FIXED EXCHANGE RATES

FIXED EXCHANGE RATES

Until the early 1970s and except during major wars, economically advancedcountries typically maintained fixed nominal exchange rates among their currencies. Figures 18.1 and 18.2 show that, from 1950 to the early 1970s, the nominal exchange rates between six major currencies and the U.S dollar moved infrequently and by small amounts compared to what came later. For the six countries considered, the main exceptions to fixed nominal exchange rates in this period were the fluctuations in the canadian dollar rate until the early 1960s and some realignments in the nominal exchange rates for the french franc, german mark, and U.K pound.

In chapter 17, we assumed an extreme form of fixed nominal exchange rates-an environment where all countries used a common currency. Since there was only one money, the fixity of nominal exchange rates had to hold. Within a country, this arrangement is so use the same U.S dollar and, therefore,maintain a fixed nominal exchange rate. However until recently, the typical setup for countries was that each one had its own currency. An important exception since 1999-2001 is the euro, now use by 12 western european countries and likly to expand to cover additional countries in europe. In earlier times, the main example of common currencies were small countries that used another country’s currency or shared  a single currency. For example, panama and ecuador use the U.S dollar, 12 countries in africa use the CFA franc, which has been linked, aside from one devaluation, to the french franc (since 1999,the euro) and 7 islanhs in the caribbean use the caribbean dollar, which is linked to the U.S dollar.

The fixed exchange rate regim that applied to most advanced countries from world war II until the early 1970s was called the bretton woods system. Under this system, the participating countries established narrow bands within which they pegged the nominal exchange rate, Ɛ, between their currency and the U.S dollar. Each country’s central bank stood ready to buy or sell its currency and the U.s dollar. For example,the german central bank (bundesbank) provided dollars for marks when households (or more likely,financial institutions) wanted to reduce their holding of marks, and the reverse when households wished to increase their holding of marks. To manage these exchanges, each central bank maintained a stock of assets as international reserves-for example, U.S currency or gold, or, more likely, interest-bearing assets such as U.S. Treasury bills that could be readily converted into U.S currency. Then the united states stood ready to exchange U.S dollars for gold (on the request of foreign official institutions) at a fixed price, which happened to be S35 per ounce. Thus, maintaining a fixed nominal exchane rate with the U.S dollar, each country indirectly pegged its currency to gold.

Another historical exampleof a system of fixed exchange rates is the classical gold standard. In this setup, each central bank directly pegged its currency to gold at a fixed rate of exchange. The united kingdom was effectively on the gold standard from the early eigthteen century until world war I, except for a period of suspension from 1797 to 1821 because of napoleonic wars. After departing from the gold standart during world war I, the united kingdom returned this system in 1026 but departed again during the great depression in 1931. The united states was on the gold from 1879 until trough of the great depression in 1933, when the dollar price of gold was raised from S20.67 to S35per ounce. Earlier periods involved a greater role for silver in the united states. From an international perspective, the high point of the gold standard  was from 1890 to 1914.

Under a gold standard (or other commodity standard), each central bank pegs the value of its currency in terms of gold (or other commodities). An ounce of gold might, for example, be set at S20 in new york and £4 in london (roughly the values prevailing in 1914). In this environment, the nominal exchange rate between U.K pounds and U.S dollars had to be close to 0,2 pounds per dollar. Otherwise (subject to the costs of shipping gold), it would be profitable to buy gold in one country and sell it in the other. As with bretton woods system, the classical gold standard would-if adhered to by the participants-maintain fixed nominal exchange rates among the various currencies.

It is possible for countries to maintain fixed nominal exchange rate a regime that has no role for gold or other commodities. For example, from 1079 to 1992, several western european countries kept the nominal exchange rates among their currencies fixed within fairly narrow bands. This arrangement, called the european monetary system (EMS), effectively evolved into the euro, which became the common currency of 12 western european countries over a transition period from 1999 to 2001. Although most countries western europe use the euro, some important are the united kingdom, sweden,denmark, and switzerland.