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CHAPTER SEVEN
Exchange-Rate Systems, Past to Present
I. Fundamental Issues
1.
2.
3.
4.
5.
6.
7.
What is an exchange-rate system?
How does a gold standard constitute an exchange-rate system?
What was the Bretton Woods system of “pegged” exchange rates?
What post-Bretton Woods system of “flexible” exchange rates prevails today?
What are crawling-peg and basket-peg exchange-rate systems?
What is a currency board, and what is dollarization?
Which is best, a fixed or flexible exchange-rate system?
II. Chapter Outline
1. Exchange-Rate Systems
2. The Gold Standard
a. The Gold Standard as an Exchange-Rate System
b. Performance of the Gold Standard
c. The Collapse of the Gold Standard
3. The Bretton Woods System
a. The Bretton Woods Agreement
b. Performance of the Bretton Woods System
c. The Smithsonian Agreement and the Snake in the Tunnel
d. Policy Notebook: The International Monetary Fund—Dismantle or Reform?
4. The Flexible Exchange-Rate System
a. Economic Summits and a New Order
b. Performance of the Floating-Rate System
c. The Plaza Agreement and the Louvre Accord
5. Other Forms of Exchange-Rate Systems Today
a. Crawling Pegs
b. Currency Baskets
c. Independent Currency Authorities
d. Dollarization
e. Policy Notebook: Should Argentina Dollarize?
6. Fixed or Floating Exchange Rates?
7. Questions and Problems
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Exchange-Rate Systems — Past to Present
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III. Chapter in Perspective
This chapter provides a historical overview of various exchange-rate arrangements from the 1800s to
today. The gold standard, the Bretton Woods system and the current “flexible” eras are explained. The
rationale for the demise of the gold standard and the Bretton Woods systems are also presented. Although
the majority of IMF members now practice some form of floating exchange rates, other exchange-rate
mechanisms used in practice are explained. The currency board will be of particular interest to students
because of its usage in Indonesia and Argentina in recent years. A brief discussion of dollarization is
presented in the text as well.
IV. Teaching Notes
1. Exchange-Rate Systems
The exchange-rate system (rules governing the management of foreign exchange values) is a subset
of the broader monetary order that establishes the framework for business transactions in a given
country. Most developed countries use fiat money today although historically commodity money or
commodity-backed money was common.
Teaching Tip:
The instructor may wish to stress that the value of fiat money is based solely on people’s faith in the
system, or faith that the money will retain its purchasing power. Because fiat money is backed by
faith in the economy and government, its value can be easily eroded by inflation and other events
such as war that severely erode consumer confidence. Fiat money is easier to manage and cheaper to
create since it is not tied to any commodity, but it creates the temptation for governments to create too
much money, which is of course inflationary. Historically, inflation as a long-term phenomenon was
very rare before the advent of fiat money.
2. The Gold Standard
The gold standard era lasted from the 1830s to the outbreak of World War I in 1914. [Convertibility
of U.S. currency to gold was suspended during the Civil War from 1861–1865.] By the mid 1870s
most major economies had established a gold standard with a set mint parity value at which their
currency could be converted to gold. The U.S. mint parity rate was $20.646 per ounce of gold. Note
that this was a commodity backed monetary order.100
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a. The Gold Standard as an Exchange-Rate System
When more than one country established the value of its currency per ounce of gold then a
defacto fixed exchange-rate system was in place. For example, as explained in the text, Great
Britain had fixed the value of the pound at £4.252 per ounce of gold. Consequently, the exchange
rate between the pound and the dollar was fixed at:
$20.646 per ounce of gold = £4.252 / ounce of gold or $1 = £0.2059.
If the exchange rate was instead $1 = £0.25, one could buy an ounce of gold in Britain for £4.252.
Next one would then ship the gold to America and sell it for $20.646 and then convert their
dollars back to pounds at the exchange rate of £0.25 /$ and wind up with £5.1615 per ounce of
gold shipped. If transaction costs were less than £5.1615 – £4.252 = £0.9095 per ounce one could
come out ahead.
b. Performance of the Gold Standard
Advantages of a gold standard:
 The major advantage of the gold standard was that it promoted long-run price stability
because the supply of money was closely tied to the supply of a relatively rare commodity;
this limited the money supply growth in economies using the gold standard. Hawks against
inflation sometimes call for a return to the gold standard for this reason.
Maintaining a gold standard does not require a central bank, which some economies, notably
the U.S., did not have at this time.
 The gold standard established fixed exchange rates, which some people feel promotes global
trade and investment.
Disadvantages of a gold standard:
 Probably the largest disadvantage is the lack of flexibility in managing the money supply. In
other words, short run price stability is sacrificed in order to maintain the exchange rate value
and large swings in the economy are likely, as we had during the gold standard era.
 The cost of obtaining, storing and transporting gold is significant, and much higher than for
fiat money systems.
 The supply of gold available was not and is not predictable, thus, the money supply could
change unpredictably, leading to inflation or liquidity crises.
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c. The Collapse of the Gold Standard
The Bank for International Settlements (BIS) was formed after World War I to facilitate payments
between nations, particularly German war reparations. The BIS:
 assists central banks in managing and transferring reserves,
 conducts economic research and is the main clearinghouse for data on derivative usage today,
and
 promotes research and international standard for regulations for the financial industry.
After WWI, the major economies attempted to return to the gold standard but were unsuccessful,
primarily because the parity rates set were based on pre-war values. The British pound was thus
highly overvalued relative to the French franc because France’s economy had suffered more from
the war. The incorrect parity values, coupled by the onset of depression in England in 1926,
followed by the U.S. in 1929, eventually broke the gold standard as countries refused to convert
their currencies to gold at fixed prices.
3. The Bretton Woods System
In 1944, as World War II was drawing to a close, a new exchange-rate agreement was drawn up in
Bretton Woods, New Hampshire. The primary architects of the system were Harry White of the
U.S. Treasury and some British economist called John Maynard Keynes. The official title of the
conference was the International Monetary and Financial Conference of the United and Associated
Nations.
a. The Bretton Woods Agreement
The main components of the Bretton Woods System included the creation of the main
architecture of the modern international financial institutions including:
 International Monetary Fund (IMF)
The original purpose of the IMF was to lend funds to member countries temporarily short of
foreign currency reserves. Countries became members by paying a quota based on the size of
their economy and their importance in foreign trade. The member’s ability to obtain IMF
funds was also based on their quota. Twenty-five percent of the quota was required to be
paid in gold, and the remainder could be paid in the national currency. Today, the primary
functions of the IMF are still to provide funds to member nations experiencing a shortage of
foreign reserves, to monitor and provide research on the economies and policies of member
nations, and to serve as a forum for policy cooperation.
 The International Bank for Reconstruction and Development, called the World Bank
The World Bank was created to provide funds for long-term development in the post war
economies then and in developing nations today. The World Bank lends to about 100
countries today.
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
General Agreement on Tariffs and Trade (GATT)
GATT was designed to liberalize trade, by encouraging signers to convert non-tariff barriers
to trade to tariffs and then to reduce the tariffs. GATT was replaced by the WTO.
Beyond the institutions, the Bretton Woods Agreement also created a new fixed or pegged
exchange-rate system. The dollar was selected as the standard currency, and member countries
agreed to peg their currency values relative to the dollar within a narrow band of  1% of the
parity value. The U.S. in turn would maintain convertibility of the dollar to gold at a fixed price
of $35 per ounce. This resulted in an indirect gold standard, whereby all other countries’
currencies were indirectly linked to gold via the peg to the U.S. dollar. With IMF approval a
country could devalue (revalue) its currency’s par value by raising (lowering) the domestic
currency price of the foreign currency. As a result of choosing to peg currency values to the U.S.
dollar, the dollar became the primary reserve currency in the world.
Teaching Tip:
Ask students the following for discussion purposes:
How is the advent of the Euro likely to change the reserve currency status of the dollar? Is this
good, or bad, for the U.S.?
b. Performance of the Bretton Woods System
For the Bretton Woods system to function properly, the world had to be confident in the value of
the dollar. This implied that the U.S. had to maintain relatively lower inflation rates than other
participating countries and that the U.S. had to be able and willing to convert dollars to gold at the
fixed price. For most of the time from 1945 to 1968, the U.S. and the rest of the global economy
experienced strong growth, in part fueled by rapid growth in international trade. Nevertheless,
the possibility of a run on the dollar was always present. In 1960, the U.S. and other nations
began intervening in the gold market in coordinated fashion to maintain the value of the dollar
(the so called “gold pool”) against gold. In the 1960s, U.S. government spending grew rapidly
due to the Vietnam War and Johnson’s Great Society programs. One of the results was U.S.
inflation was higher than inflation elsewhere. This brought speculative pressure on the value of
the dollar. In the late 1960s first England, then Germany revalued their currencies against the
dollar, but other countries did not. With the growth of private capital that was also occurring, it
began to be clear that the U.S. would not be able to maintain the value of the dollar and people
began to sell dollars, buying other currencies and buying gold. These actions obliged member
nations to buy dollars, which they did. In 1971, Germany bought about $2 billion before
realizing the value of the dollar could not be maintained. On August 8, 1971, President Nixon
closed the gold window, ending the convertibility of the dollar to gold at fixed prices.
In the late 1960s, the U.S. saw its current account surplus shrink and turn into a large deficit in
1971, increasing speculation against the dollar as U.S. gold reserves were no longer sufficient to
maintain the value of the dollar.
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c. The Smithsonian Agreement and the Snake in the Tunnel
The Smithsonian Agreement of 1971 was an attempt to restore order to the exchange-rate
system. The Smithsonian agreement had three major components:
 it revalued most currencies’ parity values against the dollar,
 it widened the bands of swings in allowable currency values from 1% to 2.5% of parity
values, and
 it devalued the dollar relative to gold.
Nevertheless, the U.S. did not reestablish the convertibility of dollars to gold, thereby probably
dooming the system. The Smithsonian Agreement was in effect for only 15 months, even though
Nixon referred to it as the “most significant monetary agreement in the history of the world.”
During this time (1972), the EEC began the Exchange Rate Mechanism, euphemistically known
as the “snake in the tunnel.” At first, the EEC attempted to maintain currency values against the
dollar as per the Smithsonian Agreement, but they abandoned this in 1973.
d. Policy Notebook: The International Monetary Fund—Dismantle or Reform?
For Critical Analysis: Currently there is only one International Monetary Fund. Is
financial market stability best served by one single institution or by a number of institutions
spread out over the globe?
There is no definitive way to answer this question. Helpful references are:
 “The International Monetary Fund 50 Years after Bretton Woods,” New England Economic
Review, 1994
 “Rethinking the International Monetary System: An Overview,” J. Little and G. Olivei, New
England Economic Review, Nov/Dec 1999
 “Why the Interest in Reforming the International Monetary System?” New England
Economic Review, Sept. Oct 1999.
The primary advantage of creating regional IMFs would be the additional knowledge about the
local area that the IMF might achieve in this way. The IMF has been accused of employing a
“one size fits all” policy, encouraging fiscal and monetary austerity and more open markets in
most cases. Perhaps rather than splitting the IMF, simply increasing staffing or reducing its
charge as the policy notebook discussion indicates would work as well. The IMF operates under
a serious handicap in that it does not have the authority to change corrupt systems and regimes,
which is often the biggest problem faced by countries in crisis.
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4. The Flexible Exchange-Rate System
In a floating rate system, market supply and demand forces set the exchange rate. In this
environment, future expectations of relative economic performance set the exchange rate.
a. Economic Summits and a New Order
The Jamaica Accords in 1976 formalized the floating rate era by amending the IMF constitution
to allow each member nation to determine its own exchange-rate system. Economic summits
then began to meet routinely each year with varying numbers of nations such as the Group of 5
(G5) or the Group of 8 (G8).
b. Performance of the Floating-Rate System
The primary advantage of a floating-rate system is that it allows a country to focus monetary
policy on domestic objectives, rather than using monetary policy to maintain the currency peg.
Moreover, allowing the exchange rate to float may theoretically at least protect the economy from
forced changes in real variables that would result due to shocks and other changes in comparative
advantage between nations. It is doubtful that any fixed exchange-rate system could have
survived the shocks of the 1970s and 1980s. The quid pro quo however is that the exchange rate
could (and did) change dramatically (see Text Figure 7-4). In the late 1970s, the dollar began a
steep decline, only to turn around after Paul Volcker (an inflation hawk) became chairman of the
Federal Reserve. The dollar continued to more or less climb from 1979 to its peak in March 1985
when it began an even sharply decline than the previous climb.
c. The Plaza Agreement and the Louvre Accord
The G5 (U.S., U.K., Germany, Japan and France) met at the Plaza Hotel in 1985 and created the
Plaza Agreement. The G5 stated in the agreement that the dollar had reached an unsustainably
high value and the G5 would intervene collectively to drive down the dollar. In 1987 under the
Louvre Accord the G7 (Italy and Canada plus the original five) announced that after the fall in
value the dollar had now reached a level consistent with economic fundamentals and the group
would now only intervene to ensure stability. The dollar continued to fall.
Teaching Tip:
By this time private capital flows in exchange markets dwarfed the ability of the countries to
force the dollar to move against the wishes of private speculators. Nonetheless, G7
announcements still have large signaling power.
Under the Louvre Accord, nations intervene from time to time as they feel it is necessary. This is
called a dirty float or a managed float.
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5. Other Forms of Exchange-Rate Systems Today
About 44 percent of countries (more or less) allow their currencies to float. About 21 percent have a
currency peg, with the dollar being the most common peg, and sometimes a currency basket is used as
a peg. Only a small number of countries use a crawling peg or a currency board.
a. Crawling Pegs
With a crawling peg, the country pegs its currency value to another currency, typically the dollar,
but it allows the parity value to be updated at regular intervals. For example, Nicaragua allows
the cordoba to be depreciated against the dollar every week (Nicaragua has been experiencing
higher inflation than the U.S.). A variation is to allow a crawling band with upper and lower
parity limits that are adjusted at regular intervals.
b. Currency Baskets
Some countries feel that a basket of currencies makes a better peg than any one currency. A
basket is usually less volatile than a single currency and employing a basket may reduce the
pegged currency’s volatility without facing destabilizing speculation. The currency basket
typically includes no more than six currencies.
c. Independent Currency Authorities (ICA)
Commonly called a currency board, an ICA normally substitutes for a central bank. The
currency board pegs the value of the domestic currency to a chosen foreign currency and stands
ready to buy or sell foreign currency as needed, issuing domestic money as needed. In this case,
changes in the domestic money supply are determined by changes in the foreign reserve holdings
of the board. Its sole purpose is to maintain the exchange value of the domestic currency and it
does not engage in domestic monetary policy.
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d. Dollarization
An extreme approach to exchange-rate policy is to dollarize the economy. To dollarize is to
substitute a foreign country’s legal tender, usually the dollar, for that foreign country’s own
currency. Ecuador and El Salvador have recently dollarized their economies. The major gain
appears to be lower inflation rates in dollarized economies, but these have come at the expense of
lower growth rates as well. The tradeoff in dollarization would appear to be inflexibility (even a
pegged parity value can be changed) versus the credibility achieved by dollarizing.
e. Policy Notebook: Should Argentina Dollarize?
For Critical Analysis: Can you still identify some benefits of dollarization, now that the
forces of supply and demand determine the exchange value of the peso? Can you argue in
favor of another type of exchange-rate arrangement?
Since the peso has devalued and is now floating to its appropriate rate, dollarization would make
more sense now than before the crisis, but not much more. The exchange-rate system is only one
variable in the economy. Allowing the exchange rate to float can help keep Argentinean goods
and services competitive as comparative advantages change. The advantage of dollarization is
the credibility that is gained by eliminating the possibility of creating too much of the local
currency. A crawling peg might be better than dollarization at this point, as this would allow the
peso to be depreciated (or appreciated) as needed at set intervals. The stability gained from a
commitment to a crawling peg may then attract enough investment to help modernize the
Argentinean economy.
6. Fixed or Floating Exchange Rates?
This is one of the major policy questions for developing countries. With fixed or pegged exchange
rates, the monetary authority must intervene in currency markets, implying that the monetary
authority cannot control the domestic money supply growth rate independently of other economies.
This means that changing relative real growth, inflation and interest rates will force the monetary
authority to change the domestic money supply to maintain currency value. Doing so can destabilize
the local economy, which is a risk that deters foreign investment. Fixed systems are often touted as
providing stability; thus reducing business risk and business contracting costs. So, we may say fixed
exchange rates increase micro level efficiency. Another argument often made is that fixed exchange
rates force governments to be disciplined in their spending and money creation, because speculators
will force an exchange rate change when an exchange value does not conform to economic reality. In
actuality, fixed exchange rates often provide short run stability at the cost of long run stability. Fixed
exchange rates may understate the true risk of investing in a given country, leading to overinvestment,
excessive borrowing and the shunting aside of problems that needed to be fixed. If we study the
periods of when fixed exchange rates worked in recent years, they worked during periods of strong
growth and resulted in problems, sometimes severe, when growth slowed and major adjustments
could no longer be put off.
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Floating rate systems should lead to greater economic efficiency as more information is continuously
incorporated into the exchange rate. Moreover, floating rate systems do not require as much intergovernment cooperation and can insulate against shocks. Some argue that floating rate systems lead
to excessive volatility. Destabilizing volatility is bad. Volatility adds to trading costs, trading risks
and results in reduced trade, and the associated misallocation of resources. However, the more rapid
adjustment of the exchange rate to current and future prospects that presumably accompanies floating
exchange rates is good for global growth as it implies improved allocational efficiency.
The debate on the proper exchange-rate system will continue. However, we do need to emphasize to
the students that no exchange-rate system can indefinitely make up for poor fiscal and monetary
policies.
7. Answers to End of Chapter Questions
1. See Figure 7-3 on page 213. The arrangements are in clockwise order: dollarized arrangement,
currency board, fixed peg, pegged with bands, crawling peg, managed float and independent float.
2. The primary functions of the IMF are to provide funds to member nations experiencing a shortage of
foreign reserves, to monitor the economies and policies of member nations, and to serve as a forum
for policy cooperation.
3. £33.33 and C$69
4. The rate of exchange between the Canadian dollar and the pound is 2.07 (C$/£).
5. Note that the value of the peso is equal to the sum of $0.50 and €0.50. Using the exchange rate
between the dollar and the euro, we can convert €0.50 to is dollar equivalent, which is $0.45. Now
we see that the value of one peso is equal to the sum of $0.50 and $0.45, or $0.95. Hence the
exchange rate between the peso and the dollar is 0.95 dollars per peso. Using similar logic, the
exchange rate between the euro and the peso is 1.056 euros per peso.
6. The main difference between the Smithsonian Agreement and the Bretton Woods system is that under
the Smithsonian Agreement the dollar was not convertible to gold. Given the uncertainty about the
value of the dollar during the period it made it very difficult to maintain pegged values to the dollar.
7. The principle responsibility of a currency board is to maintain a pegged value for its domestic
currency. A typical currency board cannot hold domestic debt, cannot set reserve requirements on its
nation’s banks, and cannot serve as a lender to its nation’s banks.
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8. Because officials could buy and sells foreign reserves to maintain some degree of stability in
exchange values, the Louvre accord represented a dirty-float, or managed-float arrangement.
9. The factors that should be considered are those factors that would cause a change in the demand for
and supply of a currency. (The most important of these factors are prices and interest rates, which
will be covered in the next few chapters.)
10. The main difference is that the nation still maintains its own domestic currency as opposed to doing
away with the currency all together. Another answer, however, would be to consider the impact of
dollarization on the economy. Empirical evidence indicates that the majority of countries that have
dollarized have lower rates of inflation and economic growth.