Exchange Rate Systems

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Exchange Rate Systems

Broadly, exchange rate systems fall into two categories, fixed systems and floating systems. As the name suggests, in a fixed system, the currencies involved are not allowed to appreciate or depreciate against each other. If a currency is floating, then it 'floats' around taking any level it wants; its value is determined in the foreign exchange markets.

Few exchange rate systems are totally fixed. The eleven countries that are currently involved in the single currency are, in a sense, part of a totally fixed exchange rate system. Their currencies were totally fixed as of 1st January 1999. But one could argue that they are not part of a fixed exchange rate system any more; they have become one and share a single currency.

Fixed exchange rate systems of the past have tended to be 'fixed but adjustable'. This meant that the participants fixed their currency at some central rate, but were allowed to move it up and down within quite tight bands, say, +1%. These systems tended to allow for 'realignments' as well. If one of the countries kept recording current account deficits, meaning that their exchange rate within the fixed system was obviously wrong (too high), the currency would be allowed to devalue to a new fixed parity. Obviously these 'realignments' were not regular occurrences. If currencies were realigning every five minutes it wouldn't really be a fixed exchange rate system anymore.

The next few sections will look at some past examples of these systems. After that, we shall look at the advantages and disadvantages of fixed and floating exchange rate systems.

This was the system set up after the Second World War to promote stability and help the countries in the world that had persistent trade imbalances. The International Monetary Fund (IMF) was set up to oversee the system. Every country chose its own initial exchange rate. This was done by choosing the number of units of their currency that they were prepared to exchange for an ounce of gold, valued at $35. This is why the dollar was the currency in which all other currencies were expressed.

In any one year, a country's currency could move by +1% against the chosen rate. Countries with severe and persistent current account deficits were allowed to devalue their currency and countries with persistent surpluses could revalue their currency, as long as the IMF agreed that the balance of payments were in 'fundamental disequilibria'. Hence, exchange rates were fixed, but not totally fixed. The system became known as the 'adjustable peg' system.

The IMF also had a lot of funds at its disposal (provided by the rich members of the system) to help poorer countries who had low reserves and whose poor international credit rating meant that it was difficult to borrow reserves from foreign countries. The money provided was only a loan, and only granted under certain conditions, but it did stop failing countries from going under.

The system worked well, but some argued that it was a little inflexible. In over twenty years, there were only six 'adjustments' in terms of revaluations and devaluations. Most famously, the UK devalued twice, in 1949 and 1967. The second devaluation is remembered by most for the 'pound in your pocket' speech by the Prime Minister, Harold Wilson. He was trying to explain to the general public that a devalued currency did not mean that 'the pound in your pocket' had been devalued (i.e. a pound was still a pound as far as UK shopkeepers were concerned). Of course, he did not explain that the inflation that tends to be a by-product of a devaluation will, in real terms, reduce the amount that any given pound can buy in the shops.

To be fair, it was a difficult balance for the IMF. Too many 'adjustments' and the system would lose its stability, credibility and discipline. But if there were too few (as many critics argued) then too many countries go through years of disequilibria and hardship. If a deficit country could not devalue, then the only way to cut imports was to deflate the economy. Import controls could be used, but the likely retaliation meant that this policy was self-defeating.

Things started to go badly wrong in the early 70s. The system was based on dollars, which, according to IMF rules, could be converted into gold at the price of $35 an ounce at any time. The USA, on whose gold the whole system was based, started to run up huge current account deficits, partly due to the Vietnam War. Countries panicked, saw that the USA's gold reserves were running down and tried to convert as many of their dollar reserves into gold as possible. This could not go on. The USA announced that the dollar would no longer be convertible into gold.

To cut a long story short, the system broke down after this. The UK pulled out of the system in 1972 and a few years later, just about all countries were part of a floating exchange rate system.

The UK has had a floating exchange rate for every year since 1972 except for the two years of the ERM (see below). Basically, the laws of supply and demand dictate the value of the pound on any given day.

As explained in the last Learn-It, a floating currency should automatically eliminate any current account deficits or surpluses. Of course, nowadays-capital flows far outweigh any currency flows required for trade so, perversely, the value of the pound can be rising even if the current account deficit is rising (the situation in the summer of 2000).

Textbooks often refer to 'dirty floating' exchange rate systems. This is where the exchange rate is technically free to float, but governments may intervene from time to time, so the currency does not float in a pure 'clean' market. The floating is 'dirty' to a certain extent.

Currencies rarely float totally free of intervention. The UK government will get nervous if the pound is too high. Exporters will get very uncompetitive on price, which could cause firms to close down resulting in job losses. In this case, the government might intervene by using pounds to buy foreign currencies and build up their foreign reserves. This will artificially increase the demand for foreign currencies relative to the pound, and so the value of the pound should fall.

The government will also be apprehensive if the pound is too low. This is great for exporters, but pushes import prices up to a relatively high level, causing inflationary pressures. This time, the government will use some of their foreign reserves to buy pounds in the foreign exchange markets. This will artificially increase the demand for pounds relative to other currencies, and so the value of the pound should rise.