FX Systems _ Central Bank Intervention

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					FX Systems
       Exchange Rate Systems
• Fixed
    – Bi-metallic system
    – Gold standard
    – Bretton Woods
•   Free Float
•   Managed (“dirty”) Float
•   Pegged
•   Dollarization
•   Currency Union
       History of FX Regimes
Bimetallism              up to 1875

Classical Gold Standard 1875 – 1914

Inter-War Period         1915 – 1944

Bretton Woods System     1945 – 1972

Flexible Exchange Rate   1973 to Present
• Currency convertible into (valued in terms of) Gold or
  Silver at Fixed rates
• Problem:
   – Whenever the Official conversion rate (gold to silver) differed
     from the world market rate arbitrage would result.
• Example:
   – US Mint sets ratio of silver to gold at 15 - 1
   – But world market values silver at a ratio of 15.5-1
     => Gold was undervalued, Silver overvalued.
       • People horde Gold and transacted in Silver
       • Gresham’s Law => “Bad Money Drives Out Good Money”
           – Gold (overvalued) flows out of the USA to where it’s value is higher.
           – Silver (undervalued) flows back into the USA where it’s value is higher.
               Gold Standard
• Currencies valued in terms of gold at fixed rates
• Currency freely convertible into gold
  – Established fixed exchange rates
  – Example:
     • Dollar = $12 / ounce of Gold
     • Pound (BP) = BP 6 / ounce of Gold
     • $12 per ounce / BP 6 per ounce = $2/BP
• Free Flow of Gold
  – To pay for international transactions
              Gold Standard
• A nation’s Money Supply depended on the
  amount of gold it possessed.
  – If Gold flows out of a country, it’s money
    supply contracts
     • Output (GDP), Employment, & Prices decline
     • Opposite occurs when gold flows into a country
  – Gold flows occur when the market value of a
    currency differs from its established or official
Hulme’s Price-Specie Flow Mechanism
• Gold Flows automatically re-establish the official
  (fixed) exchange rate
            Example of the
     Price-Specie Flow Mechanism
• US Trade Deficit with the UK:
     • The Dollar depreciates via excess demand for pounds
     • GOLD flows from USA to UK to pay for our net importing
        – US Money Supply declines
            » US GDP falls & Unemployment rises
            » Less income, so we buy fewer UK goods
        – US inflation rate falls
            » US goods more competitive v. UK goods so our exports rise
        – US demand for British trade goods (and pounds) falls
        – Dollar appreciates back to official rate

     • Opposite happens in the UK
 Benefits of the Gold Standard
• No exchange rate uncertainty
• Price stability
  – Inflation near zero when tying the money
    supply to a country’s stock of gold
• World-wide economic growth
Exchange Rates During Era of
     the Gold Standard
  Problems with the Gold Standard
• Financial Panics
  – Public believes central banks have less gold than the
    supply of paper currency
• Volatility of GDP; Wide Regional Variations in
  economic growth around the world
  – Economic Policies tied to the exchange rate and not
    available to stimulate economies
• Contagion
  – US Great Depression of the 1920’s became a world-
    wide depression
• Growth Constrained
  – By limits on money supply
•   In establishing an exchange rate regime,
    a country must be willing to forego one of
    the following:
    1. Fixed Exchange Rate
    2. Independent Economic Policy
    3. Capital Mobility
              Gold Standard

Fixed Exchange Rate       Yes

Independence of
Economic Policy

Capital Mobility          Yes
                  Inter-War Period
• Period during which nations were officially under a
  renewed gold standard officially, but in practice didn’t
  adhere to the rules:
   – Countries followed Economic Nationalism
       • Tried to stabilize their economies at the expense of the international
         monetary system
   – Nations printed more paper currency than could be backed by
     their gold supplies.
       • Rates of inflation differed between countries, so official exchange rates
         differed from market rates
   – Many countries allowed their currency to depreciate to gain a
     trade advantage.
       • This increased the gap between the official rate and the market implied
         exchange rate
   – Result: Countries abandoned the Gold Standard for an ill-
     defined floating rate system
Exchange Rates during Interwar Period
             Inter-War Period

Fixed Exchange Rate         No

Independence of
Economic Policy

Capital Mobility           Yes
       Bretton Woods System
• Fixed Exchange Rate Regime
  – $ value against gold ($35 / oz)
     • Free convertibility between $ and gold
  – Other currencies valued against the $
     • Foreign central banks tasked with FOREX intervention to
       maintain established exchange rates
     • No automatic adjustment
         – Continuous intervention needed
  – US establishes economic policy
     • Becomes the de-facto policy of the world
• Established the IMF and World Bank
       Bretton Woods System
• Mandated that:
  – Countries must follow US economic policy
  – Trade imbalances must be small and random
     • average out to “0” over time
  – Either independence of economic policy or
    capital mobility must be sacrificed to fixed the
    exchange rate
        Bretton Woods System
• Large, persistent U.S. trade deficits
  pressured the $ to depreciate
  – Required continuous central bank intervention
     • Sell domestic currency to buy dollars
         – Inflationary for foreign countries
     • Periodic devaluations of the dollar
     • Countries tried to restrict capital mobility to avoid need for
       altering official exchange rates
         – Interest Equalization Tax (1963)
         – Foreign Credit Restraint Program (1965)
              » Impeded the flow of dollars from U.S. to other countries
              » Eurodollar market resulted
     Exchange Rates under Bretton Woods
of the Dollar
          Bretton Woods System

                                  1944 - 1958   1958 – 1973

Fixed Exchange Rate                   Yes           Yes

Independence of Economic Policy       No            Yes

Capital Mobility                      Yes           No
          Bretton Woods System

                                     1944 - 1958   1958 – 1973

Fixed Exchange Rate                      Yes           Yes
  Interest Equalization Tax
  Foreign Credit Restraint Program

Independence of Economic Policy          No            Yes

Capital Mobility                         Yes           No
        (International Monetary Fund)
• Original Duties:
  – Created to enforce terms of Bretton Woods
  – Set new exchange rates when necessary
• New Duties:
  – Help countries establish sound economic
  – Allow member nations to borrow reserves
  – Created the SDR to be used as a reserve
                     World Bank
• International Bank for Reconstruction and Development
• Initially created to finance reconstruction in the aftermath
  of WWII
• Today
   – Provides financing to Emerging Market Countries
   – Provides loan guarantees for the same countries when they
     access financing outside of the World Bank
    Comparison of Float v. Fixed

                                  Float     Fixed

Fixed Exchange Rate               Yes         No

Independence of Economic Policy    No     Give up one

                                           Keep the
Capital Mobility                  Yes       other
    Flexible Exchange Rates
• Economic Shocks
  – Fixed Rates
    • Tend to transmit easily
  – Floating Rates
    • Tend not to transmit as easily
    • But they may become more severe within the
      country where the shock occurred
    Managed (“Dirty”)Float
• Floating exchange rate with periodic
  government intervention
   • Typically to achieve some policy goal
      • Example => Stimulate exports
                   Currency Union
• Group of countries with a common currency
   – European Monetary Union or EU:
        • Each country replaced its domestic currency
          (French Franc, Italian Lira, etc) with the Euro

                        With-in the EU         EU v World
Fixed Exchange Rate           Yes                   No
Independence of
                               No                  Yes
Economic Policy
Capital Mobility              Yes                  Yes
                   Currency Union
• Economic Policy
   – European Central Bank conducts monetary policy
   – Each country conducts fiscal policy
        • Limits on budget deficits to keep countries from
          enacting policies counter to that of the EU as a whole

                         With-in the EU          EU v World
Fixed Exchange Rate             Yes                   No
Independence of
                                No                   Yes
Economic Policy
Capital Mobility                Yes                  Yes
  Benefits & Costs of Currency
• Major Benefit
  – Stimulates commerce within the union
• Major Cost
  – Countries lose ability to stimulate their own
     • Asymmetric economic shocks become a problem
   Mexican Peso Crisis (1994)
• Economic prosperity came to Mexico
  during later 1980’s and early 1990’s.
  – Peso was fixed against the U.S. dollar
  – Greater wealth in Mexican economy
     • greater importing & large trade deficits
     • Mexican central bank had to sell $ (reserves) and
       buy Pesos to keep the exchange rate fixed
  – Mexico was becoming more integrated (open)
    with the world economy
     • Economic prosperity attracted inflow of foreign
       capital to invest in Mexican stocks and bonds
   Mexican Peso Crisis (1994)
• Investors eventually lost confidence that
  the Mexican central bank could continue to
  defend the fixed value of the Peso
  – Foreign investors pulled capital out of Mexico
     • “Capital Flight”
  – Lead to a rapid depreciation in the Peso that
    Mexico was not able to contain
Mexican Peso Crisis (1994)
  Asian Currency Crisis (1997)
• Rapid growth in SE Asian was fueled by
  inflows of short-term foreign capital
  – Lead to credit boom
  – Similar to Mexico, persistent trade deficits
     • eventually investors lost confidence in asian central
       banker’s ability to maintain their fixed exchange
       rates against the dollar
     • A large outflow of capital started in Thailand and
       quickly spread to other asian countries
        – Known as a Financial Contagion
   Asian Currency Crisis (1997)
• Asian countries had their currencies at fixed
  rates to stimulate cross-border commerce.
• The crisis required that they let their
  currencies float so that they could use
  economic policy to fix their economies.

                      Pre-Crisis    Post-Crisis
Fixed Exchange Rate      Yes            No
Independence of
                         No             Yes
Economic Policy
Capital Mobility         Yes            Yes
  Asian Currency Crisis (1997)
• Integration with the world economy allows for
  greater economic prosperity within a country
  – But it can expose that country to greater risks
    such as capital flight
• Lack of economic or fiscal discipline tends to
  allow an economy to “over heat” after which a
  crisis occurs when the “bubble bursts”
  – Some developing nations kept their currencies
    fixed, but in a manner to follow a more stable
    economic policy of a developed nation
  – While others erected capital controls on foreign
    portfolio investment
       Pegged FX System
• A currency’s value is pegged to a
  foreign currency or to some unit of
• It is “Fixed” against that currency, but
  floats against other currencies.
  – Example
     • Hong Kong has tied the value of the Hong
       Kong dollar to the U.S. dollar since 1983
     • HK$7.8 = $1
     • Argentina tied the value of its peso to the U.S.
       dollar (1 peso = $1) from 1991 - 2001
Exposure of a Pegged Currency
 to Exchange Rate Movements
• A currency that is pegged to another
  currency will have to move in tandem
  with that currency against all other
• So, the value of a pegged currency
  does not necessarily reflect the demand
  and supply conditions in the foreign
  exchange market, and may result in
  uneven trade or capital flows.
Tri-Lemma for a Pegged Currency

• Countries that peg their currencies give up
  independence of their economic policies
• Countries that peg their currencies usually
   – Do so because of past periods of fiscal and
     monetary irresponsibility
   – Peg their currency to that of a stable,
     developed country like the US or group like
     the EU
            Currency Board
• Pegged Fixed Rate System where:
  – Quantity of currency must be fully backed by
    reserves at the fixed rate
    • similar to a gold standard
    • Central bank cannot implement monetary policy

  – Argentina was an example
    • However, they did not adhere to the currency
      board arrangement and eventually the Peso was
      allowed to float after a 90% depreciation
• Replacement of a local currency with
  U.S. dollars.
• Ecuador implemented dollarization in
• Under a pegged system a country might
  be inclined to end the peg and resume
  unsound economic policies
• With Dollarization this is less likely to

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