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EXCHANGE RATE SYSTEMS.
Term Paper ID:25168
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Essay Subject:
History & evolution of Bretton Woods fixed-rate & floating exchange rate systems since 1944. Purposes, effectiveness, impact on currencies & trade, inflation.... More...
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Paper Abstract:
History & evolution of Bretton Woods fixed-rate & floating exchange rate systems since 1944. Purposes, effectiveness, impact on currencies & trade, inflation.
Paper Introduction:
EVOLUTION OF THE BRETTON WOODS EXCHANGE RATE SYSTEM & THE FLOATING EXCHANGE RATE SYSTEM
This research examines the evolution of the Bretton Woods exchange rate system (a fixed-rate system) and the floating exchange rate system. Advantages and disadvantages of each system type are discussed, along with a brief review of approaches to exchange risk hedging under the floating rate system, and an assessment of the possibility of returning to a fixed-rate system.
The onset of the economic depression in 1930 caused most major countries to abandon the gold standard by 1933. In 1934, however, the United States adopted the gold exchange standard, and set the gold/dollar exchange rate at one ounce/$35.
Under the gold standard prevailing prior to the beginning of
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D. [vii]A. The Bretton Woods Agreement charged the IMF with responsibilities to(1) encourage international monetary cooperation, (2) encourage the removalof foreign exchange restrictions, (3) stabilize currency exchange rates,and (4) facilitate multilateral payments between member nations.Initially, member nations were required to adhere to an agreed exchangerate regime, in which fluctuations in foreign exchange values were to beconfined within a range of +/- 1. percent of the par value of thecurrencies. "Foreign Trade and Exchange-Rate Risk in the G-7 Countries," Review of Financial Economics 6 (Winter 1997), 95-112.Bensaid, B., and Olivier, J. Rapidly fluctuating international exchange values of the G-7currencies in the mid-198 s were having significant and detrimental impactson both international trade and domestic economies of the major westernindustrial countries.[xi] Recognition of this fact led to major westernfinancial countries to introduce in 1986 what amounts to a managedfloat.[xii] The member countries of the European Economic Community (EEC)had operated such a managed float for several years, as a means ofcontrolling the internal currency exchange rates within the EEC.Essentially, a managed float means that exchange rate ranges are mutuallyagreed upon by participating countries. G., and Shaw, E. Brady, "How to Tailor Your Assets," Euromoney (April 199 ), 83. Under such a fixed-rate currencyexchange rate system, the following actions were typical:[viii] 1. Horsefield, The International Monetary Fund, 1945-1965:Twenty Years of International Monetary Cooperation (Washington:International Monetary Fund, 1969), 5. Spevack, "Floating Yuan Scuttles Import/Exportprices in China," Daily News Record 23 (22 June 1993), 4. In the developingworld economy, this group of firms continues to increase. When prices are raised in onecountry, the demand for that country's exports will, other factorsremaining unchanged, diminish and, along with that diminishing demand, thedemand for that country's currency will also diminish. The onset of the economic depression in 193 caused most majorcountries to abandon the gold standard by 1933. [xiii]M. [ix]J. C. It is important to note, however, thatcountries do not, in all situations, permit their currencies to find theirown level of exchange. "Floating Yuan Scuttles Import/Export prices in China." Daily News Record 23 (22 June 1993), 4.----------------------- [i]A. Money in A Theory of Finance 7th ed. The international transmission of inflation has been neutralized, and thesystem has permitted the country to continue to attract the level offoreign capital required to fund its governmental budget deficits, without,at the same time, re-igniting double-digit inflation. The par values of currencies were stated in terms of theUnited States dollar, which, in turn, was linked to a specified gold value. I. Othereconomic powers have taken comparable actions from time to time. Second, the United States had established the valueof the dollar as $35 per ounce of gold, and the United States guaranteedexchange at this rate. T. Theextent to which inflation would be transmitted by this mechanism woulddepend upon the magnitude of the trade in the goods for which prices wereraised. "How to Tailor Your Assets." Euromoney (April 199 ), 83-86.Driscoll, D. The argument for retaining the floating exchange rate system appearsto be strong. [xi]G. Washington: International Monetary Fund, 1984.Gurley, J. "7 Nations' Leaders Hail Achievement on Economic Steps." New York Times (7 May 1986), 1, 1 .Brady, S. The combination of these two actions provided astrong fixed-exchange rate system. In the 198 s, the reduction in demand for imports to the United Statesdid not function exactly as theory predicted, because some foreignmanufacturers, mostly Japanese, maintained prices in the American market inthe face of the declining international exchange value of the dollar, as ameans of retaining market share. Thus, the mutually shared interests of the Western Allied Nations providedthe basis for the creation of an international regime in the form of theIMF.[vi] The industrial countries have employed two general types ofinternational monetary rate change systems since the end of the SecondWorld War-fixed-rate systems and flexible-rate systems. [iii]Ibid., 161. After experimenting with devaluation of the dollar throughadjustments of the guaranteed exchange price between the dollar and gold,however, the United States joined with the other industrial countries toinstitute a general flexible-rate exchange rate system in the 197 s.[ix] Under a floating exchange rate system, each currency is permitted tofind its own level of exchange, which will change from time-to-time, aseconomic conditions change. Bloomfield, The Gold Standard (New York: McGraw-Hill BookCompany, 1982), 154. Rutberg and R. As a fixed-exchange rate existed, these price increases would be transmitted to theimporting countries from the exporting country which raised prices. Both individually and as a group, the major westernfinancial countries have intervened in the international currency exchangemarkets on numerous occasions since the introduction of the floatingexchange rate system, as a means of influencing the rate for one or morecurrencies.[x] As a consequence of the declining value of the dollar in internationalcurrency exchange markets, and a continuing and increasing drain on thecountry's monetary gold supply, President Nixon devalued the dollar,increasing the conversion value of gold. The institution became a reality in December 1945, whenthe thirtieth nation signed the Agreement. Othercountries which are parties to the agreement agree to assist with actionsof their own.[xiii] Obviously, the introduction of the flexible-rate currency exchangesystem has had significant impacts on the development of monetary andfiscal policy in the major western industrial countries. Boyd, "7 Nations' Leaders Hail Achievement on EconomicSteps," New York Times (7 May 1986), 1 . M. [ii]Ibid., 16 . As the demand forthe currency diminishes, the international exchange value of the currencywill also diminish. Obstfeld, "Destabilizing Effects of Exchange-Rate EscapeClauses," Journal of International Economics 42 (August 1997), 65. [x]P. Washington: The Brookings Institution, 1994.Horsefield, J. Shaw, Money in A Theory of Finance 7TH ed.(Washington: The Brookings Institution, 1994), 154. An increase in the price of internationally traded goodswould, in turn, result in an increase in import prices. [xv]S. Kilborn, "The Economic Summit," New York Times (7 May 1986),1. Evolution of the Bretton Woods Exchange Rate System & the Floating Exchange Rate System This research examines the evolution of the Bretton Woods exchangerate system (a fixed-rate system) and the floating exchange rate system.Advantages and disadvantages of each system type are discussed, along witha brief review of approaches to exchange risk hedging under the floatingrate system, and an assessment of the possibility of returning to a fixed-rate system. [v]D. Driscoll, (Ed.), The International Monetary Fund: ItsEvolution, Organization, and Activities (Washington: International MonetaryFund, 1984), 1. Since that time, the foreign exchange value of the dollar has beenallowed to float, with specific instances of intervention in the markets toinfluence both the level and direction of movement of the exchange rate.To be sure, the maintenance of high real interest rates in the UnitedStates, together with other actions taken by both the Federal Reserve andthe Treasury, were efforts made by this country to maintain a high foreignexchange rate for the dollar during the early-198 s, just as alternativepolicies have been employed since, in an effort to reduce the rate. [iv]J. "The Economic Summit." New York Times (7 May 1986), 1, 11.Obstfeld, M. Bensaid and J. The potential for continual shifts in currency exchange rates,however, creates risks for firm operating globally. In the late 196 s, most of the countries in western Europe began toflirt with floating exchange rates. "The Instability of Fixed Exchange Rate Systems When Raising the Nominal Interest Rate Is Costly." European Economic Review 41 (August 1997), 1461-1478.Bloomfield, A. A change in the balance of payments in one of the linkedeconomies would result in demand changes in that economy, which would,eventually, be transferred to the other linked economies. A fixed-rateexchange system is one in which different countries have agreed upon therates at which their various currencies will be exchanged in internationaltrading, or one in which one country has a fixed-exchange rate for its owncurrency which it is prepared to defend. New York: McGraw-Hill Book Company, 1982.Boyd, G. It is quite possible that the price increases would cause areduction in the amount of goods traded, thus, moderating the impact of anyinternational transmission of inflation. K. M. D. The system, even with market interventions by the FederalReserve, has significantly reduced the threat to the country's gold supply. The International Monetary Fund, 1945-1965: Twenty Years of International Monetary Cooperation. Olivier, "The Instability of Fixed Exchange RateSystems When Raising the Nominal Interest Rate Is Costly," EuropeanEconomic Review 41 (August 1997), 147 . While, in theworst of worlds, this linkage could transfer significant levels ofinflation between economies, in the best of worlds, it could also maintainstability in the linked economies. If such impactshad not occurred, there would have been no need for the managed floatagreed upon at the Tokyo summit, nor would there have been a need for theearlier internal managed float implemented by the EEC. The Gold Standard. When neither this action nor thefollowing two-tiered price for gold were successful, the United States andthe other major western industrial countries, as noted above, abandoned thefixed-rate currency exchange system, and allowed their currencies to float,or seek their own exchange rates, on the international currency exchangemarkets. [vi]B. Nevertheless, even this action precludedthe international transmission of inflation. Arize, "Foreign Trade and Exchange-Rate Risk in the G-7Countries," Review of Financial Economics 6 (Winter 1997), 96. I. At first, the United States resistedthis trend. There does exist,therefore, an argument for a contention that the floating exchange ratesystem has already been ended, and that a de facto fixed exchange ratesystem with a float range is already in place. (Ed.). Therefore,effective hedging strategies are required to minimize exchange rate risk.Currency swaps and the use of financial derivatives are importantapproaches to hedging currency exchange rate risk.[xiv] Another approachis to denominate all contracts in United States dollars, the recognizedreserve currency.[xv] ENDNOTES BIBLIOGRAPHYArize, A. Each of these situations existedamong the western industrial countries prior to the introduction of theflexible-rate exchange system.[vii] First, the industrial countries of the western world had agreed upon aset of fixed rates at which their various currencies would be exchanged ininternational trading. [xiv]S. K. The International Monetary Fund: Its Evolution, Organization, and Activities. [viii]Bensaid and Olivier, 1472. S. When the international exchange value of the currencyhas diminished sufficiently, the demand for the country's exports will thenincrease; however, the decreased value of the currency will prevent atransfer of the higher prices to the importing countries. 2. T. Actual financial operationswere commenced by the IMF in early-1947. Washington: International Monetary Fund, 1969.Kilborn, P. In 1934, however, theUnited States adopted the gold exchange standard, and set the gold/dollarexchange rate at one ounce/$35.[i] Under the gold standard prevailing prior to the beginning of the FirstWorld War, "exchange rates among gold standard countries remained fixed,without support of payments or import controls, with virtually no countriesbeing forced off the gold standard once adopted, with a minimum ofinternational cooperation, and with a relatively small stock ofinternational reserves."[ii] Offsetting this positive outcome is a beliefamong some economists that the "remarkable fixity of exchange rates may insome cases have been achieved at the cost of internal economicactivity."[iii] The impetus for the creation of the International Monetary Fund (IMF)was provided by events which staggered the international economy from 1929to the beginning of the Second World War.[iv] Attempting to maintaindomestic economic stability and retain international market positionsduring this time period, most countries engaged in competitivedevaluations, foreign exchange controls, and import restrictions.[v] Thedisastrous consequences of these actions resulted in a near universalrecognition of a need to establish some sort of mechanism through whichinternational economic stability could be both created and maintained.Following international negotiation on such a mechanism during the SecondWorld War, the Bretton Woods Agreement of 1944 created the IMF towards theend of the war. S. Gurley and E. G. Under a floating exchange rate system, the international transmissionof inflation should be more difficult. When the exchange value of thecurrency of a participating country falls outside of the agreed upon range,that country agrees to take appropriate steps, including entering theinternational currency exchange markets, to correct the problem. C. "Destabilizing Effects of Exchange-Rate Escape Clauses." Journal of International Economics 42 (August 1997), 61-77.Rutberg S., and Spevack, R. [xii]Kilborn, 1.
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