Download History of Exchange Rate Regimes

INBU 4200
INTERNATIONAL
FINANCIAL
MANAGEMENT
Lecture 3:
History of the International Monetary System
(With Focus on Exchange Rate Regimes).
The Euro-Zone.
Recall from Lecture 2 the Definition of
an Exchange Rate Regime


Defined: The arrangement by which the price
of the country’s currency is determined within
foreign exchange markets.
Arrangements ranging from:




Floating Rate
Managed Rate (“Dirty Float”)
Pegged Rate
Arrangement is determining by governments.
History of Exchange Rate
Regimes


Over the past 200 years, the world has gone
though major changes its global exchange
rate environment.
Starting with the gold standard in the latter
part of the 19th century to today’s “mixed
system” there are 3 distinct periods:



Gold Standard: 1816 - 1914
Bretton Woods: 1945 - 1973
Mixed System: 1973 – the present
Gold Standard: 1816 - 1914


During the 1800s the industrial revolution brought
about a vast increase in the production of goods and
widened the basis of world trade.
At the time, trading countries believed that a
necessary condition to facilitate world trade was a
stable exchange rate system.


Stable exchange rates were seen as necessary for
encouraging and settling commercial transactions across
borders (both by companies and by governments).
By the second half of the 19th century, most countries had
adopted the gold standard exchange rate regime.
Basics of the Gold Standard


The gold standard required that national
money be defined as a specific weight of
gold.
During this period:



The U.S. dollar had been defined as 0.0483% of
an ounce of pure gold.
The British pound as .23506%
Thus, the dollar pound parity (exchange rate) was
about $4.8665 per pound sterling

(= .23506/.0483)
Examples of Some Countries Joining
the Gold Standard

Country
U.K.
Australia
Canada
Germany
France
U.S.
Japan
Russia
Mexico
Date
1816
1852
1854
1871
1878
1879
1897
1897
1905
The Industrial Revolution and the
British Empire

The Industrial Revolution began in the 1760s.

Centered in Northwest England, it quickly
transformed the Britain from an agricultural
economy to one based on the application of
power-driven machinery to manufacturing.


Resulted in the rise of factory production.
As a result of Britain’s advantage in production,
the amount of British products available for export
(especially textiles) increased.
The Industrial Revolution and the
British Empire

The search for overseas markets for British
goods was the incentive for colonization and the
creation of the 2nd British Empire in the 1800s.



During its Industrial Revolution, Britain focused on
markets in Asia and Africa.
 Trading posts were established in these colonies.
Empire reached its apex by the end of World War I at
which time it controlled a quarter of the world’s
population
47% of the world’s holdings of international reserves
was in the form of British pounds (1913)
British Empire: Early
th
20
Century
WWI (1914 – 1919)

World War I (August 1914) marks the
beginning of the end of the Gold Standard.


During the war, countries suspended the
convertibility of their currencies into gold.
After the war, many countries suffered
hyperinflation and economic recessions.


As one policy solution, many countries turned to
competitive devaluations in an attempt to stimulate their
export sectors and gain advantages in world export
markets.
In reality, however, one country’s competitive
devaluation was followed by another country currency
devaluation (as an offset).
Interwar Period: 1919 - 1939

After WW I, various attempts were made to revive
the “classical” gold standard.



1919: United States returns to a gold standard.
1925: Great Britain joins, followed by France and
Switzerland.
These attempts were all unsuccessful.

At the time, countries were more concerned with their
national economies than exchange rate stability.


Especially true during the Great Depression (1929 - )
Countries abandoned the interwar gold standard during this
period.


Britain and Japan dropped it in 1931, the U.S. in 1933.
Countries also erected high tariff walls to “protect” their
domestic economy.
Bretton Woods: July 1944

As World War II drew to a close, all 44 allied
countries meet in Bretton Woods, New
Hampshire (Mount Washington Hotel),
to consider a new
international monetary
system.

The Bretton Woods System was agreed upon at
these meetings. During this time,


U.S. economy is the world’s strongest, so
U.S. dollar becomes the world’s key currency.
Bretton Woods Agreements

Fixed exchange rates were deemed desirable
for “restarting” world trade and investment.

U.S. dollar pegged to gold at $35 per ounce.


All other countries peg their currencies to the U.S.
dollar.


Dollar is the only currency which is convertible into gold.
Par values are set in relation to the U.S. dollar
Countries agree to “support” their exchange rates
within + or – 1% of these par values.

To be done through the buying or selling of foreign
exchange when market forces needed to be offset.
Design of the Bretton Woods System

Foreign currencies are linked to the U.S. Dollar
which in turn is linked to gold
BRITISH
POUND
Par Value
$2.80/£
GERMAN
MARK
Par Value
DM4.2/$
ITALIAN
LIRA
Par Value
Lit625/$
U.S. DOLLAR
GOLD
$35 an ounce
JAPANESE
YEN
Par Value
¥360/$
Bretton Woods Agreements

Countries agreed not to devalue their
currencies for trade gaining purposes
(competitive devaluations are prohibited)

But devaluation is allowed in response to
“fundamental disequilibrium.”



Chronic balance of payments deficit.
U.S. dollar, however, is the one currency which is
not permitted to change its value.
Bretton Woods meetings also create:


International Monetary Fund (IMF).
World Bank.
International Monetary Fund

Created to “watch over” the international
monetary system to ensure the maintenance
of fixed-exchange rates.


IMF agrees to lend country’s hard currency when
needed to defend their central rate.
Goal of the IMF: “To promote international
monetary cooperation and facilitate the
growth of international trade.”

Stable exchange rates are seen as critical to this
IMF goal.
World Bank

Also part of Bretton Woods Agreement

Initial goal of World Bank was to rebuild Europe and Asia’s
war-torn economies through financial aid.


Channels “Marshall” aid funds to Europe and Asia.
Eventually, the World Bank turns to ‘development’
issues.
 Lending money to developing countries.




Agriculture
Education
Population control
Urban development
Assessment of Bretton Woods: 1944- 1960s
During its first two decades, the Bretton Woods system is a
“success.”
 Exchange rates are relatively stable and world trade grows.
 Some countries do devalue their currencies.
This causes the U.S. dollar to effectively appreciate.

2.9
2.8
2.7
2.6
2.5
2.4
2.3
2.2
19
68
19
66
19
64
19
62
19
60
19
58
19
56
19
54
19
52
2.1
19
50
Dollar/Pound

Stable Yen During Bretton Woods
363
362
360
359
358
357
356
68
19
66
19
64
19
62
19
60
19
58
19
56
19
54
19
52
19
50
355
19
Yen/Dollar
361
Seeds of Bretton Woods’ Demise

In the 1960s, President Lyndon Johnson tries to
finance both his “Great Society” programs at home
and the American war in Vietnam.

Produces a large Federal budget deficit, which, coupled
with easy monetary policy, results in:



High inflation in the United States and
An increase in U.S. spending for cheaper imports
As a result, the United States balance of payments
moves into a deficit.


Dollar is seen by the market as “overvalued.”
Foreigners concerned about holding dollars at a rate of $35
an ounce.

Price of one ounce of gold was $35
U.S. Balance of Payments: 1965 

U.S. balance
of payments
measures
move into
deficit by
mid-1960s.
But, U.S.
dollar still
pegged at
$35 per
ounce.
1970 and 1971: Bretton Woods Begins
to Unravel

By 1970, markets are unwilling to hold the
overvalued dollar.


Dollars are sold on foreign exchange markets
Central banks engage in massive intervention in an attempt
to hold their Bretton Woods par values.


They buy U.S. dollars as they are sold in markets.
Foreign holdings of dollars exceed U.S. holdings of
gold (by 1971, gold coverage had dropped to 22%).

Dollar convertibility into gold is suspended in August 1971


Dollar trades lower in response (foreign currencies appreciate)
U.S. expresses an interested in forging a fixed exchange
rate system, but without “gold.”
Smithsonian Agreements, 1971


In December 1971, major counties
meet in Washington, D.C.
Leads to the Smithsonian
Agreements.
 Countries agree to revalue their
currencies (yen 17%, mark
13.5%, pound and franc 9%)
 In return, the U.S. agrees to raise
the dollar price of gold from $35
to $38 an ounce.



Combined, this was equivalent to
a “effective” dollar devaluation of
8.57%.
However, this dollar devaluation
had no significance because the
dollar remained inconvertible
Currencies now allowed to
fluctuate + or – 2.25%.
Renewed Attacks on the Dollar, 1973

13 months after the
Smithsonian Agreements,
the dollar comes under
renewed attack.




February 1973, markets sell
off dollars.
Central banks again
intervene and buy dollars.
In February 1973 the
dollar is devalued further
to $42
Foreign exchange
markets closed until
March 1973.
The Collapse of Bretton Woods

In March 1973, foreign
exchange markets
reopen and countries
are “allowed” to “float”
their currencies:


In March 1973, Japan
and most of Western
Europe let their
currencies float
against the dollar.
Bretton Woods
effectively ends.
Early Post Bretton Woods

During the
years
immediately
after the
collapse of
Bretton Woods,
the dollar
fluctuates, but
no discernable
trend is seen at
first.
Early Post Bretton Woods Agreements
In January 1975, IMF member countries meet in
Jamaica (Jamaican Agreement) and agree:



To accept a flexible exchange rate regime.
That central banks should intervene in foreign exchange
markets to deal with unwarranted volatilities.
Mid 1970s until 1980: the U.S. dollar weakens.
Then from 1980 to February 1985: the dollar
appreciates.




Relatively high U.S. interest rates attracted capital
inflows and offset the trade deficit.
In April 1981, the U.S. government announces that they
will no longer intervene in foreign exchange markets.
Roller Coaster Decade of the 1980s
Strong Dollar
Period:
1980 - 1985
1985: Plaza Accord

In September 1985, G7 countries meeting at the
Plaza Hotel in New York (Plaza Accord)

Agree to coordinated intervention in foreign exchange
markets to deal with the US trade deficit.


The dollar had strengthened from 1980 to 1985.



They agree to sell U.S. dollars (increase supply) and lower its
value.
G7 felt a weak dollar was needed to offset U.S. trade deficit.
Dollar weakens in response to central bank
intervention.
Longer term it continues to weaken in response to a
worsening U.S. trade deficit.

The dollar embarks on about a 10 year period of
weakness.
Roller Coaster Decade of the 1980s
WEAK
DOLLAR
1987: Louvre Accord

In February 1987, G7 meet in Paris, France (Louvre Accord):


Dollar continues to be weak until the mid-1990s.
Trade Weighted Exchange Rate
U.S. Dollar Index

Countries agree to cooperate to achieve greater exchange rate
stability, and
To consult and coordinate their macroeconomic policies.
140
130
120
110
100
90
80
83 9 84 9 85 9 86 9 87 9 88 9 89 9 90 9 91 9 92 9 93 9 94 9 95
9
1
1
1
1
1
1
1
1
1
1
1
1
1
Years (monthly average; May 1973 = 100)
Mid 1990s to Present Time

From 1996 through 2001 the dollar strengthens.

Strong U.S. economic performance attracts capital inflows.

From 2002 on it weakens again.

U.S. deficits become a concern again.
Trade Weighted Exchange Rate
U.S. Dollar Index

Economic performance offsets trade deficit concerns.
110
105
100
95
90
85
80
1993 1994 1995 1996 1997
1998 1999 2000 2001 2002 2003
Years (monthly average; May 1973 = 100)
Where are we Today?

“Mixed” International Monetary System consisting of:

Floating exchange rate regimes:


Managed (dirty float) rate regimes:



Market forces determine the relative value of a currency.
Government manages its currency’s value with regard to a
reference currency.
Market moves currency, but governments are managing the
process and intervening when necessary.
Pegged exchange rate regimes:

Government fixes (links) the value of its currency relative to a
reference currency.
Post Bretton Woods Summary

Since March 1973, major currencies of the
world operate under a floating exchange rate
system.



Market forces drive currency values!
Post Bretton Woods has resulted exchange rates
become much more volatile and less predictable
then they were during fixed exchange rate eras.
This volatility complicates the management of
global companies.
Yen Volatility Post-Bretton Woods
Year
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
Rate
291.53
296.69
296.38
267.80
208.42
218.19
226.63
220.63
249.06
237.55
237.45
238.47
168.35
144.60
128.17
138.07
% Change
-1.77%
0.10%
9.64%
22.17%
-4.69%
-3.87%
2.65%
-12.89%
4.62%
0.04 %
-0.43%
29.40%
14.10%
11.35%
-7.72%
Year
Rate
% Change
1990
145.00
-5.02%
1991
134.71
7.10%
1992
126.78
5.89%
1993
111.08 12.38%
1994
102.18
8.01%
1995
93.96
8.05%
1996
108.78 -15.77%
1997
120.99 -11.22%
1998
130.99
-8.27%
1999
113.73
13.18%
2000
107.77
5.20%
2001
121.53 -12.77%
2002
125.39
-3.18%
2003
115.94
7.41%
2004
108.15
6.72%
Note: High Rate: 1995 Low Rate: 1975
Rates: Averages for year.
Volatility of Yen: 1975-2002
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
-15.00%
-20.00%
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
-10.00%
1977
-5.00%
1975
0.00%
Volatility of Pound: 1975-2002
15.00%
10.00%
5.00%
-10.00%
-15.00%
-20.00%
-25.00%
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
-5.00%
1975
0.00%
Foreign Exchange Regime Changes


Currently the majority of the world’s countries
maintain pegged or highly managed
exchange rate regimes.
However, a growing number of countries are
adopting more flexible (e.g., floating rate)
regimes.


Letting the markets determine the exchange rate.
Examples over the last 10 years: Brazil, Chile,
Poland.
Exchange Rate Regimes, 1982 - 2001
Number of Countries
Exchange Rate Arrangements: 1982-2001
200
180
160
140
120
100
80
60
40
20
0
IMF Countries
Floating Rate
Managed Rate
Pegged Rate
82 984 986 988 990 992 994 996 998 000
9
1
1
1
1
1
1
1
1
1
2
Year
The Euro-Zone: A Currency Union

Today, 12 countries within the 25 member European
Union have adopted a single currency, the euro, as
their legal tender.

As of January 2002, the national currencies of these 12
countries have been withdrawn as legal tender.
The Euro Time Line: Pre Euro

1979: European Monetary System is created.




Designed to promote exchange rate stability within the
European Community.
Currencies tied into one another, but essentially into the
German mark.
Series of crises within the EMS, but it survives
1991: Maastricht Treaty signed


Called for the adoption of a “single” currency in Europe by
1999
Countries needed to meet specified economic and financial
criteria and could elect not to join (U.K. ops out).
The Euro Time Line: Introducing the
Euro

January 1, 1999. The European Monetary Union
(EMU) is created.

Eleven countries irrevocably lock their national currencies
to the euro.



For Example: 1,936.27 Italian lira = 1 euro; 1.95583 German
marks = 1 euro, etc.
These rates based on exchange rates between national
currencies on January 1, 1999.
January 1, 2002. euro notes and coins are
introduced into circulation, all national money is
withdrawn.


Greece joins the Euro zone on January 1, 2002
The U.K., Denmark, and Sweden remain out.
Countries in the Euro-Zone Today

In Euro-zone (12):


Austria, Belgium, Finland, France, Germany,
Greece, Ireland, Italy, Luxembourg, Netherlands,
Portugal, Spain.
Out of Euro Zone (But in the EU):

The U.K., Denmark, Sweden and the 10 countries
that joined the European Union on May 1, 2004.


Cyprus, Czech Republic, Estonia, Hungary, Latvia,
Lithuania, Malta, Poland, Slovakia, Slovenia
Bulgaria and Romania hope to join the EU by 2007.
The European Central Bank

As part of the European Monetary Union, the
European Central Bank is created.

Headquartered in Frankfurt, Germany



Primary objective to maintain price stability within
the euro-zone.



Modeled after the German Bundesbank.
Thus, highly independent.
Defined at less then 2%
Achieved through interest rate policies.
Many see the ECB as operating within too narrow
a mandate.
The Euro-Zone

In essence, the single currency has removed
exchange rate issues for transactions within
the euro-zone.


However, the euro itself is a floating currency
against the other currencies of the world.
Thus, exchange rate issues exist for foreign
companies (e.g., American) doing business in the
euro-zone and euro-zone countries doing
business outside of the singe currency area.
Performance of the Euro: Jan 1, 1999 
Note: Exchange rate on first trading day: $1.18/EUR