EXCHANGE RATE REGIMES

The Gold Standard, 1876-1913

Countries set par value for their currency in terms of

gold This came to be known as the gold standard and gained acceptance in Western Europe in the 1870s The US adopted the gold standard in 1879 Rules of the game:
Rule 1: Set a rate @ which 1 can buy/sell gold for currency. Rule 2: Credibly maintain adequate reserves of gold. Rule 3: export and import of gold were allowed so that it

could flow freely among the gold standard countries. E.g. US$ gold rate $20.67/oz, Brits pegged at 4.2474/oz US$/ rate calculation $20.67/4.2472 = $4.8665/

 Since the rate of exchange for gold was fixed, the exchange rates b/n currencies was fixed too. The money supply in the country must be tied to the amount of gold the monetary authorities have in reserve. When a country loses (gains) gold, money supply

must contract (expand). Domestic economy governed by external sector Gold standard worked until WW1 WW1 interrupted trade flows & free movement of gold forcing nations suspend gold standard

Currency Crisis under Gold Standard

Example: Importer in France wants to buy

goods from exporter in Germany

needs German currency (marks)

francs
Importer marks Bank of France

Where does French central bank get marks?

gold

marks Bank of France Bundesbank

If importing (spending gold) more than exporting (earning gold), the country eventually runs out of gold reserves. MAJOR CRISIS

Gold Points
Due to difference in demand and supply,

exchange rate would move on either side of the central exchange rate Movement was limited only to a narrow zone, the extreme points of which were called gold points These points represented max variation of exchange rate that was possible, without the possibility of arbitrage

Advantages of Gold Standard

It was very easy and simple mechanism to

operate and implement Very high level of stability in exchange rates Fully Secured system The Price Specie Adjustment Mechanism helped countries to achieve equilibrium in International Trade

Disadvantages
No provision to revise official price for Gold The Price Specie Adjustment Mechanism did

not succeed in situation of inelastic demand for foreign products The countries resorted to competitive devaluation, which diluted the system No flexibility to adjust money supply when economy was under stress

Bretton woods System (19451972)

Formation of IMF and International Bank for

Reconstruction and Development Characteristics of the System: The USD was provided the status of Universal Reserve Asset The value of USD was fixed at 1oz of Gold = USD 35 The US Federal Reserve bank entered into Gold Convertibility Clause No country was required to value its currency against gold but was required to fix its value against USD

 Currency notes issued by each country

provided an irrevocable promise of redemption against USD and only USD promised redemption in terms of gold Concept of valuing one currency in terms of other is called pegging and actual multiple expressing the relationship is called parity and 3-way relationship created between gold, USD & individual currency was called Par value Mechanism

 Variation in the exchange rate on both sides

of parity rate was permitted upto +/- 1% It introduced the concept of central bank intervention Incase of structural imbalance in the BOP, Devaluation possible only after consultation with IMF Multiple exchange rates were prohibited

Triffins Paradox
No revision in the value of USD as a result it

would loose acceptability under stress Vietnam war triggered the trade deficit 1968, the gold convertibility clause was invoked Failure of the system was formally announced on 15th August, 1971

Smithsonian Agreement
The gold convertibility clause was withdrawn The USD was devalued upto 1oz Gold = USD

38 Remaining currencies of 9 countries in G10 were up valued by 10% All other countries were required to review and revise their parities against the USD The variation zone was increased to +/- 2.5% on either side of the new parity rates

 Provide US economy greater export

competitiveness so as to reverse trade deficit to re-establish Brettonwood System Owing to further trade deficit devaluation to 1oz gold = 42.22 In 1973 the Smithsonian agreement was abandoned

Flexible Exchange Rate System

Each member country was free to use any

exchange rate of its choice The concept of valuing currency against gold was prohibited Each central bank was required to undertake to maintain orderly conditions in their respective local forex market Each central bank was required to have a mechanism for ensuring stability of the exchange rate

 Each country was required to accept the supervisory authority of the IMF over their

domestic forex market and the forex management system With the intro of this system all major countries floated their currencies Commercial banks became primary participants in Forex market Smaller countries initially pegged their currency to any 1 major international currency to prevent international speculation India adopted system of Managed Float

Central Bank Intervention

Verbal Intervention Money Market Intervention Securities Market Intervention Active Intervention