Open Economy and Exchange Rate

Bretton Woods System (1944 – 1973)

German
British mark French
pound franc
Par
Value

U.S. dollar

Pegged at $35/oz.
Gold
 The post-Bretton Wood international
monetary system
• The Bretton Woods system collapsed in August 1971 when the US accepted it
could no longer maintain the gold convertibility of the dollar

• What followed were fluctuating exchange rates with no general rule on

exchange rate adjustments

• By 1973, most major world economies had allowed their currencies to float
freely against the dollar

• This gave rise to “fiat money” which was not backed by anything other than
government promise of not printing too much money

• After the Bretton Woods system an informal, market-led system evolved,

which was centred on three floating currencies, the US Dollar, the Japanese
yen and the Deutsche Mark (the “G3”)

• The dollar remains the key reserve currency, although the system is based on
some cooperation among the US Federal Reserve, the European Central Bank
(the Bundesbank before 1999) and the Bank of Japan
 Exchange Rate Regimes
• What is an exchange rate regime?
• “the exchange rate regime is the way a country
manages its currency in respect to foreign
currencies and the foreign exchange market.”
• What are the most common types of
exchange rate regimes?
• Fixed Exchange Rate
• Floating Exchange Rate
• Pegged Exchange Rate
 Market theory
• Determined by demand and supply
• Demand for forex
– DD for foreign goods, services, securities
– Monetary authority wanting to build forex
reserves
– Inverse relation btw demand for forex and
exchange rate
• Supply of forex
– DD of domestic goods
– Monetary authority wanting to offload excess
reserves
 Exchange Rate Regimes in the World

Fixed Floats Intermediate

Currency Unions Free Float Adjustable Peg

Currency Boards Managed Float Crawling Peg

Truly Fixed exchange rate Basket Pegs

Target Zones
 Fixed versus Floating Exchange Rate

• To determine whether a regime is fixed or

floating you have to decide where to draw
the line between narrow and wide
fluctuations.
• A rule is to use annual variations in excess of
+/- 2% and +/-1% as the sign of floating
regime.
 Fixed Exchange Rate Regimes
• Definition: in a fixed exchange rate system the government or
central bank intervenes in the currency market so that the
exchange rate stays close to an ‘exchange rate target’.
• The central bank is unable to affect the exchange rate through
monetary policy. However, the central bank can use fiscal
expansion to create an excess demand for the currency causing a
rise in domestic output. The central bank will then purchase
foreign assets to increase the money supply, and prevent the
interest rate from rising causing an appreciation.
• Due to these limitations the government of a country with a
fixed exchange rate will want to control the amount of currency
they let in and out. This will prevent any unwanted
destabilization of the domestic currency.
 Floating Exchange Rate Regimes
• Definition: a country’s “currency is set by the foreign-exchange market
through supply and demand for that particular currency relative to
other currencies.”
• In a floating exchange rate system the value of the currency is affected
by everyday markets for supply and demand. Therefore trade and
capital flows play a big role in determining the currency’s value.
• There are two different types of floating exchange rate systems. Dirty
Float and Clean Float and this depends on whether or not there is
government intervention.
• The exchange rate can be stabilized through both monetary and fiscal
policy:
– Through monetary policy when there is an excess in money supply
the government would purchase domestic assets to weaken the
currency and push the interest rate down.
– Fiscal expansion causes an appreciation of the currency that forces
the government to purchase foreign assets. This will increase the
money supply preventing the currency appreciation.
 Free Float
• The movements between peaks and troughs may take months or
years to occur.
• The exchange rate will show a great deal of short-run volatility,
with lots of up-and-down movement from day to day.
• Examples between the U.S. dollar with all the three foreign
countries:
-the yen
-the pound
-the loonie
• The range of variation is about the same, with the maximum
being about one and a half times the minimum:
-The yen ranges from about $0.0065 to $0.010.
-The pound from $1.3 to $1.95.
-The loonie from $0.6 to about $0.85.
 Pegged Exchange Rate Regimes
• This is most common under developing countries as well as
communist countries. It’s somewhat similar to a fixed
exchange rate however a pegged rate has a wider range of
value versus the fixed exchange rate.
• An example of a country with a pegged exchange rate
would be China. China’s currency was pegged to the U.S.
Dollar until 2005 as you can see in the graph.
Chinese Yuan to One USD
10.0000
9.0000
8.0000
7.0000
6.0000
5.0000
4.0000
3.0000
2.0000
1.0000
0.0000
1981-01-01

2003-01-01
1982-01-01
1983-01-01
1984-01-01
1985-01-01
1986-01-01
1987-01-01
1988-01-01
1989-01-01
1990-01-01
1991-01-01
1992-01-01
1993-01-01
1994-01-01
1995-01-01
1996-01-01
1997-01-01
1998-01-01
1999-01-01
2000-01-01
2001-01-01
2002-01-01

2004-01-01
2005-01-01
2006-01-01
2007-01-01
2008-01-01
2009-01-01
 Main Features
FLOATING REGIME
• Determined by DD n SS
 Monetary authority doesn’t
intervene in forex market
Independent
 Determiend by DD n SS
 Occasional Interventions
Lightly Managed Float
(through monetary policy)
Main Adv Dis Adv
 Short term volatalitiy (esp
 More easily deflect or
mang float)
absorb adverse shocks
 Swings not related to eco
 Not prone to currency
fundamentals
shocks
 Discretion in MPC may
High reserves not required
create inflation

INTERMEDIATE REGIMES
 CB intervenes actively but
doesn’t specify that’s its for
exchange rate mang.
 Intervention may be direct or
Managed Float indirect (interest rates)
MPC relatively free to steer
domestic policy

 Exchange rate maintained  Limited flexibility - permits

within broad band around a
central rate which is adjusted 
periodically.
 Adjusted based on diff btw
targeted and expected inflation
Crawling Float in major trading partners
 Constraint on M.Policy as
policy has to function within
the band
 Lack of transparency, coz
partial
criteria of intervention not
Absorption of shocks
disclosed
Can maintain stability if
 High reserves required
regime is credible
 Main Features
SOFT PEGGING
•Exchange rate adjusted periodically
to set of indicators
Crawling Peg •Crawl can be preannounced fixed
rate or below projected inflation
•Allowed to fluctuate within bands
•Central rate fixed in terms of single
currency or basket of currencies
Pegged within bands
•Exchange rate pegged at fixed rate to
major currency or basket (or SDR)
• Monetary authority not allowed to
Fixed Peg peg indefinitely
•Discretion of central bank limited
HARD PEGGING (FIXED)
• Strict exchange rate regime
supported by monetary system
• Legislative commitment to exchange
domestic currency to foreign currency
Currency Board • Domestic currency issued only
against foreign currency
• Almost no scope for independent
monetary policy
• Another country currency is used as
only legal tender
Currency Union/ • Country belongs to a currency
Dollaraization Union
• Monetary autonomy fully
surrendered
Main Adv Dis Adv
• Prone to currency crisis if the
country is open to international
capital markets
• Encourages foreign debt
• Can maintain stability and
• High international reserves
competitiveness if peg is credible
required
• Low interest rates
• Little shock absorptive
capacity
• Shocks largely absorbed by
changes in real sector
• Provides maximum credibility for
• Central bank looses its role as
the economic policy regime
lender of last resort.
• Can facilitate disinflation
• Probability of liquidity crisis
• Not prone to currency crisis
• Low/No seiniorage under
• Low transaction costs,
currency board
• Low and stable interest rates
• Exit from dollarization is
• Lack of monetary discretion
difficult
eliminates inflationary bias
 Dollarization of the world economy
World Allocated Reserves by Currency for Q1 2016
1.90%
1.95% 3.04%
4.08%
4.79%

20.37%
63.59%

Source: IMF
 Dollarization of the world economy
• Dollar is considered as the world’s reserve currency and its
status as the dominant world currency as some consider U.S.
financial markets are a safe haven

• Developing countries now hold a much larger share of their

GDP as foreign exchange reserves than do advanced
economies. According to the IMF, advanced economies held
reserves equivalent to 5.5% of GDP in 2008. For developing
economies, the figure was 21.9%.

• A prolonged period of U.S. dollar weakness against the

currencies of its major trading partners, persistent current
account and budget deficits, and a policy of quantitative easing
by the U.S. Federal Reserve have led investors to question how
much longer the dollar’s status as the world’s de facto reserve
currency will remain unchallenged
 Why Dollar?
• All commodities, including gold and oil, are denominated in USD

• The United States has the largest, most liquid and most transparent
and deep financial markets in the world

• Many countries, including several with significant international

reserves, rely on the U.S. for military protection

• Certain mercantilist economies rely on the U.S. as a destination for

their exports. These countries manage their exchange rates against the
U.S. dollar in order to keep domestic costs low, thereby accumulating
large dollar reserve balances

• Moreover, there are no alternative currencies or investments that

provide a similar degree of safety and liquidity in the quantities
demanded by investors as US Treasuries.
Floating Exchange Rate: Impact on Trade Balance
$1 = 10 Yuan

• Export 10,000 • Export 1,000 pieces

pieces of chips to of cola cans to
US@10Yuan/chip China@$1/can
• Total value of • Total value of
consignment (in consignment (in
USD) = $10,000 Yuan) = 10,000
• Trade settled in Yuan
Yuan • Trade settled in $
• Demand for • Demand for
Yuan=100,000 $=1,000

• Demand for
• Demand for
Trade Imbalance Dollars=1,000
Yuan=100,000
• Supply of Yuan=
• Supply of Dollars =
10,000
10,000

$1 = 8 Yuan

Due to more demand for Yuan compared to supply, Yuan will appreciate against the dollar
 Fixed Exchange Rate: Absorption of Foreign
Exchange
$1 = 10 Yuan

• Export 10,000 • Export 1,000 pieces

pieces of chips to of cola cans to
US@10Yuan/chip China@$1/can
• Total value of • Total value of
consignment (in consignment (in
USD) = $10,000 Yuan) = 10,000
• Trade settled in Yuan
Yuan • Trade settled in $
• Demand for • Demand for
Yuan=100,000 $=1,000

• Demand for
• Demand for
Dollars=1,000
Yuan=100,000
• Supply of Yuan=
• Supply of Dollars =
10,000
10,000

• PBOC will print 90,000 Yuan by buying 9,000 USD

To maintain the exchange rate, the Chinese Central Bank, PBOC, will print more currency and buy
dollars. The dollars will become a part of the Reserves.
 Factors affecting foreign exchange rates
• Interest rates
• Degree of speculation in the foreign exchange market
(Volatility)
• Inflation rates
• Balance of payments position
• Financial integration: Global economic situation or events
• FDI policy
• Capital flows: liquidity
• Political stability

• What changes equilibrium exchange rate

– Changes in domestic prices (increase/decrease)
– Change in real income
– Change in interest rates (2008 India)
– Speculative demand