Exchange Rate SystemsExchange Rate Systems

Past, Present, and Past, Present, and FutureFuture

The Evolution of MoneyThe Evolution of Money

The evolution of the international The evolution of the international financial structure is really more about financial structure is really more about the evolution of domestic monetary the evolution of domestic monetary systemssystems

““Money” is any commodity which Money” is any commodity which satisfies the following:satisfies the following: Medium of ExchangeMedium of Exchange Store of ValueStore of Value Unit of AccountUnit of Account

Prior to 561BC, Commodity were used as the medium of exchange

561BC – 1600AD, Coins created standardized weights of precious metal

1600AD – 1972AD: Paper was used as a proxy for gold

1972 AD: Ties between gold and paper currency are completely severed

The evolution of money

L (i, Y )+ + P MS

1

--

Md= M

S

PY = G(1+i)

Y= G (1+i)PM

With a commodity money system, the money supply is simply equal to the gold stock

Trade with Trade with commodity moneycommodity money

American ships set sail for England – loaded with gold to buy British goods

(US Imports = Outflow of gold)

British ships sail to the US with gold to buy American goods

(US Exports = Inflow of gold)

PG

M

P

M

If the US runs a trade deficit with Britain, then gold is flowing out of the US and into Britain

US prices fall relative to British prices which reduces the trade deficit

Note: the exchange rate is fixed at 1!!

G

Starting in the 1600’s, paper money began to replace gold/silver coins as the dominant medium of exchange

Assets Liabilities

Individual deposits $100 worth of gold

$100 $100

Bank issues $100 worth of notes

With 100% reserve banking, bank notes simply act as a proxy for the physical metal

Reserve Ratio = 100%

Assets Liabilities

$100 (Gold) $200 (Notes)

$100 (Loan)

However, banks would create more notes than it held in gold!

Reserve Ratio = 50%

The notes are loaned out to create a business loan

The bank prints $100 worth of new notes

L (i, Y )+ + P MS

1

--

Md= M

S

PY = G(1+i)

Y= G (1+i)PM

Now the supply of money us related to the supply of gold, but that relationship can change! (rr = reserve ratio)

rr

rr

Assets Liabilities

$50 (Gold) $150 (Notes)

$100 (Loan)

When gold prices rose, individuals would redeem their gold and melt it down!

Suppose $50 worth of gold is redeemed and melted down

Reserve Ratio = 30%

PM S

M

PM S

M

Still, bank notes didn’t interfere with the stabilizing force of gold flows – trade deficit countries would see a net outflow of gold which would contract the money supply

US prices fall relative to British prices which reduces the trade deficit

Note: the exchange rate is still fixed at 1!!

By 1860, most countries had adopted national currencies had adopted national currencies. The values of these currencies were maintained by tying them to gold

The Gold Standard (1860-The Gold Standard (1860-1945)1945)

The Gold Standard had three basic The Gold Standard had three basic rules:rules: In each country, currency was In each country, currency was

convertible into gold on demand at a convertible into gold on demand at a fixed, pre-specified rate ($20.67 = 1 oz)fixed, pre-specified rate ($20.67 = 1 oz)

Each country allowed for coinage of gold Each country allowed for coinage of gold at a mintat a mint

No restrictions on imports/exports of goldNo restrictions on imports/exports of gold

The Gold Standard The Gold Standard

LiabilitiesLiabilities AssetsAssets

Currency: $6,614,400Currency: $6,614,400 Gold: 10 tons (320,000 Gold: 10 tons (320,000 oz)oz)

x $20.67/ozx $20.67/oz

$6,614,400$6,614,400

In this example, the reserve ratio is 100%. That In this example, the reserve ratio is 100%. That is, the dollar is is, the dollar is 100% backed by gold100% backed by gold

The Gold Standard The Gold Standard

LiabilitiesLiabilities AssetsAssets

Currency: $56,222,400Currency: $56,222,400 Gold: 10 tons (320,000 Gold: 10 tons (320,000 oz)oz)

x $20.67/ozx $20.67/oz

$6,614,400$6,614,400

Other Assets: $49,608,000Other Assets: $49,608,000

During the gold standard, the ratio of gold to currency in the During the gold standard, the ratio of gold to currency in the US was approximately 8.5 (US was approximately 8.5 (Reserve Ratio = 11.7% backed Reserve Ratio = 11.7% backed by goldby gold))

Gold and The Money Gold and The Money SupplySupply

Under a gold standard, the central bank Under a gold standard, the central bank can’t increase (or decrease) the money can’t increase (or decrease) the money supply:supply: Suppose the central bank prints new money Suppose the central bank prints new money

and uses it to buy gold:and uses it to buy gold: This purchase forces up the market price of gold. This purchase forces up the market price of gold.

When the market price rises above the official When the market price rises above the official price ($20.67), individuals buy gold from the fed price ($20.67), individuals buy gold from the fed to sell on the open market – this reverses the to sell on the open market – this reverses the central bank’s initial transaction.central bank’s initial transaction.

Gold and The Money Gold and The Money SupplySupply

Under a gold standard, the central bank Under a gold standard, the central bank can’t increase (or decrease) the money can’t increase (or decrease) the money supply:supply: Suppose the central bank prints new money Suppose the central bank prints new money

and uses it to buy other assets (say, and uses it to buy other assets (say, government securities):government securities):

As money in circulation increases (reserve ratio As money in circulation increases (reserve ratio drops), the price level rises. As dollars lose their drops), the price level rises. As dollars lose their purchasing power, individuals start buying gold purchasing power, individuals start buying gold from the central bank – this, again reverses the from the central bank – this, again reverses the original currency transactionoriginal currency transaction

Devaluations Devaluations

LiabilitiesLiabilities AssetsAssetsCurrency: $56,222,400Currency: $56,222,400 Gold: 10 tons (320,000 oz)Gold: 10 tons (320,000 oz)

x $20.67/ozx $20.67/oz$6,614,400$6,614,400

Other Assets: Other Assets: $49,608,000$49,608,000

Suppose that the US Suppose that the US increases the official increases the official price of gold to $35/ozprice of gold to $35/oz

Current Reserve Ratio = 11.7%

Devaluations Devaluations

LiabilitiesLiabilities AssetsAssetsCurrency: $56,222,400Currency: $56,222,400 Gold: 10 tons (320,000 oz)Gold: 10 tons (320,000 oz)

x $35.00/ozx $35.00/oz$11,200,000$11,200,000

Other Assets: Other Assets: $49,608,000$49,608,000

Current Reserve Ratio = 20%

The Gold Standard as The Gold Standard as an Foreign Exchange an Foreign Exchange SystemSystem

P = $20.67 P* = L 4.87

e = $20.67L 4.87 = 4.25

If e = $5.00 (the pound is overvalued), an arbitrage opportunity exists

•Buy gold in US ($1 = 1/20.67 oz$1 = 1/20.67 oz)

•Sell gold in Britain (1/20.67)*L4.87 = L.2356(1/20.67)*L4.87 = L.2356

•Convert Pounds back to $s ( L.2356 * 5.00 = $1.18)L.2356 * 5.00 = $1.18)

The gold standard system still maintained The gold standard system still maintained the “price/specie” flow mechanism that the “price/specie” flow mechanism that stabilized trade balancesstabilized trade balances

The Gold Standard as The Gold Standard as an Foreign Exchange an Foreign Exchange SystemSystem

P = $20.67

P* = L 4.87e = $20.67

L 4.87 = 4.25

Trade deficits would tend to depreciate the dollar in currency markets – this would lead to gold flowing out of the US through arbitrage

The Bretton Woods The Bretton Woods System (1945 – 1972)System (1945 – 1972)

$35/oz.

1L = $2.80

625 Lira = $1

DM 2 = $1The dollar became the “nominal anchor” - tying (indirectly) every other currency to gold

Assets Liabilities

$100M (Gold) $500M (Currency)$400M (T-Bills)

Assets Liabilities

$30M ($) DM 100M (Currency)DM 10 (Gold)

$35/oz. DM 2 = $1

DM 30M (Bonds)

While gold would be the primary reserve asset in the US, $s were the primary reserve asset in Europe

Assets Liabilities

$100M (Gold) $500M (Currency)$400M (T-Bills)

Assets Liabilities

$30M ($) DM 100M (Currency)DM 10 (Gold)

$35/oz. DM 2 = $1

DM 30M (Bonds)

Suppose that trade imbalances were causing a Deutschemark depreciation. Germany would be obliged to use its dollar reserves to buy back its currency – this costs them reserves!!

- $5M ($) - DM 10

Assets Liabilities

$100M (Gold) $500M (Currency)$400M (T-Bills)

Assets Liabilities

$30M ($) DM 100M (Currency)DM 10 (Gold)

$35/oz. DM 2 = $1

DM 30M (Bonds)

However, if the US ran a trade deficit that was causing the dollar to depreciate (all other currencies are appreciating), again Germany would need to respond – buying dollars

+$5M ($) + DM 10

-3

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

1/1/60

1/1/61

1/1/62

1/1/63

1/1/64

1/1/65

1/1/66

1/1/67

1/1/68

1/1/69

1/1/70

1/1/71

1/1/72

1/1/73

1/1/74

-80000

-70000

-60000

-50000

-40000

-30000

-20000

-10000

0

10000

Trade Balance Government Deficit

The Twin Deficits

With the Vietnam War and Johnson’s With the Vietnam War and Johnson’s Great Society Great Society programs, the US began running sizable trade deficits programs, the US began running sizable trade deficits and government deficits – this creates a perceived and government deficits – this creates a perceived weakness in the dollarweakness in the dollar..

Collapse of Bretton WoodsCollapse of Bretton Woods In 1967-1968: the British pond devalues to $2.40 (-In 1967-1968: the British pond devalues to $2.40 (-

14%). This triggers a massive run on US gold. The US 14%). This triggers a massive run on US gold. The US loses $3.2B (20% of reserves) in three months! Private loses $3.2B (20% of reserves) in three months! Private market prices of gold rise as high as $45! Convertibility market prices of gold rise as high as $45! Convertibility of gold is suspended in open marketsof gold is suspended in open markets

1969-1971: The US enters a recession. This creates 1969-1971: The US enters a recession. This creates even more speculation against the dollar.even more speculation against the dollar.

1970-1971: In an effort to stimulate the economy (and 1970-1971: In an effort to stimulate the economy (and to get re-elected), Nixon pressures the Fed to cut to get re-elected), Nixon pressures the Fed to cut interest ratesinterest rates

August 15, 1971: Nixon officially closes the gold August 15, 1971: Nixon officially closes the gold window. Without implicit gold backing, the system window. Without implicit gold backing, the system totally collapses.totally collapses.

Creation of the EuroCreation of the Euro 1979: European Community Members (Belgium, Denmark, 1979: European Community Members (Belgium, Denmark,

France, Germany, Greece, Ireland, Italy, Luxembourg, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, UK) agree to the European Netherlands, Portugal, Spain, UK) agree to the European Exchange Rate MechanismExchange Rate Mechanism

An artificial currency (European currency unit) is created. An artificial currency (European currency unit) is created. Each country fixes to the ECU. Margins of 2.25% are set for Each country fixes to the ECU. Margins of 2.25% are set for each bilateral rate. each bilateral rate.

1992: high German interest rates and a recession in Britain 1992: high German interest rates and a recession in Britain led George Soros to speculate against the pound. The led George Soros to speculate against the pound. The pound is devalued by 25%. Italy and Britain drop out of the pound is devalued by 25%. Italy and Britain drop out of the ERMERM

1998: Euro introduced. ECU converted to Euros at 1:1 rate.1998: Euro introduced. ECU converted to Euros at 1:1 rate. January 2002: Euros begin circulatingJanuary 2002: Euros begin circulating

The EurozoneThe Eurozone

Current member countries (12): Austria, Current member countries (12): Austria, Belgium, Finland, France, Germany, Greece, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Ireland, Italy, Luxembourg, Netherlands, Portugal, SpainPortugal, Spain

Will join in 2004 (10): Cyprus, Czech Republic, Will join in 2004 (10): Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, SloveniaPoland, Slovakia, Slovenia

Will join in 2007 (4): Bulgaria, Croatia, Romania, Will join in 2007 (4): Bulgaria, Croatia, Romania, TurkeyTurkey

Will most likely Will most likely NOTNOT join (3): Denmark, Sweden, join (3): Denmark, Sweden, UKUK

Requirements of the Requirements of the EurozoneEurozone

A Budget Deficit of no more than 3% of A Budget Deficit of no more than 3% of GDPGDP

National debt of no more than 60% of National debt of no more than 60% of GDPGDP

Inflation within 1.5% of 3 best Inflation within 1.5% of 3 best performing EU countriesperforming EU countries

Long term interest rates within 2% of 3 Long term interest rates within 2% of 3 lowest interest rate EU countrieslowest interest rate EU countries

Can the Euro Last?Can the Euro Last?

The common currency makes it much The common currency makes it much more difficult for countries to abandon more difficult for countries to abandon the system.the system.

Decision making power of ECB spread Decision making power of ECB spread out over a large number of people – out over a large number of people – each with their own national interestseach with their own national interests

Monetary policy must compete with Monetary policy must compete with several fiscal policies.several fiscal policies.