This document discusses foreign exchange systems and currency crises. It begins by defining foreign exchange and the forex market. It then examines different exchange rate systems such as fixed and floating rates as well as managed floating. It discusses concepts like devaluation, revaluation, and the impossible trinity. The document also covers currency crises, capital controls, and examples of currency boards in Hong Kong and Argentina. It concludes with an overview of dollarization and its potential effects.

1. Foreign Exchange
Exchange-Rate Systems
and Currency Crises

2. Learning Outcome
• Ability to understand and develop skills on
Exchange Rates and different Exchange Rate
Regimes, types of exchange rates and how
exchange rate functions in International Trade
works

3. • Which is the major currency in the world
trade?
A. US $ B. INR C. Riyad
• Does foreign trade influence value of any
currency ?
A. Yes B. No

4. • Foreign currency
• The currency of any foreign country which is
authorized medium of circulation and the
basis for record keeping in that country.
Foreign currency is traded by banks either by
the actual handling of currency or checks, or
by establishing balances in foreign currency
with banks in those countries.

5. • What Is Foreign Exchange (Forex)?
• Foreign Exchange ( Forex or FX) is the trading of one currency
for another. For example, one can swap the U.S. dollar for the
euro. Foreign exchange transactions can take place on the
foreign exchange market, also known as the Forex Market.
• The Forex market is the largest, most liquid market in the
world, with trillions of dollars changing hands every day.1
There is no centralized location, rather the Forex market is an
electronic network of banks, brokers, institutions, and
individual traders (mostly trading through brokers or banks).

6. Exchange Rate Systems
2) floating rate
a) determined by market forces
b) float independently or with a group
of other currencies
1) fixed rate
a) also known as pegged exchange rate
b) anchored to the value of one other
currency or a group of currencies

7. IMF Principles
2) Members should intervene to counteract
disruptive short term exchange rate
movements
1) Member nations must avoid manipulating
exchange rates in order to impact balance of
payments
3) Members should take into account the
impact of intervention policies on other
members

8. Impossible Trinity
1) free capital flows
2) a fixed exchange rate
3) independent monetary authority
It is not possible for a country to maintain all
three of the following:

9. Impossible Trinity (continued)
A country can choose any two of the three:

10. Impossible Trinity (examples)
2) Hong Kong has a fixed exchange rate &
allows free flow of capital but does not have
independent monetary authority
1) U.S. allows free flow of capital &
maintains monetary authority but does not
have a fixed exchange rate
3) In the past, China had a fixed and
maintained monetary authority but did not
allow the free flow of capital

11. Fixed Exchange Rates
Fixed exchange rates are the norm for
developing economies. By tying their
currencies to a key currency – that of a
larger, more developed nation they promote
1) a means of international settlement
2) stabile prices for imports/exports
3) limits on inflationary pressure

12. Fixed Exchange Rates (continued)
Under a fixed exchange rate system
governments maintain
o par value for their currencies
o an official exchange rate determined by
comparing par values
o an exchange rate stabilization fund to buy
and sell foreign currencies in order to
preserve the official exchange rate

13. Preventing Depreciation
If the demand for
the euro
increased, the
value of the euro
would rise and
the value of the
dollar would fall.
In order to
maintain the fixed
exchange rate,
the U.S. would
use its reserve of
euros to buy
dollars.
$1.70
Q
$1.50
Market for Euros
D1
S1
P
D2
S2

14. Preventing Appreciation
If the supply of
the euro
increased, the
value of the euro
would fall and the
value of the
dollar would rise.
In order to
maintain the fixed
exchange rate,
the U.S. would
use dollars to buy
euros.
$1.25
Q
$1.50
Market for Euros
D1
S1
P
D2
S2

15. • Baharin - Dinar - 2.65 - 1 US $
• Suadi Arabia –Riyal - 3.75 – 1 US $

16. Devaluation & Revaluation
Devaluation
o legal reduction of a currency’s par value
o market impact termed depreciation
o counters a balance of payment deficit by making
exports less expensive
Revaluation
o legal increase of a currency’s par value
o market impact termed appreciation
o counters a balance of payment surplus by
making imports less expensive

17. Bretton Woods System ( 1944)
1) response to crises of Great Depression when
floating exchange rates had been unsuccessful
2) Bretton Woods created a semi-fixed system
known as adjustable pegged exchange rates
3) currencies values tied to each other
4) nations to use fiscal and monetary policies first
to address balance of payments disequilibria
5) last resort was to re-peg currencies; greater than
10% change required IMF permission

18. Floating Exchange Rates
o also known as flexible exchange rates
o equilibrium exchange rate determined by
demand for and supply of home currency
o changes in exchange rate correct
payments imbalance by changing the
effective cost of imports and exports
o will not fluctuate erratically unless there is
significant instability in financial markets

19. • End of Bretton Woods system
In August 1971, U.S. President Richard Nixon
announced the "temporary" suspension of the
dollar's convertibility into gold. While the
dollar had struggled throughout most of the
1960s within the parity established at Bretton
Woods, this crisis marked the breakdown of
the system.

20. Depreciation & Exports
If real income in
the U.S.
increased, then
demand for
imports and
demand for the
euro would
increase. The
value of the euro
would rise and
the value of the
dollar would fall.
$1.70
Q
$1.50
Market for Euros
D1
S1
P
D2

21. Depreciation & Exports (cont.)
Since more dollars are required to purchase a euro,
the dollar has depreciated.
1) As a result, U.S. goods will become less
expensive to European citizens leading to more
exports from the U.S.
2) European goods will become more expensive to
U.S. citizens leading to fewer imports to the U.S.
$150 U.S. auto part
before $150 = 100 €
after $150 = 88.2 €
(150÷170)
100€ French wine
before 100 € = $150
after 100 € = $170

22. Appreciation & Imports
If real income in
the U.S. declined,
then demand for
imports and
demand for the
euro would also
decrease. The
value of the euro
would fall and the
value of the
dollar would rise.
$1.25
Q
$1.50
Market for Euros
D2
P
D1
S1

23. Appreciation & Imports (cont.)
Since fewer dollars are required to purchase a
euro, the dollar has appreciated.
1) As a result, U.S. goods will become more
expensive to European citizens leading to fewer
exports from the U.S.
2) European goods will become less expensive to
U.S. citizens leading to more imports to the U.S.
$150 U.S. auto part
before $150 = 100 €
after $150 = 120 €
(150/125)
100€ French wine
before 100 € = $150
after 100 € = $125

24. Arguments on Floating Exchange
Advantages Disadvantages
Fixed • simplicity and clarity of • loss of independent
exchange-rate target monetary policy
• automatic rule for • vulnerable to
monetary policy speculative attacks
• controls inflation
Floating • continuous adjustment • conducive to
in balance of payments inflation
• simplified institutional • disorderly markets
arrangements can disrupt trade and
investment patterns
• independent monetary • reckless financial
and fiscal policies policies by government

25. Managed Floating System
o intervention to stabilize rates in short run with
market forces determining rates in long run
o informal guidelines established by IMF
o clean float – free-market forces of supply and
demand determine equilibrium
o dirty float – central banks intervene to promote
depreciation of their currencies
o leaning against the wind – intervention to reduce
fluctuations in the short run only

26. Managed Float Example
permanent change in demand
to D1 – exchange rate allowed
to increase
temporary increase in demand -
central bank sells francs while
demand is D1 until return to D0

27. Monetary Policy
if demand for pounds decreases
Fed increase MS lowering rates
decreasing demand for dollars
if demand for pounds increases
Fed decrease MS raising rates
increasing demand for dollars

28. Crawling Peg
o uses small, frequent changes in par value
to correct balance of payments disequilibria
o primarily nations with high inflation
o differs from adjustable pegged rates under
which par values change infrequently
o crawling peg is appropriate for developing
nations but not for industrialized nations
whose currencies provide international
liquidity

29. Currency Crises
o also known as speculative attacks
o weak currency depreciates significantly as
a result of selling
o can substantially reduce economic growth
o usually ended by official devaluation or
adoption of a floating rate
o extreme cases => currency crashes

30. Causes of Currency Crises
1) speculation
2) deficit financed by inflation
3) weak financial systems
4) recent deregulation of financial markets
5) weak economic performance
6) political factors
7) external factors such as interest rates
8) choice of exchange rate system

31. Capital Controls
1) also known as exchange controls
2) barriers to foreign savers investing in
domestic assets
3) pro: government can control its balance of
payments position and possibly prevent
speculative attacks
4) con: weakened confidence in the
government may actually cause an
increase in capital outflows

32. Question of Foreign Exchange Tax
1) volatile capital movements lead to severe
repercussions across economies
2) a tax on inflows or outflows would reduce
the number of transaction based on short
term speculation
3) such a tax would still allow market forces
to influence investment and exchange
rates over the long term
4) how much volatility is acceptable

33. Currency Board
1) monetary authority that issues notes
convertible into a foreign anchor currency
at a fixed rate
2) anchor currency chosen for stability and
acceptability
3) government finance only by taxation and
borrowing – not by printing money
4) implies elimination of discretionary
monetary policy by domestic government

34. Case Study – Hong Kong
1) Hong Kong adopted a currency board
system in 1983
2) U.S.$ = 7.75 to 7.85 HK$
3) reversed lack of confidence in the
economy despite anticipation of control
shifting from the U.K. to China
4) contributed to significant economic growth
in Hong Kong; per capita real GDP of
$37,300 ranks 13th of 216 nations

35. Case Study – Argentina
1) adopted currency board in 1991 to limit
inflation
2) 1 U.S.$ = 1 Argentine Peso
3) issues: dollar appreciated, U.S. interest
rates rose, domestic commodity prices
fell, and Brazil’s currency depreciated
4) U.S. fiscal & monetary policy ill suited to
conditions in Argentina
5) results: deficits, borrowing, default and
economic chaos

36. Dollarization
1) partial dollarization indicates use of the
U.S. dollar alongside domestic currency
2) full dollarization indicates use of the dollar
and elimination of domestic currency
3) benefits:
a) lower inflation
b) decreased transactions costs
c) greater openness

37. Effects of Dollarization
o U.S. monetary policy would not
necessarily be appropriate for a foreign
economy
o Federal Reserve is not the lender of last
resort for that economy
o loss of seigniorage which is the income
that would have been derived from
interest bearing foreign reserves