3. What are Foreign
Exchange Rates
An exchange rate (also known as
a foreign-exchange rate, forex
rate, FX rate) between two currencies
is the rate at which one currency will be
exchanged for another. It is also
regarded as the value of one country’s
currency in terms of another currency.
4. Why Are Exchange Rates
Important?
• When the currency of our country appreciates
relative to another country, our country’s goods
prices abroad and foreign goods prices ¯ in
our country.
• Makes domestic businesses less competitive.
• Benefits domestic consumers .
5. History of Exchange Rates
To explain the nature of the forex exchange
market, it's important to first examine and learn
some of the important historical events relating
to currencies and currency exchange. In this
section we will look at the international
monetary system and how it has evolved to its
current state. Then we'll look at the major
players that occupy the forex market -
something that is important for all potential
forex traders to understand.
7. Evolution of International
Monetary Fund
• Bimetallism: 1870-1875
• Classical Gold Standard: 1875-1914
• Interwar Period: 1915-1944
• Bretton Woods System: 1945-1972
• The Flexible Exchange Rate Regime: 1973-Present
8. Bimetallism: Before 1875
• A “double standard”: both gold and silver were
used as money, accepted as means of payment.
• Some countries were on the gold standard,
some on the silver standard, some on both.
• Exchange rates among currencies were
determined by either their gold or silver
contents.
• Bimetallism was intended to increase the
supply of money, stabilize prices, and facilitate
setting exchange rates.
9. The Classical Gold
Standard
(1875-1914)
• During this period in most major countries:
–Gold alone was assured of unrestricted
coinage
–There was two-way convertibility
between gold and national currencies at a
stable ratio.
–Gold could be freely exported or imported.
• Many country set a par value for its
currency in terms of Gold and tried to
maintain it.
10. The Classical Gold
Standard
(1875-1914)
The exchange rate between two country’s
currencies would be determined by their
relative
gold contents.
Implied Dollar/Pound Exchange Rate
• Dollar pegged to gold at U.S.$30 = 1 ounce
of gold
• British pound pegged to gold at £6 = 1 ounce of gold
• Exchange rate determined as:
• £6 = 1 ounce of gold = $30
• £1 = $5
11. The Classical Gold
Standard
(1875-1914)
• Highly stable exchange rates under the
classical gold standard provided an
environment that was conducive to
international trade and investment.
• The outbreak of World war I Suspended the
operation of Gold Standard
• Misalignment of exchange rates and
international imbalances of payment were
automatically corrected by the price-specie-flow
mechanism.
12. Price-Specie-Flow
Mechanism
• Suppose Great Britain exported more to France
than France exported to Great Britain.
• This cannot persist under a gold standard.
– Net export of goods from Great Britain to France will
be accompanied by a net flow of gold from France to
Great Britain.
– This flow of gold will lead to a lower price level in
France and, at the same time, a higher price level in
Britain.
• The resultant change in relative price levels
will slow exports from Great Britain and
encourage exports from France.
13. In Gold Standard how much
money could be printed?
The gold standard prevents a country from
printing too much money.
If the supply of money rises too fast, then
people will exchange money (which has become
less scarce) for gold (which has not). If this goes
on too long, then the treasury will eventually
run out of gold.
A gold standard restricts the Federal Reserve
from enacting policies which significantly alter
the growth of the money supply which in turn
limits the inflation rate of a country.
14. Interwar Period: 1915-1944
• Exchange rates fluctuated as countries widely
used “predatory” depreciations of their
currencies as a means of gaining advantage in
the world export market.
• Attempts were made to restore the gold
standard, but participants lacked the political
will to “follow the rules of the game”.
• The result for international trade and
investment was profoundly detrimental.
15. Interwar Period: 1915-1944
• Only U.S. and Britain allowed to hold gold
reserves.
• Other countries could hold both gold, dollars or
pound reserves.
• During World war I: currencies fluctuate over
wide ranges to gold.
• Due to Supply & Demand for imports/exports.
16. What Happened in the World
War - I
Governments with insufficient tax revenue
suspended convertibility repeatedly in the 19th century.
By the end of 1913, the classical gold standard was at its peak but
World War I caused many countries to suspend or abandon it.
According to Lawrence Officer the main cause of the gold
standard’s failure to resume its previous position after World War
1 was “the Bank of England's precarious liquidity position and the
gold-exchange standard.”
Price levels doubled in the US and Britain, tripled in France and
quadrupled in Italy. Exchange rates change less, even though
European inflations were more severe than America’s. This meant
that the costs of American goods decreased relative to those in
Europe.
Between August 1914 and spring of 1915, the dollar value of US
exports tripled and its trade surplus exceeded $1 billion for the
first time. Because inflation levels varied between states, when
they returned to the gold standard at a higher price that they
determined themselves.
17. (Cont.)
The US did not suspend the gold standard during
the war.
For example, Germany had gone off the gold
standard in 1914, and could not effectively return to
it because War reparations had cost it much of its
gold reserves.
The newly created Federal Reserve intervened in
currency markets and sold bonds to “sterilize”some
of the gold imports that would have otherwise
increased the stock of money.
By 1927 many countries had returned to the gold
standard. As a result of World War 1 the United
States, which had been a net debtor country, had
become a net creditor by 1919.
18. Bretton Woods System:
1945-1972
• Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
• The purpose was to design a postwar
international monetary system.
• The goal was exchange rate stability without the
gold standard.
• The result was the creation of the IMF and the
World Bank.
19. Bretton Woods (1945-
1971)
• Under the Bretton Woods system, the
• U.S. dollar was pegged to gold at $35 per ounce
and other currencies were pegged to the U.S.
dollar.
• Each country was responsible for maintaining
its exchange rate within ±1% of the adopted par
value by buying or selling foreign reserves as
necessary.
• The Bretton Woods system was a dollar- based
gold exchange standard.
20. Bretton Woods (1945-
1971)
Bretton Woods Conference
Bretton Woods Conference, formally United Nations
Monetary and Financial Conference, meeting at Bretton
Woods, N.H. (July 1–22, 1944), during World War II to
make financial arrangements for the post-war world after
the expected defeat of Germany and Japan.
The conference was attended by experts noncommittally
representing 44 states or governments, including the Soviet
Union. It drew up a project for the International Bank for
Reconstruction and Development (IBRD) to make long-term
capital available to states urgently needing such foreign
aid, and a project for the International Monetary
Fund (IMF) to finance short-term imbalances in
international payments in order to stabilize exchange rates.
After governmental ratifications the IBRD was constituted
late in 1945 and the IMF in 1946, to become operative,
respectively, in the two following years.
21. TRIFFINS PARADOX
The Triffin paradox, is the fundamental problem of the United States
dollar's role as reserve currency in the Bretton Woods system, or more
generally of a national currency as reserve currency.
By the early 1960s, an ounce of gold could be exchanged for $40 in
London, even though the price in the U.S. was $35.
This difference showed that investors knew the dollar was overvalued
and that time was running out.
There was a solution to the Triffin dilemma for the U.S.: reduce the
number of dollars in circulation by cutting the deficit and raising interest
rates to attract dollars back into the country.
Triffin Paradox pointed out the basic contradiction in the Bretton Woods
system especially when dollar started losing its credibility to convert into
gold at the promised rate of $35 per ounce of gold.
The contradiction was that only when US ran deficits, could other
countries build up forex reserves; but as soon as the US BoP deficits
became unsustainably large, other countries lost faith, leading to demise
of Bretton Woods in 1971.
22. Why Nixon’s suspended the
convertibility of US Dollars
into Gold
• Richard Nixon's August 1971 decision to suspend the
convertibility of dollars into gold was one of the most
important chapters in modern economic history.
• Nixon's move, which was precipitated by rising U.S.
balance of payments deficits, ended the system of fixed
exchange rates that had been established at the Bretton
Woods conference of 1944 and ushered in a regime of
floating rates.
• Spending on the Vietnam War and Great Society as well
as the revival of Western Europe and Japan led to a
decline in the U.S. balance of payments. This, in turn,
placed significant pressure on the dollar: U.S. gold
holdings could not keep pace with the expanded money
supply required by domestic and international economic
growth.
23. Why Nixon’s suspended the
convertibility of US Dollars
into Gold
• Nixon decision to suspend the convertibility of US$
into Gold was a plan to combat inflation , effectively
ended the Bretton Woods monetary regime and
brought about a system of floating exchange rates
within a few years. The implications of the "Nixon
shock" for domestic and international affairs were
numerous.
• Since the dollar no longer had to be backed by gold,
the end of the Bretton Woods fixed exchange rate
system increased the freedom of the U.S. Federal
Reserve to engage in counter-cyclical monetary policy
24. World Bank
The World Bank is a United Nations international financial
institution that provides loans to developing countries for capital
programs. The World Bank is a component of the World Bank Group, and
a member of the United Nations Development Group.
The World Bank's official goal is the reduction of poverty. According to its
Articles of Agreement, all its decisions must be guided by a commitment
to the promotion of foreign investment and international trade and to the
facilitation of capital investment.
The World Bank was created at the 1944 Bretton Woods Conference,
along with three other institutions, including the International Monetary
Fund (IMF). Although many countries were represented at the Bretton
Woods Conference, the United States and United Kingdom were the most
powerful in attendance and dominated the negotiations.
25. International Monetary Fund
(IMF)
The International Monetary Fund (IMF) is an international
organization that was initiated in 1944 at the bretton woods
conference and formally created in 1945 by 29 member countries.
The IMF's stated goal was to assist in the reconstruction of the
world's international payment system post–World War II.
Countries contribute funds to a pool through a quota system from
which countries with payment imbalances temporarily can borrow
money and other resources.
The IMF is a self-described "organization of 188 countries, working
to foster global monetary cooperation, secure financial stability,
facilitate international trade, promote high employment and
sustainable economic growth, and reduce poverty around the
world.”
The IMF works to foster global growth and economic stability. It
provides policy advice and financing to members in economic
difficulties and also works with developing nations to help them
achieve macroeconomic stability and reduce poverty.
26. (Cont.)
Stepping up crisis lending: The IMF responded quickly
to the global economic crisis, with lending commitments
reaching a record level of more than US$250 billion in 2010.
This figure includes a sharp increase in concessional
lending (that’s to say, subsidized lending at rates below
those being charged by the market) to the world’s poorest
nations.
Greater lending flexibility:The IMF has overhauled its
lending framework to make it better suited to countries’
individual needs. It is also working with other regional
institutions to create a broader financial safety net, which
could help prevent new crises.
Drawing lessons from the crisis: The IMF is
contributing to the ongoing effort to draw lessons from the
crisis for policy, regulation, and reform of the global
financial architecture.
Historic reform of governance:The IMF’s member
countries also agreed to a significant increase in the voice of
dynamic emerging and developing economies in the decision
making of the institution, while preserving the voice of the
low-income members.
27. SDR
The SDR is an international reserve asset, created by the IMF in
1969 to supplement its member countries' official reserves.
Its value is based on a basket of four key international
currencies, and SDRs can be exchanged for freely usable
currencies.
Created in response to concerns about the limitations of gold and
dollars as the sole means of settling international accounts, SDRs
are designed to augment international liquidity by
supplementing the standard reserve currencies.
The SDR interest rate provides the basis for calculating the
interest charged to members on regular (non-concessional) IMF
loans, the interest paid to members on their SDR holdings and
charged on their SDR allocation, and the interest paid to
members on a portion of their quota subscriptions. The SDR
interest rate is determined weekly and is based on a weighted
average of representative interest rates on short-term debt
instruments in the money markets of the SDR basket currencies.
28. Buying and Selling SDR’s
IMF members often need to buy SDRs to
discharge obligations to the IMF, or they may
wish to sell SDRs in order to adjust the
composition of their reserves.
The IMF may act as an intermediary between
members and prescribed holders to ensure that
SDRs can be exchanged for freely usable
currencies.
For more than two decades, the SDR market
has functioned through voluntary trading
arrangements
29. Flexible Exchange Rate: 1973-
Present
• Flexible exchange rates were declared acceptable to the
IMF members.
– Central banks were allowed to intervene in the exchange rate
markets to iron out unwarranted volatilities.
• Gold was abandoned as an international reserve asset.
• Non-oil-exporting countries and less- developed
countries were given greater access to IMF funds and
World Bank.
30. Current Exchange Rates
• Free Float
– The largest number of countries, about 48, allow
market forces to determine their currency’s value.
• Managed Float
– About 25 countries combine government intervention
with market forces to set exchange rates.
• Pegged to another currency
– Such as the U.S. dollar or euro (through franc or
mark).
• No national currency
– Some countries do not bother printing their own, they
just use the U.S. dollar.