represented an international
money par excellence.
• The Confidence problem
• The foreign holdings of dollars increased until
they exceeded U.S. gold reserves and the U.S.
could not redeem them.
Bretton Woods system
• Postwar experience showed some
difficulties with the Bretton woods system
of adjustable pegged exchange rates set up
in 1944.
• Under this system, private speculators
were given a strong incentive to attack
reserve-losing currencies and force large
devaluations.
• The role of the dollar as a reserve
currency also became increasingly strained
in the Bretton Woods era.
Bretton Woods system
• Under Bretton Woods, foreign central banks acquired
large holdings of dollars through official
intervention, when the US shifted to running official
settlements balance deficits. At first these were
welcomed as additions to official reserve holdings in
these foreign countries, but the dollars became
unwanted as the reserves grew too large.
• Foreign central banks’ conversions of dollars into
gold decreased US official gold holdings, further
reducing foreign officials’ confidence in the dollar.
• The US had to adjust its balance of payments position
or change the rules. The US opted for new rules,
divorcing the private gold market from the official
gold price in 1968, suspending gold convertibility
and forcing a devaluation of the dollar in 1971, and
shifting to general floating in 1973.
The Current Regime
• The current exchange rate system permits each
country to choose its own exchange rate policy.
Two major blocs exist, one of currencies pegged
to the US dollar and the other of currencies
pegged to Euro.
• The dollar bloc and the Euro bloc float against
each other, and the currencies of a number of
industrialized countries—Australia, Canada,
Japan, New Zealand, Sweden, Switzerland, and the
UK—float independently.
• For countries with flexible exchange rates,
governments generally are sceptical of purely
market-driven exchange rates, and they practice
some degree of management of the floating rate.
The Current Regime
• Most developing countries have a pegged exchange
rate of some sort, but the trend is toward
greater flexibility and floating.
• A series of exchange rate crises in the 1990s and
early 2000s, including Mexican peso in 1994, the
Asian crisis (Thai baht, Malaysian ringgit,
Indonesian rupiah, and South Korea won) in 1997,
the Russian ruble in 1998, the Brazilian real in
1999, the Turkish lira in 2001, and the
Argentinean peso in 2002, shows the difficulty of
defending a pegged rate against speculative flows
of short term capital when the speculators have a
one way speculative gamble against a currency
that they believe is misvalued.
The Renminbi and Foreign
Exchange Control
• The Renminbi, China’s legal currency, is issued and controlled solely by the
People’s Bank of China. The exchange rates of the Renminbi are decided by the
People’s Bank of China and issued by the State Administration of Exchange
Control.
• China operates foreign exchange in a unified way, with the State
Administration of Exchange Control exercising the functions and powers of
exchange control. In 1994, China reformed the foreign exchange system,
combined the Renminbi exchange rates, adopted the bank exchange settlement
system and set up a unified inter-bank foreign exchange market. On this
basis, China included the foreign exchange business of the foreign-invested
enterprises in the bank’s exchange settlement system in 1996. On December 1,
1996, China formally accepted Article Eight of the Agreement on
International Currencies and Funds, and realized the Renminbi’s
convertibility under the current account ahead of schedule. In 1997, when
confronted with the Asian financial crisis, the Chinese government declared
that the exchange rate of the Renminbi would remain stable, and the Renminbi
would not be devalued. This earned China the praise of the international
community. In 2001, China’s foreign exchange reserves reached US$ 212.2
billion. In addition, the variety of financial businesses has been
increasing steadily, and China has opened an array of new businesses to
become integrated into the various aspects of modern international financial
business, such as consumer credit, securities investment funds and
investments linked with insurance.
The Renminbi and Foreign
Exchange Control
• On July 21, 2005, China announced that it had revalued the
RMB by 2.1 percent and that it would henceforth manage the
currency against a basket of other currencies instead of
against the dollar. Though the move to a basket peg is
positive, these reforms are disappointing in several key
respects. Most obviously, the initial move is far too small.
The real trade-weighted value is undervalued by 20 to 25
percent, and this small revaluation will have practically no
effect in reducing global payments imbalances—especially
the large US current account deficit. Nor will it silence
protectionist pressures in Washington and elsewhere or
charges that China is engaging in currency manipulation.
China should quickly convert its initial move into a
significant revaluation.
• On May 21, 2007, the daily floating band of RMB has been
increased from 0.3% to 0.5% by the People’s Bank of China.
