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Instructor's Manual 2
CHAPTER 14
EXCHANGE-RATE SYSTEMS AND CURRENCY CRISES
CHAPTER OVERVIEW
This chapter conducts a survey of exchange-rate systems and identifies the economic factors that influence
the choice of alternative exchange-rate systems.
The chapter begins by identifying the factors that underlie a nation’s decision to allow its currency to be
Under floating exchange rates, market forces of supply and demand determine currency values. Among the
major arguments for floating rates are (a) simplicity, (b) continuous adjustment, (c) independent domestic
policies, and (d) reduced need for international reserves. Arguments against floating exchange rates
emphasize (a) disorderly exchange markets, (b) reckless financial policies on the part of governments, and
(c) conduciveness to price inflation.
With the breakdown of the Bretton Woods system in the early 1970s, the major industrial nations adopted a
systems are especially vulnerable to speculative attacks. Methods used by governments to prevent these
attacks such as capital controls, currency boards and dollarization are discussed.
After completing the chapter, students should be able to:
• Identify the criteria which underlie a nation’s preference for fixed exchange rates or floating exchange
rates.
• Explain the importance of the special drawing right for the international monetary system.
1. The choice of floating exchange rates versus fixed exchange rates relates to the economic and
political characteristics of nations. For example, small nations, whose financial and trade relationships
Instructor's Manual 3
2. Managed floating exchange rates utilize the philosophy of "leaning against the wind," in which
exchange market intervention is conducted so as to reduce short-term fluctuations in exchange rates
3. Currency boards and dollarization are seen as methods of stabilizing exchange rates of developing
countries. With a currency board, a monetary authority issues notes and coins convertible into a
4. The Bretton Woods adjustable-pegged exchange rate system attempted to provide essentially fixed
exchange rates for international transactions. When the balance of payments moved away from its
5. Nations sometimes use crawling pegged exchange rates so as to make small but frequent exchange
6. Capital controls, including the rationing of foreign exchange among domestic importers, are
sometimes used to help a nation gain control over its balance-of-payments position.
7. Among the causes of currency crises are budget deficits financed by inflation, weak financial systems,
political uncertainty, and changes in interest rates on world markets. Although a fixed exchange rate
8. Small countries with several major trading partners often peg their exchange rates to a basket of
currencies of these trading partners so as to reduce the impact of exchange fluctuations on the
9. The SDR is a currency basket composed of the currencies of the five IMF countries having the largest
shares of world exports. The basket valuation technique allows the SDR's value to be more stable
10. Among the major arguments for floating rates are (a) simplicity, (b) continuous adjustment, (c)
independent domestic policies, and (d) reduced need for international reserves. Arguments against floating
11. Central bankers attempt to stabilize exchange rates via the purchase/sales of currencies and via
12. Devaluations or revaluations can be used to adjust the par value of a currency when it becomes
overvalued or undervalued.
