Introduction 3
1. History of exchange rate systems 4
1.1. Commodity money 4
1.2. Paper money 4
1.3. The gold standard 4
1.4. The Bretton-Woods system 6
1.5. Deficiencies of Bretton-Woods system 7
1.6. Further development of exchange rate systems 8
1.7. Modern variants of exchange rate systems 12
2. Pros and Cons of Each System 14
2.1. Advantages of fixed exchange rate system 14
2.2. Disadvantages of fixed exchange rate system 15
2.3. Advantages of floating interest rate system 16
2.4. Disadvantages of floating rate exchange system 17
4. Examples of exchange rate management 20
Conclusion 25
Literature 27
Introduction
An exchange rate is the rate at which one currency is exchanged on another one.
This rate differs from country to country and depends on many economical variables,
the main of which are the general balance and disbalance of economy, monetary
and fiscal policy, the state of the budget, international policy, the condition
and development of the country’s economy compared to the world situation
and dominating countries, purchasing power of the currency, and other internal
and external factors.
The history of world exchange rate systems shows us that the world community
(in its majority) has in fact shifted from the system of fixed exchange rates
to floating exchange rate system. Currently there exist different combinations
of floating and fixed exchange rate systems, together with specific economical
instruments, created for exchange rate regulating.
This essay is aimed to describing the existing exchange rate systems, their
impact on local and international economy and analysis of pros and cons of each
system. This essay also contains an attempt to show the examples of exchange
rate management in different countries, and analyze their consequences; the
return effects of exchange rate management on the condition of major economical
variables have also been regarded and a conclusion basing on all the above-listed
material has been made.
1. History of exchange rate systems
1.1. Commodity money
Since the development of production and a number of divisions of labor there
existed such a phenomenon as commodity money. There was no other monetary system
until 17th century when there appeared coins having an intrinsic value, not
linked with commodity. Usually the value of the coin was associated with the
content of gold in the coin. The exchange rate between different coins and different
currencies depended on the content of gold in the coin as well, and equaled
to the relative content of gold in the coins.
1.2. Paper money
In 17th century banks started issuing own banknotes which had the same purchasing
power as coins and were backed by precious metals in the banks. People could
convert these banknotes into precious metals if they wished so. It is important
to note that this backing was not 100%.
1.3. The gold standard
With the development of this system (the so-called fractional reserve banking)
and with the development of international relations the idea of the gold standard
appeared. In 1870 major countries had an agreement to base their exchange rates
on the gold standard: the amount of gold which was backed for the banknote by
the bank. Therefore the exchange rates between different countries equaled to
the ratio of gold content linked with the currencies. This system existed until
1913, and, as we can see, represented the fixed exchange rate idea (since the
gold content of each currency was fixed).
None of the countries offered 100% backing for their currency, and therefore
the demand and purchasing power of a particular currency depended on the credibility
of the currency; the countries with weaker or slower economical development
had less credible currencies. The problems started to appear after World War
I, when most of the countries were trying to improve their economical condition
after the war and were undertaking speculative attacks, to increase the purchasing
power of their currency and to decrease the purchasing power of other countries.
Naturally, the economies of the countries with less credible currencies have
been affected by such attacks, and the state of these economies has worsened.
This situation has shown one of the weaknesses of fixed exchange rate system.
With the development of financial and banking system the backing of currencies
has shifted from gold standard to backing by government debt instruments, such
as treasury bills etc. Since the currencies progressively less depended on the
gold content, the main variable that defined the purchasing power of a currency
was the credibility of it. Economical fluctuations and crisis specified the
instability in currency exchange rates. Until World War II the world community
has undertaken attempts to return to the gold standard, but they were not very
successful because of the changed economical conditions [7, p.12].
1.4. The Bretton-Woods system
After World War II the major countries adopted the Bretton-Woods system, which
continued the policy of fixed exchange rates, but offered a shift from the inefficient
gold standard to the so-called gold exchange standard. The exchange rates were
fixed compared not to gold, but to the US dollar; the US dollar, in its turn,
was linked by a specific exchange rate with gold. The change of exchange rates
(either devaluation or evaluation) was allowed only in extreme cases. This system
strengthened the position of the US as a dominating economy, and affected the
exchange rates of countries with weaker economies.
As an attempt to solve this disbalance, the International Monetary Fund (IMF)
has been created. The countries with weaker economies were given loans on specific
conditions to improve their economical state. Nevertheless, the huge gap between
the stability and level of exchange rates of dominating countries and the exchange
rates of other countries proved that the existing exchange rate system needed
to be improved.
The main controversy between exchange rates and domestic policies is that, on
one hand, fixed exchange rates offer relative stability and better conditions
for local and international trade conditions; the enterprisers could easily
predict the rates and plan their work according to this. On the other hand,
to eliminate instability and stimulate economical growth, it is required that
currencies could be exchanged without any restrictions [7, p.50]. And the last
condition that is necessary for sound economical development is that governments
have to conduct monetary and fiscal policies without any restrictions in order
to be able to cope with appearing crises, reduce such factors and unemployment
and inflation etc.
1.5. Deficiencies of Bretton-Woods system
Unfortunately these three conditions cannot be reached within the terms of one
economical system; one of them is always not compatible with the other two conditions.
For example, if the state chooses free and unlimited currency conversion and
fixed exchange rate policy, it is then unable to provide domestic interventions
in order to control appearing economical disbalances and becomes very vulnerable
to outer economical interventions and speculative attacks. If the state provides
strong domestic policy and controls the appearing economical troubles such as
inflation and unemployment, and at the same time offers free and unrestricted
conversion of currencies, it will be unable to keep the exchange rate on a desired
level because the changing demand for the currency and changing economical conditions
will require to devalue or revalue the national currency. And finally, if the
state chooses to have strong domestic policy and fixed exchange rates in order
to reach economical stability, it will have to limit the amount of converted
currencies to preserve the exchange rate in the proper scope.
Depending on these three main factors, three main exchange rate systems have
appeared: fixed exchange rate system, floating (or flexible) exchange rate system,
and managed exchange rate system which combined both above-listed systems.
1.6. Further development of exchange rate systems
Let us now return to historical development of exchange rate systems. The Bretton-Woods
system existed until 1973. In 1971 there was an attack on the US dollar which
made it significantly overvalued against other currencies; but the US government
did not try to protect the dollar value, and therefore the floating of dollar
exchange rate started. There was an attempt to return back to fixed rate system
in 1973, but it didn’t have any significant effect and as other currencies
were strongly linked to dollar value, the world exchange rate system gradually
shifted from fixed exchange rate to floating exchange rate.
The attitude to this shift is different in different parts of the world, and
it specified the emergence of three distinct types of exchange rate systems
(they were listed above) and different combinations of these types.
It is historically conditioned that the US supports the idea of self-adjusting
market; therefore the US government mostly supports floating exchange rate system.
The European community has mostly provided the policies of regulating their
economy and intervening into market mechanism; therefore countries of these
region have hosen the direction towards a fixed exchange rate system and finally,
towards a common currency in 1999.
The European Monetary System (EMS) has been created in 1979; it included 15
countries of Europe and offered the fixation of exchange rates of one currency
compared to another one; the rates for the pairs of currencies differed which
allowed more flexibility than simply fixing exchange rates. This system also
allowed the change of the exchange rate in certain situations; for weaker countries
the fluctuation barrier has been made wider than for dominating countries [3,
p. 42]. As a development of this system, euro has been created; in 1999 all
currencies have been fixed against euro and finally in 2002 all currencies were
replaced by euro.
The countries of Asian region in their majority opted for the stability of their
exchange rate and introduced the policies that linked the national currency
to the dollar value and let it fluctuate only in small scope around the dollar
value.
The dynamics of currencies during the 20th century can be illustrated by the
exchange rate between dollar and pound in the period from 1957 to 2001(fig.1).
1.7. Modern variants of exchange rate systems
Today there exist three major currencies: dollar, euro and yen; other currencies
are in some way dependent from these ones.
Currently we can witness the development of three major exchange rate systems
and several their modifications. The countries that use managing exchange rate
system have worked out several policies for maintaining economic stability.
One of the long-living policies is the usage of currency boards. The idea of
a currency board means full backing of international currency reserves. Since
the countries using fixed exchange rate systems need to have reserves of international
currency, one of their main problems is to cover the excess demand for foreign
currency in case of instability; and the main reason that causes economical
disbalance in such countries, is the inability to cover excess demand and therefore
the inability to keep the fixed exchange rate on the desired level. This problem
can be avoided by currency board: i.e. the bank only issues as much national
money, as it can cover by the reserves of international currency. Such systems
have proved their viability, but, like all fixed exchange rate systems, they
are still vulnerable to the speculative attacks. However, the examples of Argentinean
and Hong Kong currency boards show us that these systems can be effective, at
least in the short run.
The other economical instruments that are used for exchange rate managements,
are pegging the currency (either to one currency, or to the basket of currencies),
accepting a managed float for a specific currency within the region where different
currencies are in use, and letting the currency to float freely against all
other currencies.
2. Pros and Cons of Each System
Since exchange rates and economies of all countries have experienced significant
instability in 20th century, there have appeared a lot of arguments concerning
the choice of exchange rate system. Since the fixed exchange rate system has
been widely used before, there have been a lot of its supporters. The main their
argument has been that floating exchange rates mean instability. However, there
appeared a number of researchers offering arguments in favor of floating exchange
rate system.
2.1. Advantages of fixed exchange rate system
First of all, fixed exchange rates offer much greater stability for the enterprisers
and stimulate international trade; since the exchange rates stay on the same
level, the importers and exporters can plan their policy without begin afraid
of depreciation or appreciation of the currency. Moreover, fixed exchange rates
make the producers more disciplined, i.e. they are forced to keep up with the
quality of their production and to control the costs of the production to stay
competitive compared to international enterprisers. This advantage of fixed
exchange rates allows the government to decrease inflation level and stimulate
international trade and economical growth in the long period [10, p. 37].
Secondly, it is believed that fixed exchange rates stimulate the reduction of
speculative activity worldwide; but this statement is true under the condition
that the adopted exchange rates are profitable for the foreign dealers as well
as for domestic ones (closer examination of this condition shows us that monetary
and fiscal policies attempting to protect domestic producers – which are
often required to preserve economical stability – violate this condition
and therefore create the ground for speculative intervention).
2.2. Disadvantages of fixed exchange rate system
The main disadvantage of it is the high vulnerability of the economical system
to speculative attacks. Any economy experiences excess supply and demand in
either national or foreign currency: and if the national banks are unable to
cover the gap between the existing resources and demand, the fixed rate needs
to be changed; this situation reduces the positive effects of the fixed rate
exchange system and decreases the credibility of the currency.
One more disadvantage of this system is that if the government artificially
supports the exchange rate, which is not adjusted to changed economical condition,
the development of the country’s economy is not as efficient as it could
be if the rate was adjusted to the situation. Moreover, interest rates, which
directly depend on the exchange rate, can stop possible economical growth in
case of their disparity to market needs.
In the conditions when the national currency is tied to some international currency,
there exists very significant dependence of the condition of these countries’
economical stability. In this case the government is actually forced to solve
the economical problems of the countries, with currency of which it is linked.
This situation creates the possibility for dominating countries to improve the
state of their economy at the expense of related countries with weaker economies;
and at the same time destabilizes the market situation in these related countries.
I think that taking into consideration the growing economical and political
integration, the strengthening of the economical connection between countries,
the fast development of world trade and economical specialization, the advantages
of fixed interest rates do not cover the losses caused by the restrictions imposed
by this system.
2.3. Advantages of floating interest rate system
The main advantage of this system is its flexibility and the possibility for
the country’s economy to be quickly adjusted to changing market conditions.
If the balance of payments deficit is violated, the floating exchange rate system
allows to adjust a currency outflow or inflow into the country; this automatically
makes the domestic goods either more competitive (in case of appreciation on
the currency market) or makes foreign goods more competitive (in case of the
currency’s depreciation).
The second advantage of floating exchange rate system is that it automatically
determines interest rates within the country and therefore allows controlling
the economical balance more effectively.
2.4. Disadvantages of floating rate exchange system
It is believed that this exchange rate system leads to instability on the market
and does not stimulate the development of trade and production; floating exchange
rates destabilize economical situation and lead to economical crises. The instability
of exchange rates after the end of Bretton-woods system and the whole depression
in world economy at that time illustrated this point of view; however, with
the flow of time the economists started regarding this system from a different
point of view: the work of Milton Friedman in 1953 opposed the common belief
that instability was caused by the float of exchange rates. Friedman stated
that instability was caused by wrong economical policy of the governments and
other factors, not depending on the exchange rates mechanism. Indeed, the effects
of flexible exchange rates on the stability of prices and production have appeared
to be much smaller than they were expected to be; for example, in Germany in
1980s the purchasing power of DM shifted from 20% above the purchasing power
of USD to 25% below this level, and then returned to 25% above USD purchasing
power. According to the predictions, this shift has to cause significant disbalance
in German economy; but contrary to these assumptions, the changes were very
modest. It has appeared that most producers chose to keep up with the strategy
of “pricing to market”. This means that the prices of the goods
remained stable in the currency of importing country, and therefore they were
not heavily destabilized by the shift in exchange rates.
The instability of exchange rates is the main argument of floating exchange
rates opponents. However, besides Friedman’s explanations, there have
been other attempts to explain this great instability. For example, Dornbush
in 1976 suggested that there existed a phenomenon of “over-shooting”.
This means that to be successful in the long run the economy needs to depreciate
its currency, in order to reduce inflation and stimulate economical growth.
However, in the short period depreciation will cause the decrease of interest
rates and the fall of activity; in order to stimulate the activity of firms,
the currency needs to be expected to rise in future. The only variant that can
provide depreciation in the long run together with the expected rise of the
purchasing power of the currency is the fall of the currency lower than it’s
needed in the long run; for example, if the money supply of the country rises
by 5%, its currency needs to be depreciated by 5% in the long run – but
to stimulate economical activity, the currency needs to be depreciated by 15%
with expected rise by approximately 10% (the so-called mechanism of “over-shooting”).
Another advantage of floating rate system is that it allows the government to
introduce separate monetary and fiscal policies, which is rather difficult under
the conditions of a fixed exchange rate system. In general, the arguments between
the supporters and opponents of floating exchange rate system lie in the relation
between the price paid for the instability of exchange rates and the possibility
to introduce independent monetary and fiscal policy, and therefore to adjust
quickly to changing economical conditions.
4. Examples of exchange rate management
Exchange Rate Arrangements as of December 31, 1997
Pegged
Single currency Currency composite
U.S. dollar
Angola
Antigua and Barbuda
Argentina
Bahamas, The
Barbados
Belize
Djibouti
Dominica
Grenada
Iraq
Lithuania
Marshall Islands
Micronesia, Federated States of
Nigeria
Oman
Panama
St. Kitts and Nevis
St. Lucia
St. Vincent and the Grenadines
Syrian Arab Republic French franc
Benin
Burkina Faso
Cameroon
Central African Rep.
Chad
Comoros
Congo, Rep. of
Cote d’Ivoire
Equatorial Guinea
Gabon
Guinea-Bissau
Mali
Niger
Senegal
Togo Other
Bhutan
(Indian rupee)
Bosnia and Herzegovina
(deutsche mark)
Brunei Darussalam
(Singapore dollar)
Estonia
(deutsche mark)
Kiribati
(Australian dollar)
Lesotho
(South African rand)
Namibia
(South African rand)
San Marino
(Italian lira)
Swaziland
(South African rand) SDR
Latvia
Libyan Arab
Jamahiriya
Myanmar Other
Bangladesh
Botswana
Burundi
Cape Verde
Cyprus
Czech Republic
Fiji
Iceland
Jordan
Kuwait
Malta
Morocco
Nepal
Seychelles
Slovak Republic
Solomon Islands
Thailand
Tonga
Vanuatu
Western Samoa
Flexibility Limited vis-a-vis a Single Currency or Group of Currencies More
Flexible
Single currency Cooperative arrangements Other managed floating Independently
floating
Bahrain
Qatar
Saudi Arabia
United Arab Emirates Austria
Belgium
Denmark
Finland
France
Germany
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain Algeria
Belarus
Brazil
Cambodia
Chile
China, People’s Rep. of
Colombia
Costa Rica
Croatia
Dominican Republic
Ecuador
Egypt
El Salvador
Georgia
Greece
Honduras
Hungary
Indonesia
Iran, Islamic Rep. of
Israel
Kazakhstan
Kyrgyz Republic
Lao P.D.R.
Macedonia, former Yugoslav Rep.of
Malaysia Maldives
Mauritius
Nicaragua
Norway
Pakistan
Poland
Russian Federation
Singapore
Slovenia
Sri Lanka
Sudan
Suriname
Tunisia
Turkey
Turkmenistan
Ukraine
Uruguay
Uzbekistan
Venezuela
Vietnam Afghanistan, Islamic State of
Albania
Armenia
Australia
Azerbaijan
Bolivia
Bulgaria
Canada
Eritrea
Ethiopia
Gambia, The
Ghana
Guatemala
Guinea
Guyana
Haiti
India
Jamaica
Japan
Kenya Republic
Korea
Lebanon
Liberia
Madagascar
Malawi Mauritania
Mexico
Moldova
Mongolia
Mozambique
New Zealand
Papua New Guinea
Paraguay
Peru
Philippines
Romania
Rwanda
Sao Tome and Principe
Sierra Leone
Somalia
South Africa
Sweden
Switzerland
Tajikistan, Rep. of
Tanzania
Trinidad and Tobago
Uganda
United Kingdom
United States
Yemen, Rep. of
Zaire
Zambia
Zimbabwe
The recent Asian crisis and a number of currency falls that took place in Argentina,
Chile etc. raised the question about the correlation between exchange rate system,
the purchasing power of the currency and the state of national economy. There
exists an opinion that the undervaluation of euro and the related overvaluation
of US dollar, which led to the consolidation of European Union and increased
the level of its export, has also negatively affected the developing market
economies in Asia and Latin America, and actually was the reason of the financial
crisis in these regions. However, after the Bank of European Union decreased
the level of euro undervaluation, the market situation has improved [10, p.
83].
Though the process of European integration shows the stable and confident economical
growth in his region, a lot of researchers believe that in the long run this
economical union will be forced to change into some form of political union,
where the countries will represent themselves and introduce separate policies.
The possible dangers of the common currency mechanism depend on the state of
economy of each member of the union; if one country experiences problems, it
leads to the instability in the whole union. The possibility of this dangerous
situation can be well illustrated by the example of the UK, which had to leave
the ERM system in order to be able to introduce domestic policy and adjust interest
rates (which helped to get the UK economy out of the long recession).
The countries that use currency boards, also are exposed to the dangers of instability
more than countries with flexible exchange rates: an example of this is the
financial crisis in Argentina. Though currency boards have proved their right
for existence (for example Hong Kong has been practicing currency boards for
almost two decades), the use of currency boards imposes rather high restrictions
on the country, the country practicing it needs to have rather strong and sound
economy. Argentina, Bulgaria, Lithuania, Estonia – all these countries
managed to stop the cycle of high inflation level by using currency boards;
but this method can work only as an urgent measure, but is rather inefficient
and even dangerous in the long run.
In general, every country and every region in the world have different historical
background and therefore have to choose own economical policies. But at the
same time, if the world community is becoming more and more integrated, it is
natural that the mechanisms of regulating national economy have to be coordinated
with the general trend of economical development.
As the managing director of the International Monetary Fund Horst Kohler indicated
during the Asia-Europe Meeting of Finance Ministers in 2001: “The process
of integration in Europe has not yet ended, and its final outcome is still to
be determined… I am not here to suggest that the European experience is
a model that Asia can and should copy. Regional developments in Asia should
be driven by is own political dynamics and unique historical background. But
trading patterns and geography do make it reasonable to think of the creation
of an internal market in Asia as possible, future stage in regional cooperation.
And why should this not be a basis for greater monetary integration, if that
is what people of Asia desire?”
Conclusion
In the current world, where globalization, informatization and technical progress
play the leading role, old economic factors and variables are being replaced
by new ones. The process of globalization, together with the development of
communication means and increase of international trade, in the conditions of
international labor specialization etc. defines the importance of economical
flexibility. Therefore the advantages of the existing fixed exchange rate systems
and the measures of pegging the currency to a stronger one are gradually losing
their advantage. The choice for stability at the extent of flexibility and independence
of monetary and fiscal policy is, in my opinion, no more justified in the new
conditions. The importance of shift from the fixed exchange rate system to flexible
exchange rates can hardly be overestimated. However, in case of poor economical
policy and non-balanced government management of the economy can reduce all
the advantages of flexibility. Moreover, as the economical ties between countries
strengthen, the responsibility on the government concerning monetary and fiscal
policy increases, because now the economical crisis in one country easily develops
into world economical depression.
In general, most international economists today state that the benefits of integrating
into world financial system and liberalization of financial markets exceed the
risks of instability, and the future is promising greater perspectives for the
countries whose financial system is based on the floating exchange rate system.
The level of financial liberty can be different for different regions of the
world, and the policies that can lead them to economical growth can also be
different, but the general belief is that the flexible exchange rate system
offers better opportunities for successful economical development than fixed
exchange rate system.
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