Unit Exchange rates

Before you read

Discussion 1. If you keep a banknote in your pocket, you know that it will almost certainly be worth less after a few months. If you deposit it in a bank, of course, it will be worth a little more. Why? 2. If you change your bank notes into another currency, you will receive a certain amount of notes and coins, but this amount can change every day, or more than once a dat. Why? Reading 1

Exchange rates
The Bretton Woods agreement of 1944 established fixed exchange rates, defined in terms of gold and the US dollar, i.e. their parities with the US dollar were fixed. In this period, a US dollar was a promissory note issued by the United States Treasury. If anybody requested it, the Treasury had to exchange the note for 1/35th of an ounce of gold. Under this system, overvalued or undervalued currencies could only be adjusted with the agreement of the International Monetary Fund. Such adjustments are called devaluations and revaluations. The Bretton Woods system of gold convertibility and pegging against the dollar was abandoned in 1971, because following inflation, the Federal Reserve did not have enough gold to guarantee the American currency. Gold convertibility was replaced by a system of floating exchange rates. ( Today, the US dollarthe unofficial world currency- is merely a piece of paper on which is written In God We Trust. God, not gold!) A freely (or clean) floating exchange rate is determined purely by supply and demand. Theoretically, in the absence of speculation, exchange rates should reflect purchasing power parity- the cost of a given selection of goods and services in different countries. Proponents of floating exchange rates, such as Milton Friedman, argued that currencies would automatically establish stable exchange rates which would reflect economic realities more precisely than calculations by central bank officials. Yet they underestimated the impact of speculation, and the fact that companies and investors frequently follow short-term money market trends even if these are contrary to their own long-term interests.

In the late 1970s and early 1980s, the American, British and other governments deregulated their financial systems, and abolished all exchange controls. Residents in these countries are now able to exchange any amount of their currency for any other convertible currency. This has led to the current situation in which 95% of the worlds currency transactions are unrelated to transactions in goods but are purely speculative. Enormous amounts of money move round the world, chasing high interest rates or capital gains, as investors- including rich individuals, companies and pension funds- seek to maximize the value of their assets. In London alone, in the late 1990s, over $300 billion worth of currency was traded on an average day- the equivalent of about 30%of the value of the goods Britain produces each year. Banks, of course, make a profit from the spread between a currencys buying and selling prices. Few governments, however, leave exchange rates wholly at the mercy of market forces. Most of them attempt to influence the level of their currency when necessary. Managed (or dirty) floating exchange rate are more common than freely floating ones. For example, in the 1980s, most Western European government joint the EMS ( European Monetary System) which established parities between member currencies. There was also an Exchange Rate Mechanism (ERM): if the rate diverged by more than plus or minus 2 per cent from the central parity, central banks had to intervene in exchange market, buying and selling in order to increase or decrease the value of their currency. Yet international speculators can be more powerful than governments. For example, on a single day in September 1992 the Bank of England lost five billion pounds in a hopeless attempt to support the pound sterling. For weeks, all the worlds financial institutions and rich individuals had been selling their pounds, as everyone except the British Government believed that the pound had been seriously overvalued ever since it belatedly joined the ERM in 1990. When the British central bank ran out of reserves and could no longer buy pounds, the currency was withdrawn from the ERM and allowed to float, instantly losing about 15% of its value against the D-mark. The next year, speculators attacked five other European currencies, and the European Monetary System was suspended. It was later reintroduced in a looser form. Many manufacturers are in favor of fixed exchange rates, or a single currency. Although it is possible to some extent to hedge against currency fluctuations by way of futures contracts, forward planning is difficult when the price of raw materials bought from abroad, or the price of your products in export markets, can rise or fall by 50% in only a few months. (Since exchange controls were abolished, currencies including the US$ and the sterling have in turn appreciated by up to 100% and then depreciated by more than 50% against the currencies of major trading partners). Pressure from industrialists and government led to the introduction of the euro. Twelve countries fixed their exchange rates against the new currency, and beginning in 1999 the new currency was used as a mean of payment between companies and in foreign trade, and bonds were

denominated in it. The euro came into existence as a real currency in 2002, when the old notes and coins in the twelve member countries were withdrawn.

Reading comprehension tasks

Are the following statements TRUE or FALSE? 1. Gold convertibility was abandoned because there was too much gold.F 2. It is now impossible to exchange dollars for gold.F 3. Only a pegged currency can be devalued or revalued.T 4. A floating currency can either appreciate or be devalued.F 5. Central banks sometimes attempt to decrease the value of their currency.T 6. The EMS was designed to stabilize exchange rate.T 7. To speculate is to take risks; to hedge is to try to avoid risks.T 8. Under the system of floating exchange rates, currencies can depreciate 100% in a short time.F Reading 2

What is the gold standard?

What is gold, and why is it so important? Is it still the basis that our modern monetary system rests on? First, a little history. Gold is thought to be one of the first known metals. The word gold came from an old English word geolo, meaning yellow. The ancient Egyptians were very proficient goldsmiths hammering gold into leaf so thin that it took 367,000 leaves to make a one inch pile. Gold has been a valuable metal throughout the ages because it is scarce. It is a beautiful metal that has a lovely yellow color and a soft metallic glow. It is soft and easy to work with. It can be drawn into a fine wire, and as the Egyptians discovered, hammered into thin leaf. It is very malleable and can be easily shaped into various forms. It is highly resistant to rust and is corrosion-resistant. Because of golds versatility, it can be used in many applications. One of its primary uses is as jewelry and adornment. In Mesopotamia (now Iraq) gold cups and jewelry have been excavated that date back to 3500 B.C. In the Egyptian tombs, jewelry and masks made of gold have been discovered. During the Middle Ages a science called alchemy evolved as a way to try to artificially create gold. Worldwide, the gold rush led to the development of frontiers. The largest U.S. gold strike occurred in the 1900s near Carlin, Nevada. In 1965 an open-pit mine began operating there and

the Carlin mine added about 10 percent to the annual gold production of the U.S. United States wasnt the only country to have gold rushes. In 1851 gold was discovered in Australia and that rush saw the population of Australia triple in the following nine years. New Zealand experienced a gold rush in 1861 and their population also grew tremendously. Johannesburg in South Africa was founded as a result of the 1886 gold rush. Canadas Yukon Territory was developed as result of a gold rush that started in 1897. It appears that gold rushes played an important part in developing territories in many parts of the world. Gold (AU is the chemical symbol) is also used today in many electrical components. But its most well-known use as money as a medium of exchange. Money used to actually be made out of gold. Gold coins were traded for goods and services. In todays market, what place does gold maintain? The phrase gold standard is defined as the use of gold as the standard value for the money of a country. If a country will redeem any of its money in gold it is said to be using the gold standard. The U.S. and many other Western countries adhered to the gold standard during the early 1900s. Today, however, golds role in the worldwide monetary system is negligible. Britain abandoned the gold standard 1931; the USA abandoned it 1971. Holdings of gold are still retained because it is an internationally recognized commodity, which cannot be legislated upon or manipulated by interested countries. On August 15, 1971, the world entered the first era in its history in which no circulating paper anywhere was redeemable in gold, by anyone. At one point in time it was illegal for a U.S. citizen to own gold. President Richard Nixon of U.S. closed the gold window. This action broke the last tie between gold and circulating currency, resulting in our modern financial system which is called a floating currency system. Since 1976 gold the U.S. government no longer sets the gold value of a dollar. The price of gold rises and falls in relation to the demand for the metal. Gold coins have not been minted as legal currency since 1933. In 1986 the U.S. Mint did begin to issue gold coins for collectors four denominations: $50, $20, $10, and $5. And there really is a Fort Knox! Since 1937 most of the nations gold has been stored there, underground. Even though the worlds monetary systems are no longer based on the value of gold, people are still intrigued and impressed with it. It is a valuable metal with many high-tech uses, and a beautiful metal that still adorns the artifacts of kings.

Reading comprehension tasks

1. Briefly describe the importance of gold and gold standard. 2. Under the gold standard, currencies were convertible into gold. This convertibility was abolished for most currencies in early 1970s. Why? Gold convertibility ended because the Federal Reserve no longer had enough gold to back to dollar, due to inflation

Exercises
Exercise 1: Vocabulary A. Match up the half-sentences below 1. To peg a currency against something means to B 2. A clean floating exchange rate D 3. Exchange controls used to limit A 4. Speculators buy or sell currencies in order to C 5. Market forces means F 6. Hedging means E A the amount of a countrys money that residents were able to change into foreign currencies B fix its value in relation to it. C make a profit by making capital gains or by investing at higher interest rates D is determined by supply and demand E trying to insure against unfavorable price movements by way of futures contract F the determination of price by supply and demand ( the quantity available and the quantity bought and sold).

B. Which six of these verbs are defined below? Abolish revalue 1 2 3 4 5 6 adjust appreciate convert diverge establish fluctuate peg suspend

to make changes to something adjust to change something into something else convert to end something permanently Abolish to end something temporarily suspend to go up or down (in quantity, value, etc.) fluctuate to move away from what is considered normal diverge

Exercise 2 Add appropriate words to these sentences: 1. Another verb for fixing exchange ............peg...................... them. rates against something else is to

2. Increasing the value of an ............revaluation......................

otherwise

fixed

exchange

rate

is

called

3. Gold ..............convertibility.................... ended in the early 1970s. 4. The current system is one of .............floating..................... exchange rates. 5. A currency can appreciate if lots of ..............speculators.................... buy it. 6. In fact we have managed floating exchange rates, because governments and ...............central................... banks sometimes intervene on currency markets. 7. Bartering is based on the exchange of .............goods............... for goods. 8. The Bretton Woods Agreement stipulated that all members would express their currencies in ............gold................ 9. When central banks intervene in the foreign exchange markets at the intervention points, this is called the system of ...........foreign................. exchange rates. The opposite is called the system of ............floating................ exchange rates. 10. If dealers buy currency forward but do not sell forward simultaneously, their position is said to be ..............open.............. Exercise 3 There are some key dates in the development of exchange rate systems around the world (1994, 1971,1973,1992,2002). Match the dates with the events below: 1. Most industrialized countries switched to a system of floating rates. However, governments and central banks occasionally attempted to influence exchange rates by intervening in the markets. So there was a system of managed floating exchange rates. 1973 2. The Bank of England lost over 5 billion in one day attempting to protect the value of the pound sterling. After this, governments and central banks intervened much less, so there was almost a freely floating system.- 1992 3. A fixed exchange rate system was started. The values of many major currencies were pegged to the value of the US dollar. The American central bank, the Federal Reserve, guaranteed that it could exchange an ounce of gold for $35.- 1944 4. Twelve states of the European Union introduced a single currency, the euro, to replace their national currencies.- 2002

5. Gold convertibility ended because the Federal Reserve no longer had enough gold to back to dollar, due to inflation.- 1971