Chapter 3:
Exchange Rate Systems, Past to Present
I. Chapter Overview
Chapter 3 begins with a general discussion monetary orders and exchange rate systems. To relate exchange rate systems and monetary orders, and to understand the evolution of the exchange rate system, the chapter presents the historical experience under three different systems: (1) the gold standard system which lasted from the mid 1870's to World War I, as well as the subsequent brief return to the system after the war, (2) the Bretton Woods pegged exchange rate system, which lasted from World War II through the early 1970's, and, (3) the current post-Bretton Woods floating exchange-rate system. Each is treated in separate sections of the chapter.
The second and third sections of the chapter review the historical conditions that led to the development of Gold standard and the Bretton Woods system, as well as the events that culminated in the eventual collapse of each. The treatment of the post-Bretton Woods system also includes discussions of several of the prominent accords and agreements that were reached among the industrialized countries during this period, including the Smithsonian Agreement of 1971, the Jamaica Accords of 1976, the Plaza Agreement of 1985 and the Louvre Accord of 1986.
The fourth section of the chapter provides important details about the practical
functioning of various types of exchange rate arrangements currently in place as part of the post-Bretton Woods system, including crawling pegs, currency basket pegs, currency boards, and dollarization. The chapter concludes with a brief discussion of the pros and cons of fixed versus flexible exchange rate systems and highlights the importance of sound macroeconomics policy making under either type of system.
Throughout the chapter, frequent references are made to present-day issues as they relate to the different types of exchange rate arrangements that have been practiced over time. The chapter begins with a discussion of the introduction of the euro and the replace ment of the legacy currencies. The section on the gold standard era includes a discussion of recent arguments that have been made for a return to a commodity based gold standard system, most notably by conservative politicians such as Jack Kemp and Steve Forbes during the 1996 U.S. presidential election. The section on crawling-peg exchange rates describes the Nicaraguan experience in which the government, having noted the inflation differential between Nicaragua and the U.S., adopted a crawling peg, and slowed the rate of the crawl as inflation was brought under control. These topical cases can serve as valuable pedagogic devices that will help to facilitate discussion on exchange rate systems that have been in place both in the present and in the past.
II. Outline
A. Exchange Rate Systems
B. The Gold Standard
1. The gold Standard as an Exchange-Rate System 2. Performance of the Gold Standard
a. Positive and Negative Aspects of a Gold Standard b. The Economic Environment of the Gold Standard Era 3. The Collapse of the Gold Standard
C. The Bretton Woods System
1. The Bretton Woods Agreement
2. Performance of the Bretton Woods System a. The Gold Pool
b. President Nixon Closes the Gold Window
3. The Smithsonian Agreement and the Snake in the Tunnel
D. The Flexible-Exchange-Rate System
1. The Economic Summits and a New Order 2. Performance of the Floating-Rate System 3. The Plaza Agreement and the Louvre Accord 4. The Euro
E. Other Forms of Exchange-Rate Arrangements Today 1. Crawling Pegs
a. Nicaragua’s Crawling-Peg Arrangement b. The Parity Band 2. Currency Baskets
a. Selecting a Currency Basket b. Managing the Currency Basket 3. Independent Currency Authorities 4. Dollarization
F. Fixed or Floating Exchange Rates?
G. Chapter Summary
III. Fundamental Issues
1. What is an exchange-rate system?
2. How does a gold standard constitute an exchange-rate system?
3. What was the Bretton Woods system of \
4. What post-Bretton Woods system of \
5. What are crawling-peg and basket-peg exchange-rate arrangements?
6. What is a currency board, and what is dollarization?
7. Which is best: a fixed- or flexible-exchange-rate arrangement?
IV. Chapter Features
1. Management Notebook: Should the Iraqi Dinar Be Pegged to a Basekt of Oil?
This management notebook considers the management of the Iraqi dinar in post-war Iraq. It discusses a proposal by Professor Frankel of Harvard University. He argues that there are a number of problems?both economic and political?of pegging the dinar to the U.S. dollar. He suggests that the dinar be pegged to the value of crude oil. Pegged to the value of oil, the value of the dinar would decline whenever the value of oil declines on the global oil market. In this way, though each barrel of oil would fetch fewer dollars, each dollar would translate into a great number of dinars. Frankel admits that peggin to oil might be too dramatic and suggests a currency basket peg?with oil included in the basket-as a more practical alternative.
For Critical Analysis: If the dinar was pegged to the value of oil, then it would depreciate by 10 percent relative to the value of the dollar. If the dinar was pegged to basket that included oil, the euro, and the dollar, it would still depreciate relative to the dollar. The amount of depreciation, however, would be determined by 1 minus the weight attached to the dollar.
2. Policy Notebook: Should China Peg or Float?
This notebook characterizes the debate among U.S. and Chinese policymakers as to whether the renminbi should be pegged or allowed to float. Chinese official rejected an outright float of their currency, but did allow for wider bands around the official parity rate.
For Critical Analysis: There are a number of other options to free floating the renminbi.. A managed float is one. Chinese officials could also peg to a basket of currencies, way the dollar and the euro. This would provide a nominal peg for monetary policy, but would allow some limited flexibility of the renminbi relative to the dollar.
V. Answers to End of Chapter Questions 1. Ranking the various exchange rate arrangements by flexibility is not so clear cut.
Nonetheless the arrangements described in this chapter are (from fixed to flexible): dollarization, currency board, commodity (standard) peg, dollar (standard) peg, currency basket peg, crawling peg, managed float, flexible.
2. 3. 4. 5.
The two primary functions of the International Monetary Fund are: surveillance of member nations' macroeconomic policies, and to provide liquidity to member nations experiencing payments imbalances.
The value of the Canadian dollar relative to gold is CAN$69 (1.38 ? $50) and the value of the British pound relative to gold is ￡33.33 ($50/1.50). The exchange rate between the Canadian dollar and the British pound is C$/￡2.07 (1.38 ? 1.50).
The currency value of the peso can be expressed as $0.50 +