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ExchangeRatesPt2v1.pptxExchange Rates: Part II
Other Systems
For Converting Money Into Other Money
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Other Systems
While all the major economics, except China’s, use floating exchange rates, there are some other types of arrangements for setting exchange rates that we should note. These often come with variations, but we’ll only focus on the main alternatives.
We’ll cover:
Managed Floats
Fixed Exchange Rates
Currency Pegs
Currency Boards
Dollarization
To properly understand this material, you will need to have reviewed the Floating Exchange Rates presentation.
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Managed Floats
Managed Floats come in two general types:
A widely used one is also called a “Dirty Float” and is questionably legal within the international currency framework.
Here a currency technically freely floats, but the currency issuing government’s central bank routinely buys and sells it’s own currency in order to influence it’s exchange rate. The objective is to keep the exchange rate within a range the central bank believes helps the economy.
However, this approach only works with currencies that are not heavily traded. In other words, currencies for which that is not a lot of demand.
Thus, this type of managed float has little impact on international trade.
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Managed Floats Continued
The more important form of Managed Float is when the currency issuing government sets a daily range or percentage in which the currency value relative to the US Dollar (or sometimes to a weighted market basket of multiple currencies) can change.
This prevents the currency from appreciating or depreciating very much on any given day.
As long as the daily appreciation or depreciation stays within an acceptable range as determined by the central bank, the central bank doesn’t need to buy or sell it’s own currency.
The Chinese Yuan uses this approach. And over time it has been widening the range in which the Yuan’s exchange rate can change.
The ultimate goal for China is to let the Yuan freely float and turn it into a global reserve currency. And it is making progress towards that goal.
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Fixed Exchange Rates
A Fixed Exchange rate is one where the currency issuing government sets the rate at which its’ currency will exchange for every other currency in the world and it does this on an individual currency basis.
Fixed Exchange rates require the currency issuing central bank to actively trade it’s own currency in order to maintain the fixed exchange rate. Many countries had difficulties doing this.
A serious problem with this system was over valued currencies. Countries with continual trade surpluses (Exports>Imports) could not be forced to reduce the value of their currency. This lead to long term trade imbalances.
No major country still uses this system.
Gold Standard and Bretton Woods System
The Gold Standard was a fixed exchange rate system. That was based on physical gold stocks.
The Gold Standard was originated by the United Kingdom in 1821 and was slowly adopted by other countries until it became the standard global system. It began to collapse during WWI and was generally abandoned during the Great Depression.
The Bretton Woods system (1944-1973) was a fixed rate system based on the US Dollar converting to gold at US$35 per Troy Ounce of gold. It ended in 1973 when the US ended the convertibility of the US Dollar into gold.
The Bretton Woods system was replaced by the Floating Exchange Rate system which was discussed in detail in the Floating Exchange Rate presentation.
Currency Pegs and Boards
Currency Pegs and Currency Boards: Both of these approaches are methods of tying the exchange rate of one currency to a fixed percentage of another country’s currency.
They are sometime called Linked Exchange Rates.
The benefit they bring to the currency that is linked to a stronger currency is the stability of the stronger currency.
The Hong Kong Dollar is pegged at 75% of the US Dollar. This has worked well for Hong Kong by providing stability to its’ exchange rate.
For a few years Argentina used a currency board that set their currency at 1 to 1 with the US Dollar. This didn’t work well for very long because it produced an overvalued Argentine Peso. The currency board was abandoned and their Peso now floats.
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Dollarization
Dollarization is the term used when a country adopts, either in whole or in part, another currency as a legal domestic currency.
Full dollarization occurs when a country eliminates it’s own currency and replaces it with a stronger more stable currency. (The country will still produce it’s own coins.)
Partial Dollarization occurs when a country keeps it’s own currency, but makes another, stronger currency a legal domestic currency. Thus, producing a bi-currency system.
This process is called Dollarization because it began with and is most commonly done with the US Dollar. But it is also done with the Euro.
Dollarization Continued
When a country dollarized, it eliminated exchange rate risks.
Since the US Dollar is the most commonly used currency for international trade, a dollarized country no longer has an exchange rate. It has adopted the US Dollar exchange rate.
Panama and East Timor both adopted the US Dollar at independence and never had their own currency.
Ecuador and El Salvador had fully dollarized.
Monaco used the French Franc and now uses the Euro, but it is not a member of the European Union.
These countries normally produce their own coins as coins are heavy and expensive to ship. While currency (paper money) is easier to transport. They obtain their US Dollars or Euros through trade or by direct purchase from the appropriate central bank.
Conclusion
This presentation gives you a basic overview of the most common non-floating exchange rate systems.
Since the world is very varied, there are several variations of the systems reviewed here and there are a few less commonly used approaches that we have not considered.
But the point of floating and non-floating systems is the same:
How to convert one country’s money into another country’s money so that goods and services can be bought and sold globally.
And now you have a better understanding of the ways of making that happen.
(Note: The currency on the title slide is the Chinese Yuan.)
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