New_Collapse of Fixed Exchange Rate System_Final

8/4/2019 New_Collapse of Fixed Exchange Rate System_Final

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Collapse of FixedExchange Rate Regime

Kunal Gupta 12

Sunil Nerurkar 34

Manish Pandey 36Snehal Prajapati 38

Rahul Punalekar 39

Vishal Radhesham 40

Nishant Soni 53

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Introduction

What is an Exchange Rate?An exchange rate is the rate at which one currency can be

exchanged for another

In other words, it is the value of another country's currency

compared to that of your own

Example

The exchange rate is the price at which you can buy the

currency of other country. If you are traveling to US and the

exchange rate for U.S. dollars 1:43 INR, this means that for

every U.S. dollar, you can buy 43 Indian Rupees

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Factors Influencing Exchange Rates

Differentials in Inflation Country lower inflation exhibits a rising currency value, asits purchasing power increases relative to other currencies

Differentials in Interest Rates Interest rates, inflation and exchange rates are all linked.

By manipulating interest rates, central bank exert influenceover both inflation and exchange rates, and changinginterest rates impact inflation and currency values

Current-Account Deficits

A deficit in the current account shows the country isspending more on foreign trade than it is earning, and thatit is borrowing capital from foreign sources to make up thedeficit

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What is its Importance?

Stable foreign investment

With a peg, the investor will always know what his

or her investment's value is, and therefore will not

have to worry about daily fluctuations

Inflation

A pegged currency can also help to lower inflation

rates and generate demand, which results fromgreater confidence in the stability of the currency

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Types of Exchange Rate

Floating Exchange Rate

Fixed Exchange Rate

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Floating Exchange Rates

Determined by the private market through supplyand demand

Termed "self-correcting", as any differences insupply and demand will be corrected in the market

A floating exchange rate is constantly changing

If demand for a currency is low, its value willdecrease, thus making imported goods moreexpensive and stimulating demand for local goodsand services

This in turn will generate more jobs, causing anauto-correction in the market

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Fixed Exchange Rates

Sometimes called a Pegged Exchange Rate

Government sets and maintains as the officialexchange rate

Set price will be determined against a major worldcurrency (usually the U.S. dollar, euro, the yen or a

basket of currencies)

In order to maintain the local exchange rate, the

central bank buys and sells its own currency on theforeign exchange market in return for the currency

to which it is pegged

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Maintenance

Government can maintain a fixed exchange rate byeither buying or selling its own currency in the openmarket

This is one reason governments maintain reserves of

foreign currencies If the rate drifts too far below the desired rate, thegovernment buys its own currency in the market usingits reserves

This places greater demand on the market and

pushes up the price of the currency If the exchange rate drifts too far above the desired

rate, the government sells its own currency, thusincreasing its foreign reserves

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History of Exchange Rate System

Between 1867 and 1933, most of the worldseconomies used the gold standard

Gold standard : A system of fixed exchange rates inwhich the value of currencies was fixed against

gold and gold was used as the primary reserve

asset

By fixing its currencys price to gold, it automaticallyfixed its currencys price to other currencies

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The gold specie flow mechanism was the long-runmechanism that maintained the gold standard

Gold flowed out of the country when it experienceda deficit and into the country with a surplus

The gold standard determined a countrys

monetary policy

History (Contd..)

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History (Contd..)

The Depression led the U.S. to partially abandonthe gold standard in 1933.

U.S. citizens could no longer exchange gold fortheir dollars, but instead were given silver.

That ended in the late 1960s

In 1971, the U.S. totally cut off the relationshipbetween dollars and gold

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Bretton Woods System

An agreement that fixed exchange rates thatgoverned international financial relationships from

the period after World War II until 1971

The Bretton Woods system established theInternationalMonetary Fund (IMF) and the World

Bank

The InternationalMonetary Fund (IMF) arrangesshort-term loans between countries

The World Bank makes longer-term loans to

developing countries

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Features of Bretton Woods System

Obligation to adopt a policy that maintained theexchange rate by tying its currency to the U.S.

dollar

A fund was set up to make short-term loans tocountries that ran out of currency reserves

Exchange rate adjustments were overseen by theIMF

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Features (Contd..)

The IMF created a type of international money calledSpecial Drawing Rights (SDR)

SDRs never became established as aninternational currency

Instead, U.S. dollars served as official reservesfor individuals and countries

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Collapse of Bretton Woods

By the early 1970s, the number of U.S. dollars held byforeigners exceeded the amount of U.S. gold

Fixed regimes, led to severe financial crises, since a peg is

difficult to maintain in the long run.

An attempt to maintain a high value of the local currency tothe peg resulted in the currencies eventually becoming

overvalued.

The governments could no longer meet the demands toconvert the local currency into the foreign currency at the

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With speculation and panic, investors scrambled to gettheir money out and convert it into foreign currency

before the local currency was devalued against the

peg; foreign reserve supplies eventually became

depleted

InMexico's case, the government was forced todevalue the peso by 30%

In Thailand, the government eventually had to allow the

currency to float, and by the end of 1997, the Thai bhathad lost 50% of its as the market's demand and supply

readjusted the value of the local currency

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When France and other countries demanded goldfor their dollars, the U.S. ended its policy of

exchanging gold for dollars in 1971

With that change, the Bretton Woods system wasdead

The exchange rates of most Western countries arenow allowed to fluctuate

At various times, governments buy or sell their owncurrencies to affect the exchange rate

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Time Table ofCollapseDec 1958 Fourteen European countries start convertibility of their currencies for

current account transactions

Mar 1961 Basle Agreement among central banks to hold each others currency and

to lend to each other.

Oct 1961 Establishment of the London Gold Pool.

Jan Mar 1962 Start of persistent French gold purchases from the United States

Beginning of the swap facilities to provide reciprocal lines of creditamong central Banks

Beginning of the GAB

Oct 1963 Start of technical studies and discussions that would lead to the

establishment of the SDR

Oct Nov 1967 End of persistent French gold purchases from the United StatesThe United Kingdom devalues the pound sterling from $2.80 to $2.40

Mar Nov 1968 Gold Pool interventions end; the two-tiered market for gold begins

SDR amendments are sent to IMF members for approval

Exchange pressure on the French franc because of internal political crisis

Exchange crisis closes markets in France, Germany, and the United

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Time Table of Collapse

Mar Nov 1968 Gold Pool interventions end; the two-tiered market for goldbegins

SDR amendments are sent to IMF members for approval

Exchange pressure on the French franc because of internal

political crisis

Exchange crisis closes markets in France, Germany, and

the United Kingdom

Jul Oct 1969 SDR amendments are in forceThe French franc is devalued from .18 grams of gold per

franc to .16 grams

The deutsche mark is revalued from $0.25 to $0.273

Jan 1970 First SDR allocation

Jan Aug 1971 Second SDR allocationThe deutsche mark and the Dutch guilder floatThe United States suspends convertibility of the dollar into goldfor official transactions, suspends the use of swaps, andimposes price controls and a 10 percent import surcharge; allcountries with major currencies except France start to float,

impose exchange controls, and undertake major interventions to19


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Exchange Rate RegimesMain Features Country Circumstances Advantages

Independent

Float

Exchange Rate inmarket

Monetary Authoritydoes not intervene

Can be used freely

to steer domesticeconomy

Appropriate for large

industrialized countries

some emerging

market economies that

are relatively closed

to international tradebut fully integrated in

the global capital

markets

More easily deflector absorb adverse

shocks.

Not prone to

currency crisis

Managed Float Monetary Authority

intervention.Direct or Indirect

Intervention

through change of

exchange rates

Appropriate for

emerging economieswith strong financial

sector.

Limited flexibility for

partial shockabsorption

Low vulnerability to

currency crises.

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Main Features Country

Circumstances

Advantages

Fixed Peg Ex Rate is pegged atfixed rate to major

currency or basket of

currency or to SDR.

Monetary authority is

not committed to peg

indefinitely.

The peg is adjustedwhen misalignment

Appropriate for

developing

economies with

limited link to global

financial markets.

Can maintain

stability and

competitiveness if

the peg is credible.

Lower interest rates

Provides a clear

and easily monitor

able

nominal anchor

Currency Union

Dollarization

Another country'scurrency is used as

only legal tender

No scope forindependent

monetary

policy.

Appropriate for

countries that have

already

developed extensive

trade and other

economic ties

(EMU).

Maximum credibility

for the

economic policy.

Facilitate

disinflation

Not prone to

currency crisis.

Exchange Rate Regimes

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Criticism of Fixed Exchange Rate

System

Flexible exchange rates serve to automaticallyadjust the balance of trade

During trade deficit there will be increased demand

for the foreign currency which will increase the priceof the foreign currency in terms of the domestic

currency

Makes the price of foreign goods less attractive to

the domestic market and thus pushes down thetrade deficit

Under fixed exchange rates, this automaticrebalancing does not occur

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Fixed Exchange Rate Regime Vs.

Capital Control

Fixed Exchange Rate Capital Control

speculative attacks tend totarget currencies with fixed

exchange rate regimes

the stability of the economicsystem is maintained mainly

through capital control

A fixed exchange rate regime

should be viewed as a tool in

capital control

Capital Control includes fixed

exchange rate

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Conclusion

Although the peg has worked in creating globaltrade and monetary stability, it was used only at a

time when all the major economies were a part of it

And while a floating regime is not without its flaws,it has proved to be a more efficient means of

determining the long-term value of a currency and

creating equilibrium in the international market

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References

http://en.wikipedia.org/wiki/Bretton_Woods_system

http://www.investopedia.com/articles/03/020603.asp

http://www.investopedia.com/terms/f/fixedexchangerate.asp

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New_Collapse of Fixed Exchange Rate System_Final

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