I. Fixed Exchange-Rate Regimes
A. Exchange-Rate Pegs and the Bretton Woods System
1. The Bretton Woods System, which lasted from 1945 to 1971, was a system of fixed
exchange rates that offered more flexibility over the short term than had been possible
under the gold standard.
2. Each country maintained an agreed-upon exchange rate with the U.S. dollar
(currencies were pegged to the dollar). Every country held dollar reserves and stood
ready to exchange its own currency for the dollar at the fixed rate.
3. Since other countries did not want to adopt U.S. monetary policy, the fixed exchange
rates required complex capital controls, but even so, countries had to intervene
regularly to maintain the fixed rates at the peg.
4. The International Monetary Fund (IMF) was created to manage the system by making
loans to countries in need of short-term financing to pay for an excess of imports over
exports.
5. As capital markets opened up the system came under increasing strain, because with a
fixed exchange rate and the free movements of capital, countries could no longer have
independent monetary policies.
6. When U.S. inflation began to rise in the late 1960s many countries balked; they didn’t
want to match the rise in inflation.
7. By 1971 the system had completely fallen apart, and American officials have allowed
the dollar to float freely ever since. Europeans took the different approach of
maintaining various fixed exchange rate mechanisms, up to the introduction of the
euro.
B. Hard Pegs: Currency Boards and Dollarization
1. Under a hard-peg system the central bank implements an institutional mechanism that
ensures its ability to convert a domestic currency into the foreign currency to which it
is pegged.
2. Only two exchange-rate regimes can be considered hard pegs: a currency board
(whereby the central bank commits to holding enough foreign currency assets to back
domestic currency liabilities at a fixed rate) and dollarization (whereby the country
formally adopts the currency of another country for use in all its financial
transactions).
3. Currency Boards and the Argentinean Experience
a. Somewhere between 10 and 20 currency boards operate in the world today, the
best known of which is the Hong Kong Monetary Authority.
b. With a currency board, the central bank’s only job is to maintain the exchange
rate.
c. While that means that policymakers cannot adjust monetary policy in response to
domestic economic shocks, the system does have its advantages.
d. Prime among the advantages is the control of inflation.
e. But currency boards do have their problems, including the fact that the central
bank loses its role as the lender of last resort to the domestic banking system.
4. Dollarization in Ecuador
a. In January of 2000, Ecuador officially gave up its currency, and almost
immediately interest rates dropped, the banking system reestablished itself,
inflation fell dramatically and growth resumed.
b. A year later El Salvador followed suit. Panama has been dollarized since 1904.
c. A country might choose dollarization because with no exchange rate there is no
risk of an exchange-rate crisis, it helps the country become integrated into world
markets, and it can reduce their risk premium (associated with inflation risk).
d. The benefits of dollarization are balanced against the loss of revenue from issuing
currency (called seigniorage), the loss of the central bank’s role as lender of last
resort, the loss of autonomous monetary or exchange rate policy, and the
importing of U.S. monetary policy (like it or not).
e. Dollarization is not the same as monetary union, because dollarized countries
have no “vote” in the monetary policy chosen by the FOMC. A monetary union is
shared governance; dollarization is not.
Appendix: What You Really Need to Know about the Balance of Payments
1. To understand the international financial system you need to know three important
terms connected with the international balance of payments: (1) current account
balance; (2) capital account balance; and (3) the official settlements balance.
2. The current account tracks the flow of payments across national boundaries; the
balance on the account is the difference between a country’s exports and imports of
goods and services (also included are transfers and investment income).
3. The capital account tracks the purchase and sale of assets, and the balance is the
difference between a country’s capital inflows and outflows.
4. The official settlements balance is the change in a country’s official reserve holdings;
it shows the change in the central bank’s foreign exchange reserves (or gold reserves).
5. The three must sum to zero. A country running a current account deficit can pay for it
by running a capital account surplus or it can draw down its foreign exchange
reserves.
6. Countries with current account deficits would lose reserves and those with surpluses
would gain them.
Terms Introduced in Chapter 19
capital controls
currency board
dollarization
foreign exchange intervention
gold standard
hard peg
reserve currency
renminbi
speculative attack
sterilized intervention
unsterilized intervention
yuan
Using FRED: Codes for Data in This Chapter
Data Series FRED Data Code
US$/Euro exchange rate EXUSEU
Japan yen/US$ exchange rate EXJPUS
Mexico/US$ exchange rate EXMXUS
Mexico consumer prices MEXCPIALLMINMEI
US consumer price index CPIAUCSL
US$/UK pound exchange rate EXUSUK
LIBOR US$ 12‐month interest rate USD12MD156N
LIBOR UK pound 12‐month interest rate GBP12MD156N
Thailand baht/US$ exchange rate EXTHUS
Korea won/US$ exchange rate EXKOUS
China yuan/US$ exchange rate EXCHUS
Malaysia ringgit/US$ exchange rate EXMAUS
Canada dollar/US$ exchange rate EXCAUS
Switzerland franc/US$ exchange rate EXSZUS
Gold price (US$) GOLDAMGBD228NLBM
China foreign exchange reserves (excluding gold) TRESEGCNM052N
Lessons of Chapter 19
1. When capital flows freely across a country’s borders, fixing the exchange rate means giving
up domestic monetary policy.
a. Purchasing power parity implies that in the long run, exchange rates are tied to inflation
differentials across countries.
b. Capital market arbitrage means that in the short run, the exchange rate is tied to
differences in interest rates.
c. Monetary policymakers must choose two of the following three options: open capital
markets, control of domestic interest rates, and a fixed exchange rate.
d. Countries that impose controls on capital flowing in and/or out can fix the exchange rate
without giving up their domestic monetary policy.
2. Central banks can intervene in foreign exchange markets.
a. When they do, it affects their balance sheet in the same way as an open market
operation.
b. Foreign exchange intervention affects the exchange rate by changing domestic interest
rates. This is called unsterilized intervention.
c. A sterilized intervention is a purchase or sale of foreign exchange reserves that leaves
the central bank’s liabilities unchanged. It has no impact on the exchange rate in a deep,
well-functioning currency market.
3. The decision to fix the exchange rate has costs, benefits, and risks.
a. Both corporations and investors benefit from predictable exchange rates.
b. Fixed exchange rates can reduce domestic inflation by importing the monetary policy of
a country with low inflation.
c. Fixed exchange-rate regimes are fragile and leave countries open to speculative attacks.
d. The right conditions for choosing to fix the exchange rate include
i. A poor reputation for inflation control.
ii. An economy that is well integrated with the one to whose currency the rate is
fixed.
iii. A high level of foreign exchange reserves.
4. There are a number of examples of exchange-rate systems.
a. The Bretton Woods System, set up after World War II, pegged exchange rates to the
U.S. dollar. It collapsed in 1971 after U.S. inflation began to rise.
b. Most fixed exchange rate regimes are no longer thought to be viable in the absence of
capital controls.
c. Two that may work are currency boards and dollarization.
d. With a currency board, the central bank holds enough foreign currency reserves to
exchange the entire monetary base at the promised exchange rate.
e. Argentina’s currency board collapsed when the regional governments began printing
their own money.
f. Dollarization is the total conversion of an economy from its own currency to the
currency of another country.
g. Several Latin American countries have adopted the dollar recently, with good results
over the short run.