Under the gold standard all national governments promised to follow the “rules of the game.” This meant defending a fixed exchange rate. What did this promise imply about a country’s money supply?
A country’s money supply was limited to the amount of gold held by its central bank or treasury. For example, if a country had 1,000,000 ounces of gold, and its fixed rate of exchange was 100 local currency units per ounce of gold, that country could have 100,000,000 local currency units outstanding. Any change in its holdings of gold needed to be matched by a change in the number of local currency units outstanding.
Causes of Devaluation (If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the fixed exchange rate to be devalued?)
An interest rate that is too low compared to other competing currencies
A continuing balance of payments deficit
An inflation rate consistently higher than in other countries
Fixed Exchange Rate - Advantages
Provide stability in international prices for the conduct of a trade.
Stable prices aid in growth of international trade and lessen risks for all businesses.
Fixed Exchange Rate - Disadvantages
- Inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies.
- Restrictiveness burdens countries wishing to pursue policies that alleviate continuing internal economic problems (high unemployment or slow economic growth).
- Banks must hold large quantities of international reserves (hard currencies and gold) for use in occasional defence of the fixed rate.
- May be maintained inconsistently with economic fundamentals.
- Rate changes are changed administratively (usually too late, too highly publicised and with too large a one-time cost to the economy's health).
Impossible Trinity (Sacrifices)
Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability.
Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate, but surrender their ability to be integrated with the world’s capital markets.
Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy.
The country issues its own currency, but that currency is backed 100% by foreign exchange holdings of a hard foreign currency—usually the U.S. dollar.
- Hong Kong, Argentina
The country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic transactions.
Euro Affects on the Market
- Countries within the euro zone enjoy cheaper transaction costs
- Currency risks and costs related to exchange rate uncertainty are reduced
- All consumers and businesses both inside and outside the euro zone enjoy price transparency and increased price-based competition.
International Monetary Fund (IMF) Objectives
Bretton Woods Agreement (1944)
- To render temporary assistance to member countries trying to defend the value of their currencies against cyclical, seasonal, or random occurrences.
- To assist countries having structural trade problems.
- Attempted to help countries (Russia, Brazil, Argentina, and Indonesia) to resolve financial crises.
Special Drawing Right (SDR)
Currently the weighted average of four major currencies (U.S. dollar, euro, Japanese yen, British pound).
Updated every 5 years
- - Hard Peg
- - Soft Pegs
- - Floating Arrangements
- - Residual
- - Countries have given up their own sovereignty over monetary
- Countries that have adopted other country currencies.
- Countries utilizing a currency board structure which limits monetary expansion to the accumulation of foreign exchange.
Soft Pegs (Fixed Exchange Rates)
- The five subcategories of soft peg regimes are differentiated on the basis of what the
- currency is fixed to, whether that fix is allowed to change—and if so under what conditions,
- what types, magnitudes, and frequencies of intervention are allowed/used, and the degree of variance about the fixed rate.
Currencies that are predominantly market-driven.
- - Free Floating, values determined by open market forces without governmental influence or intervention.
- - Floating (Floating with Intervention), where
- government occasionally does intervene in the market in pursuit of some rate goals or objectives.
- - all exchange rate
- arrangements that do not meet the criteria of the previous three categories.
- Country systems demonstrating frequent shifts in policy typically make up the bulk of this category.
Exchange rate stability - the value of the currency would be fixed in relationship to other major currencies, so traders and investors could be relatively certain of the foreign exchange value of each currency in the present and into the near future.
Full financial integration - complete freedom of monetary flows would be allowed, so traders and investors could willingly and easily move funds from one country and currency to another in response to perceived economic opportunities or risks.
Monetary Independence - domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions, and fostering prosperity and full employment.
Rules of the Game (1876-1913)
Each country set the rate at which its currency unit could be converted to a weight of gold.
Independent monetary policy