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Lecture notes on FX regimes and history of FX regimes1

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									Bo Sjö 2009-05-06

Lecture notes on FX regimes and history of FX regimes.1
Types of Foreign Exchange Regimes From Fixed to Floating – very brief. You must be able to have a meaningful discussion about FX history, the Gold standard, the experience of the 30´, Bretton Woods, and the background and construction of the EMU. Fixed: The FX rate is fixed by the authorities. Freely floating means no intervention by the authorities (central bank + government) what so ever, by any means. From fixed to floating and between (to explained more later in the course) Currency union, all countries have the same currency by law, like UK. Gold standard (Metal standard)2 Currency board Completely fixed rates (Bilateral (and often unilateral decision) peg) Fixed but adjustable Pegged but within horizontal bands (Target zone) Crawling peg Pegged within crawling bands Managed float Dirty float - hidden intervention or target Floating with some intervention Freely floating without intervention

Questions: The definition of a gold standard. What is a currency board? What is a target zone? What is meant by dirty float? The History of Foreign Exchange Regimes Very brief, read more in the text book(s). (Eichengreen and McKinnon provide several surveys.) Research questions: Does it matter which regime we choose? Why was a certain regime adopted at a certain time? Is there a difference between the choice of FX regime and sustainable

Lecture notes are handed out as supplementary reading material. These notes are preliminary, the language is not corrected. If questions are asked in the text, these are addressed to students. If you think something is wrong, hard to understand etc, you are strongly advised to contact your professor before the exam. This is a work in progress. 2 The gold standard is only completely fixed if the transportation cost of gold is zero - the so-called gold points. 1

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economic growth, low and stable inflation, full employment and income distribution targets? Which are the main regimes? Give a brief history of FX regimes. What is a gold standard, or metallic standard? 1) The coins and all outstanding notes are always convertible to gold a fixed price, at the central bank. Or any bank for that matter, you can have several competing banks issuing money if you want. 2) Gold should be freely traded across boarders. This means that the money stock is given, and the price level becomes very stable. It will change with exports and imports (which will be paid for in gold of course) and with the discovery of new gold mines, in places such as California and Alaska. However, there is no room for monetary policy. What we call “the international gold standard” was a sussseful period for many countries that were able to maintaning high growth rates and almost zeo inflation for almost 40 years.

In chronological order:3 Currencies were usually based on some metallic standard (silver, bronze, etc.) - 1873 Pre-International Gold Standard 1873/78 - 1914 “The International Gold Standard” 1914-1919 World War I floating or tied to natural leader 1920-1930 Floating rates But gradual return to Gold – but crash in 1931. Sweden deflated its price level and returned in 1923 at the old pre-war parity, UK returned in 1925. But, did so conditional on an expected inflation in the US which never happened. The UK economy did badly and the UK gold standard crashed in 1931. 1931-1938 Floating around "natural leader" 1932-36 ‘Dirty float’ 1939-1945 World War II 1947-1971 The Bretton Woods System A type of gold standard. USD convertible to gold, all others convertible to dollars. (IMF, World Bank) 1971-1973 Free float 1973-1978 "The Currency Snake" (Europe) In the snake countries followed Germany. 1978-1998 The European Monetary System is formed gradually. 1978-1986 1986-1992 1992 1992-1999 1999 The EMS system with realignment (Flexible exchange rates) The fixed EMS system, no realignments of FX rates The EMS system crashes after speculative attacks The EMS system is in practice a system of floating exchange rates The European Monetary Union is established, and increases with new members

The pre-gold standard. Metallic standards. Money = gold, silver, bronze. Often bimetallism silver and Gold standard. (Gold relatively scarce)
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I am sorry, but I neglect the Third world and Asia in this survey. 2

Gold standard More common in the 1980s Gold standard principles (= metallic standard) 1) All coins, bank notes redeemable into gold at a fixed price, at the central bank. If all coins and notes are backed up with 100% gold it is a pure gold standard. If only a share of the outstanding currency is backed up with gold we have a gold exchange standard. 2) Absolutely free trade with gold, domestically and internationally. When many countries "are on gold" an international gold standard exists, such as in 19781914. The advantage: the money supply is given by the amount of gold. The authorities cannot create inflation. You get stable prices and a system with great credibility. The International Gold Standard a period of high economic growth, stable prices, low inflation and absolutely free international capital flows. (In addition it was a period of rapid "globalization", much more than today. ) The way it was supposed to work: In deficit countries, gold flows out, their money stock declines. Prices falls, interest rates up. Exports get more expensive, inflow of capital, etc. In surplus countries, gold flows in, money stock expands, prices go up, interest rates goes down. New equilibrium is restored when demand and supply of gold is stable in all countries. "The Rules of the Game" Central banks should not interfere in this adjustment process. They should either be passive, or active trying to increase the flow of gold and speed up the adjustment. World War I put an end to this. Governments needed to finance the war through printing money. In addition trade regulation and consequently a fall in world production and income. 1921-1930 After the war, mass unemployment and low production. Situations which seemed to be very persistent in many economies. The hard conditions imposed on the losing side of the war depressed their economies even more (Germany). After WWI, countries tried to restore the gold standard. They faced two choices. The first was to establish a new parity for redeeming notes into gold. The other was to deflate domestic prices back to pre-war levels, and return to gold at pre-war gold parity. (Sweden and UK choose the latter alternatives. Sweden did it; UK did not do well. The attempts to restore the gold standard ended in 1931, after a couple of months of speculation against the British pound. 1931-1939 A dark period for economic development. Countries decide to float around their natural leader.

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But, also trade and FX restrictions imposed. "Beggar- my- neighbour" devaluations. The policy disturbances lead to instability in exchange rates, speculative attacks etc. More seriously policy leads to a decline in trade, and consequently production and income falls. (Unemployment up) Unemployment and inflation increases. The above is based on facts and scientific research. The 30s are however surrounded by myths. Example, the floating exchange rate regimes and lack of regulations lead to instability. It was the other way around, economy policy was the main destabilising force. Another example, Nazi-Germany had an economy of rapid growth and stable prices. The truth was that they run a war economy, huge investments in the military build-up infrastructure for the coming war and regulated prices. Regulated prices means, no official inflation, but queues, and barter trade. After WWII, The Bretton Woods System. IMF and The World Bank A Gold Exchange standard. U.S. on gold, other countries tied their currencies to the USD. They could then choose to redeem notes into gold or USD. The system was combined with regulations of international capital flows. Ragnar Nurkse 1944, report to the League of Nations. The system started to brake down in the mid 60s. A growing demand for international capital and reserves. The US did follow "the rules of the game" (The Vietnam War) 1971, Nixon decided that the US had to devalue against gold. The system breaks up. 1973, countries again starts to float around natural leaders. In Europe, countries team up around Germany in the "currency snake" In and among EU countries, a different system starts, with closer co-operation around Germany. The European Monetary System (EMS). Up until 1986, participating countries frequently realignment their currencies against the DEM. From 1986 the system was supposed to be fixed, and glide over into the Euro. Policy, however, was diverging among the countries. In 1992, the system crashes after speculative attacks. 1999. The Euro is established.

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