The expansion of international trade and the massive capital movements led to a Dollar shortage.
Later, during the 50's, the Bretton Woods system was under enormous pressure and needed help to function properly when the major economies started to evolve in different directions. While the classical gold standard collapsed because of external forces (the outbreak of WWI), the Bretton Woods regime failed due to internal inconsistency. US monetary policy was the system's anchor
and the growing inflation in the US destabilized the system until it started to disintegrate.
After WWII, Europe and Japan needed to import from US all kinds of manufactured goods and machinery for its own reconstruction while US wanted to favor Western European countries in front of the menace of Eastern European countries and the USSR. But there were not enough Dollars in circulation. So in 1948 the US decided to give west Europe an economic aid, under the name of the Marshal Plan, officially called the European Recovery Program.
In the 60's the situation started to revert and an oversupply of Dollars in circulation gradually appears. The Vietnam war, welfare expenditure and the space race with the USSR were the major reasons for the increased US government spending. When US inflation began to accelerate, other countries refused to import it into their economies. This whole situation destabilized the exchange rates agreed upon in Bretton Woods.
Shortage in international currencies and abundance of US Dollars rise some doubts about its convertibility to gold. The already high trade deficit of the US led to speculative pressures awaiting a strong devaluation of the US Dollar versus gold. A series of readjustments held the system for a while but finally, on August 15, 1971, everything changed. US President Nixon suspended the gold convertibility standard and in 1973 the US formally announced the permanent floating of the US Dollar, thereby officially ending the fixed exchange rate regime and the Bretton Woods system.
The system became an open US-Dollar-based world payments arrangement.
Let's define some of the concepts that we have learned so far:
For instance, if you are a European wanting to travel to the US and the exchange rate for EUR 1.00 is USD 1.50 this means that for every Euro, you can buy one and a half US Dollar.
You have also seen that there are different ways the price of a currency can be determined against another:
Through a fixed, or pegged, rate which is a rate the central bank sets and maintains as the official exchange rate. In this case a set price will be determined against a major world currency (usually the US Dollar, but also other major currencies such as the Euro, the Yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return of the currency to which it is pegged. To do this, the central bank must keep enough foreign reserves to release or absorb into or out of the market.
Some governments may also choose to have a semi-peg whereby the government periodically reassesses the value of the peg and then changes the peg rate accordingly. Usually the change is devaluation but one that is controlled so that market panic is avoided. This method is often used in the transition from a peg to a floating regime.
Although the peg has worked in creating global trade and monetary stability, it was only used at a time when all the major economies were a part of it.
And while a floating regime has its flaws, it has proven to be an efficient means of determining the long term value of a currency and creating equilibrium in the international market.
You may now ask: "Why the need to fix a currency?" It has to do with the aim to create a stable atmosphere for foreign investment, specially among developing nations. If the currency is pegged, the investor will always know what its value is and will not fear hyperinflation. However the peril exists that such countries experience financial crisis as well, like Mexico in 1995 and Russia in 1997.
An attempt to maintain a high value of the local currency to the peg can result in the currencies eventually becoming overvalued. This means that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors would start to convert their currency into foreign currency before the local currency is devalued against the peg, depleting the central bank's foreign reserves.
There is also a floating condition, which allows the Forex market to function as we know it nowadays with most of the major currencies. A floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market.
A floating exchange rate is constantly changing as a decrease in demand for a currency will lower its value in the market. This in turn will make imported goods more expensive and stimulate demand for local goods and services. As a consequence, more jobs are created, and hence an auto-correction occurs in the market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, compared with a fixed system, it is less frequent that the central bank of a floating regime interferes.
A country can also opt to implement a dual or multiple foreign exchange rate system, where both modalities run in parallel. Unlike a pegged or floating system, the dual and multiple systems consist of different rates, fixed and floating, running at the same time. The fixed rate is usually a preferential rate and the floating a more discouraging one.
While the fixed rate is only applied to certain segments of the market, like the import/export of essential goods, the floating rate is set by the forces of supply and demand in the market and is applied to non-essential goods like luxury imports.
This system is also usual in transitional periods as a means by which governments can quickly implement control over foreign currency transactions. In those cases, instead of depleting its foreign reserves, the government diverts the heavy demand for foreign currency to the free-floating exchange rate market.
As with the other solutions, a multiple exchange rates system is not free from negative consequences: creating artificial conditions for certain market segments is one of them. But it could also be used as an effective means to address the problem in the balance of payments developed under the conditions of a completely free floating system.
Note that none of these systems are perfect, but that all are thought as mechanisms to deal with those underlying problems in economic crisis and inflation periods. Their aim is to eventually keep the equilibrium in the monetary system.
Just to summarize, these are the four exchange rate systems, or regimes:
* Pegged exchange rate system: the value of the currency is tied to another currency, to a basket of currencies or to the price of gold. The purpose of a fixed exchange rate system is to maintain a country's currency value within a very narrow band.
* Semi-pegged exchange rate system: the central bank periodically readjusts the fixed (pegged) value of its currency.
* Floating exchange rate system: the value of a currency changes freely and is determined by supply and demand in the Forex market.
* Multiple exchange rate system: both systems are simultaneously used in different segments of the economy.
Previous,3, 4,
Later, during the 50's, the Bretton Woods system was under enormous pressure and needed help to function properly when the major economies started to evolve in different directions. While the classical gold standard collapsed because of external forces (the outbreak of WWI), the Bretton Woods regime failed due to internal inconsistency. US monetary policy was the system's anchor
and the growing inflation in the US destabilized the system until it started to disintegrate.After WWII, Europe and Japan needed to import from US all kinds of manufactured goods and machinery for its own reconstruction while US wanted to favor Western European countries in front of the menace of Eastern European countries and the USSR. But there were not enough Dollars in circulation. So in 1948 the US decided to give west Europe an economic aid, under the name of the Marshal Plan, officially called the European Recovery Program.
In the 60's the situation started to revert and an oversupply of Dollars in circulation gradually appears. The Vietnam war, welfare expenditure and the space race with the USSR were the major reasons for the increased US government spending. When US inflation began to accelerate, other countries refused to import it into their economies. This whole situation destabilized the exchange rates agreed upon in Bretton Woods.
Shortage in international currencies and abundance of US Dollars rise some doubts about its convertibility to gold. The already high trade deficit of the US led to speculative pressures awaiting a strong devaluation of the US Dollar versus gold. A series of readjustments held the system for a while but finally, on August 15, 1971, everything changed. US President Nixon suspended the gold convertibility standard and in 1973 the US formally announced the permanent floating of the US Dollar, thereby officially ending the fixed exchange rate regime and the Bretton Woods system.
The system became an open US-Dollar-based world payments arrangement.
Let's define some of the concepts that we have learned so far:
For instance, if you are a European wanting to travel to the US and the exchange rate for EUR 1.00 is USD 1.50 this means that for every Euro, you can buy one and a half US Dollar.
You have also seen that there are different ways the price of a currency can be determined against another:
Through a fixed, or pegged, rate which is a rate the central bank sets and maintains as the official exchange rate. In this case a set price will be determined against a major world currency (usually the US Dollar, but also other major currencies such as the Euro, the Yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return of the currency to which it is pegged. To do this, the central bank must keep enough foreign reserves to release or absorb into or out of the market.
Some governments may also choose to have a semi-peg whereby the government periodically reassesses the value of the peg and then changes the peg rate accordingly. Usually the change is devaluation but one that is controlled so that market panic is avoided. This method is often used in the transition from a peg to a floating regime.
Although the peg has worked in creating global trade and monetary stability, it was only used at a time when all the major economies were a part of it.
And while a floating regime has its flaws, it has proven to be an efficient means of determining the long term value of a currency and creating equilibrium in the international market.
You may now ask: "Why the need to fix a currency?" It has to do with the aim to create a stable atmosphere for foreign investment, specially among developing nations. If the currency is pegged, the investor will always know what its value is and will not fear hyperinflation. However the peril exists that such countries experience financial crisis as well, like Mexico in 1995 and Russia in 1997.
An attempt to maintain a high value of the local currency to the peg can result in the currencies eventually becoming overvalued. This means that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors would start to convert their currency into foreign currency before the local currency is devalued against the peg, depleting the central bank's foreign reserves.
There is also a floating condition, which allows the Forex market to function as we know it nowadays with most of the major currencies. A floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market.
A floating exchange rate is constantly changing as a decrease in demand for a currency will lower its value in the market. This in turn will make imported goods more expensive and stimulate demand for local goods and services. As a consequence, more jobs are created, and hence an auto-correction occurs in the market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, compared with a fixed system, it is less frequent that the central bank of a floating regime interferes.
A country can also opt to implement a dual or multiple foreign exchange rate system, where both modalities run in parallel. Unlike a pegged or floating system, the dual and multiple systems consist of different rates, fixed and floating, running at the same time. The fixed rate is usually a preferential rate and the floating a more discouraging one.
While the fixed rate is only applied to certain segments of the market, like the import/export of essential goods, the floating rate is set by the forces of supply and demand in the market and is applied to non-essential goods like luxury imports.
This system is also usual in transitional periods as a means by which governments can quickly implement control over foreign currency transactions. In those cases, instead of depleting its foreign reserves, the government diverts the heavy demand for foreign currency to the free-floating exchange rate market.
As with the other solutions, a multiple exchange rates system is not free from negative consequences: creating artificial conditions for certain market segments is one of them. But it could also be used as an effective means to address the problem in the balance of payments developed under the conditions of a completely free floating system.
Note that none of these systems are perfect, but that all are thought as mechanisms to deal with those underlying problems in economic crisis and inflation periods. Their aim is to eventually keep the equilibrium in the monetary system.
Just to summarize, these are the four exchange rate systems, or regimes:
* Pegged exchange rate system: the value of the currency is tied to another currency, to a basket of currencies or to the price of gold. The purpose of a fixed exchange rate system is to maintain a country's currency value within a very narrow band.
* Semi-pegged exchange rate system: the central bank periodically readjusts the fixed (pegged) value of its currency.
* Floating exchange rate system: the value of a currency changes freely and is determined by supply and demand in the Forex market.
* Multiple exchange rate system: both systems are simultaneously used in different segments of the economy.
Previous,3, 4,