CHAPTER 15
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 determined
by free market forces or to be fixed against some standard of value. It is noted that small, developing nations tend
to peg their currencies to a single currency or a currency basket. Pegging to a single currency is generally used by
small nations whose trade and financial relationships are mainly with a single trading partner. Small nations with
more than one major trading partner often peg their currencies to a basket of currencies such as the special drawing
right.
Under floating exchange rates, market forces of supply and demand determine currency values. Among the major
arguments for floating rates are (1) simplicity, (2) continuous adjustment, (3) independent domestic policies, and
(4) reduced need for international reserves. Arguments against floating exchange rates include (1) disorderly
exchange markets, (2) reckless financial policies on the part of governments, and (3) conduciveness to price
inflation.
With the breakdown of the Bretton Woods system in the early 1970s, the major industrial nations adopted a system
BRIEF ANSWERS TO STUDY QUESTIONS
1. The choice of floating exchange rates versus pegged exchange rates relates to the economic and political
2. Managed floating exchange rates utilize the philosophy of “leaning against the wind,” in which exchange
3. Currency boards and dollarization are seen as methods of stabilizing exchange rates of developing countries.
4. The adjustable-pegged exchange rate system attempted to provide essentially fixed exchange rates for
6. Exchange 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
9. The SDR is a currency basket composed of the currencies of the five IMF countries having the largest shares
10. Proponents of floating exchange rates emphasize the following points: (a) simplicity, (b) continuous
11. Central bankers attempt to stabilize exchange rates via the purchase/sales of currencies and via monetary
policy.
