The arguments for floating and fixed exchange rates

The arguments for floating and unbending telephone transmute reckonsEvaluate the respective arguments for floating and fixed flip-flop pass judgments. Your answer should include an exploration of theoretical issues and evaluation of historical and contemporary experiences of alternative world-wide financial regimes.Historical Overview of the Inter content monetary System (IMS)The Inter guinea pig Monetary System refers to the institutional framework within which International payments are made, movements of capital are accommodated and exchange accounts are determined. An appreciation of the international financial system of rules is essential for the judgment of the flow of international capital or currency1.The exchange rate regimes that have been practised for over a century have taken the forms of fixed and floating mechanisms. Floating exchange rate is that which bothows exchange rate to vary in accordance with the changes in the supply and demand for foreign exch ange. contracted exchange rate refers to a currency price that is intentionally pr showcaseed from fluctuating by means of specific government policies that influence the supply and demand for foreign exchange2.Reviewing the principal international monetary systems that nations have practised over the past century, it would be seen that each mechanism carries with it a present of practices which are sometimes straightforward in the form of laws or regulations and sometimes implicit in the form of conventions or customs that are in the comparisonlance of international finance termed the rule of the game3.Ronald McKinnon (1993) describes the summonss of he principal international systems of the last century and noned that the period from 1914 to 1945 reflected the global turmoil of two dry land Wars and the Great falling tally that no uniform system could be ascribed to the period.Mckinnon (1993) organises his review into seven different episodes except the inter-war period, each having own set of rules4. McKinnons categorization appears to have been rendered outdated by more recent development in the international monetary system. From my own point of view, I would rather classify the metamorphosis of the international monetary system into eight episodes that are discussed below-1. Bimetallism Period Before 1875-Commodity capital system using both silver and gold which are precious metals for international payments and for domestic currency because they possessed the features of a means of exchange such as intrinsic value, portable, recognizable, homogenous, divisible, durable and non-perishable5. Under a bimetallic standard (or both time when more than one type of currency is acceptable for payment), countries would experience Greshams Law which is when bad money drives out good money6.2. The International flamboyant Standard -(1879-1913)For about 40 years most of the world was on an international gold standard, ended with World War II when most c ountries went off gold standard. London was the financial centre of the world, most advanced economy with the most international trade.Rules of the stake I The International Gold Standard -(1879-1913)Fix an functionary gold price or mint parity and allow reposition convertibility between domestic money and gold at that price subvert no restriction on the import or export of gold by private citizens, or on the use of gold for international minutesIssue national currency and coins only with gold backing, and link the growth in national bank deposits to the availability of national gold applys.In the event of a brusk-run liquidity crisis associated with gold outflows, the central bank should lend freely to domestic banks at higher interest rates.If Rule (i) is ever temporarily suspended, restore convertibility at the original unit parity as soon as practicable.As a result of these practices, the worldwide price level volition be endogenously determined based on the overall wor ld demand and supply of gold.Source- All the Rules of the Game were adapted from Ronald I. Mckinnon, The Rules of the Game- International currency in Historical Perspective, Journal of Economic Literature, Volume 31 (Mar 1993)Arguments in Support of the Gold StandardPrice Stability through the tying of money supply to the supply of gold, central banks are unable to expand the money supply. The only ways in which they can do so are by acquiring more supplies of gold through production or by running proportionateness of payments surpluses with other countries7.Facilitates Balance of Payment adjustment automatically this was start-off described by David Hume and is referred to as Humes specie flow mechanism8.Arguments Against the Gold StandardThe growth of out put and the growth of gold supplies needs to be closely linked.- For example, if the supply of gold increased faster than the supply of goods did there would be inflationary crush outure9.Volatility in the supply of gold c ould cause unfavorable shocks to the economy10.In practice, the monetary authorities may non be forced to strictly tie their hands in limiting the creation of money, so some of the theoretical advantages may not hold up. For example, the substitution cuss could issue more currency without having acquired more gold, and the public may not bewilder aware of what is going on11.Countries with respectable monetary insurance receivers cannot use monetary policy to fight domestic issues like unemployment.3. The Inter-War Period (1919-1939)After the irruption of the World War I, each warring country afterwards the other put the gold convertibility on hold and embraced the floating exchange rates. However, the joined States which conjugate the battle late, upheld gold convertibility but the dollar floated effectively against other currencies that had ceased to become convertible into dollars.Many exchange rates fluctuated sharply after the war and in the early and through mid-twent ies as a lot of currencies experiencing massive devaluations against the dollar but the join States currency had greatly improved its competitive force play over the European currencies during the war in tandem with the stronger relative position of the United State economy12.Sequel to a prolonged internal debate, the United Kingdom restored the gold convertibility at the pre-war parity against the United State dollar13. It was not surprising to see other countries emulate Britain and returned to the gold but in many cases at devalued rates and what was the impact of this action on those countries economy?The anomalies and disequilibria created during the war were not well manifested in the par values that were found in the mid-twenties14.The exchange trades were characterised by turbulence and chaos during the 1930s. Under a condition serious global depression and erosion of confidence, the international monetary system broke down into rival currency blocs, competitive devaluat ions, discriminatory trade restrictions and exchange controls, high tariffs and barter trade arrangements. Several efforts geared at re-establishing order proved abortive.154. The Spirit of the Bretton Woods Agreement (1945)In July, 1944, the International Monetary and Financial Conference organised by the United Nations attempted to put together an international financial system that eliminated the chaos of the inter-war years. The term of the agreement were negotiated by forty four nations, conduct by the U.S. and Britain. The British delegation was led by John Maynard Keynes, perhaps the most famous economist of the twentieth century16.In essence, the Bretton Woods Agreement sought a set of rules that would demand countries from the tyranny of the gold standard and permit greater autonomy for national monetary policies. The negotiators recognised the historical shortcomings of other systems and the trade-offs they would face in trying to balance stable yet adjustable exchange rates.Rules of the Game II- The Spirit of the Bretton Wood Agreement (1945)Fix an formalised par value for domestic currency in terms of gold or a currency tied to gold as a numeraireIn the short run, pass the exchange rate pegged within 1.0% of its par value, but in the long run leave open the option to adjust the par value unilaterally if IMF concursPermit free convertibility of currencies for current account proceedings but use capital controls to limit currency speculationOff-set short-run balance of payments imbalance by use of official reserves and IMF credits, and sterilize the impact of exchange mart interventions on the domestic money supply.Permit national macro sparing autonomy each member pursue its own price level and employment objectives.The IMF was created with the specific goal of being the multilateral body that monitored the implementation of the Bretton Woods agreement. Its role was to hold gold reserves and currency reserves that were contributed by the me mber countries and then lend this money out to nations that had currency difficulty meeting their obligations under the agreement.17Currencies had to be convertible- central banks had to exchange domestic currency for dollars upon request. However, authoritative countries were also allowed to institute capital controls on certain types of transactions. Only current account related transactions were needful to be fully convertible and countries were allowed to impose restrictions on the exchange of capital account related transactions.18The Asymmetric Position of the Reserve Centre Country In a world with N countries there are only N-1 exchange rates against the reserve currency. If all the countries in the world are fixing their currencies against the reserve currency and acting to keep the rate fixed, then the reserve country has no need to intervene19.The Collapse of the Bretton Woods SystemBretton Woods faltered in the 1960s because of a U.S. trade and budget deficits. Nations holding U.S. dollars doubted the U.S. government had gold reserves to redeem all its currency held outside the U.S. Demand for gold in exchange for dollars caused a large global sell-off of dollars20. In 1971, the U.S. government closed the gold go upow by decree of President Nixon. The world moved from a gold standard to a dollar standard from Bretton Woods to the Smithsonian Agreement21. Growing increase in the amount of dollars printed further eroded faith in the system and the dollars role as a reserve currency. By 1973, the world had moved to search for a new financial system one that no longer relied on a worldwide system of pegged exchange rates.(Levich, 2004)5. The Floating Rate Dollar Standard (1973-1984)The floating rate system that developed after the fall of the Bretton woods was not devoid of rules and the rules which were of two folds, one set of rules for countries other than the United States and the other set for the United States. The US dollar remained the ce ntrepiece of international financial markets. To assess the external values of domestic currency, officials would typically refer to an exchange rate in US$. And when intervention was called for, it was generally conducted in U.S. dollar.While the system was called floating, it was far from a freely floating laissez-faire system. Policy makers were unwilling to let private market forces be the sole antigenic determinant of exchange rates. This is not surprising given the importance of exchange rates to an economy. Richard Cooper (1984) reminds us that it is inconceivable that a government held responsible for managing its economy could keep its hands off the exchange rate. And sure enough, they are not left alone.The IMF also recognised that each country saw its exchange rate as an important policy variable quantity and that the exchange rate policy of one country could have significant negative spill-over effects on other countries. Therefore, in 1974, the IMF enacted a set of gu idelines designed to limit the potential for conflicts regarding exchange rate policies22.While these guidelines are not binding, they show that the IMF sanctions intervention as a system to promote orderly conditions in the foreign exchange market23. Essentially, the foreign exchange rate was left to play the role of a residual variable that did a great deal of the adjusting to offset the macro-economic policy differences across countries. With little coordination of these policies, one would expect exchange rate volatility to increase sharply.(Adam Bennett, 1995)Rules of the Game iii Industrial Countries Other Than the United States.Smooth short term variability in the dollar exchange rate but do not direct to an official par value or to long term exchange rate stabilityPermit free convertibility of currencies for current account transactions maculation endeavouring to eliminate all remaining restrictions on capital account transactionsUse the US$ as the intervention currency (except for transactions to stabilise European exchange rates) and keep official reserves primarily in U.S. Treasury BondsModify domestic monetary policy to support major exchange rate interventions, reducing the money supply when the national currency is weak against the dollar and expanding the money supply when the national currency is strong. identify long-run national monetary and price targets independently of the United States let the exchange rates adjust over the long run to off-set those differences.Rules of the Game The United States.Remain passive in the forex market practise free trade without a balance of payment or exchange rates target. No need foe sizeable official foreign exchange reservesKeep the U.S. capital markets open for borrowing and investing by private residents and foreign sovereignsPursue a monetary policy independent of the exchange rate or policies in order countries, thereby not strong for a common stable price level (or anchor) for tradable goods.7 . The Plaza- flipper treatment gibes the Floating Rate Dollar Standard-(1985-1999)The US had held a fairly passive stance toward exchange rates during first 10-years of float. In 1981, the induction of an expansive US fiscal policy combined tight monetary control (supported by President Ronald Reagan) combined with tight monetary control (guided by Federal reserves Chairman, Paul Volcker) started the US dollar on a prolonged appreciation.By early 1985, the US$ had appreciated nearly 50% (relative to 1980) in real terms against an average of the worlds other major currencies. As the US dollar rose higher, some economists characterised its price behaviour as a speculative bubble (meaning a movement greater than, and progressively greater than justified by macroeconomic fundamentals) and predicted that the foreign exchange value of the dollar was not sustainable.24The entire episode persuade policy makers that-exchange rates were too important to be left to market forces, hence in tervention was deemed appropriate to smooth disorderly markets and halt market excesses, andexchange rates were too important to be the residual from uncoordinated economic policies, so better policy coordination was required to establish a set of economic fundamentals that in turn would produce a smother path of the exchange rate.As a result, since 1985, a new set of rules has evolved accenting the role of exchange market intervention and macroeconomic policy coordination. The first part of the policy change, the easy part, was foreign exchange intervention. Although, the appreciation of the US$ reach in early March, 1985, the dollar did not initially fall by much and the use Congress continued to favour import restrictions (Barry Eichengreen, 1996).7(a) The Plaza AccordOn September 22, 1985, officials from the Group of Five (G-5) countries Britain, France, West Germany, Japan and the US met at the Plaza Hotel in New York City, where they issued a communiqu announcing that they would interfere jointly promote dollar depreciation. The dollar fell sharply on this news and continued to decline through 1986.The Plaza communiqu represented a sharp break with former policies. Exchange market intervention was often characterised by leaning against the wind behaviour to policy change the market trend. The Plaza meeting had the Central Banks leaning with the wind of the recently weak dollar. Further exchange market interventions were often kept secret and were often the doings of a single central bank25.7(b) The tailfin AccordThe dollars free fall continued into 1987, so much that some European officials began to fear for the competitiveness of their own export industries which prompted policy makers from the G-5 countries plus Canada to make another attempt at exchange rate co-operation in a meeting at the LOUVRE in Paris in February 22, 1987. At the Louvre meeting, policy makers agreed to foster stability of exchange rates around their current levels.This was not an unusual statement as part of a press release from a meeting of international finance minister but the Louvre accord was more than an emotional statement in praise of stability.The midpoint of the Louvre meeting was a set of target zones, or exchange rate range, that the Central Bankers agreed to defend using active foreign exchange intervention26.The Louvre accord has been criticised on the ground that the target zone strategy could have no real force and the decision to keep the zonary boundaries secret was simply a device to prevent any evaluation of the policys success.The Rules of the Game IV-The Plaza-Louvre Intervention Accords and the Floating Rate Dollar Standard-(1985-1999)-Germany, Japan and United States (G-3)Set broad target zones for the US$/DM and US$/Y exchange rates. Do not announce the agreed upon central rates, and allow for flexible zonal boundariesAllow the implicit central rates to adjust when economic fundamentals among the G-3 countries change substa ntiallyCentral Banks intervene collectively but infrequently to reverse short-run exchange rate trends that threaten a zonal boundary. Signal the collective intent by announcing rather than hiding intervention.G-3 countries hold reserves in each others currencies, for the U.S. This means building up reserves in deutsche marks, yen, and possibly other convertible currencies.Sterilize the immediate impact of exchange market interventions by not adjusting short-term interest rates.Each G-3 country aims its monetary policy towards stable prices (measured by domestic consumer or wholesale prices or the GNP deflator), which indirectly anchors the world price level and reduces the drift in exchange rate zones.The Rule of the Game Other Industrial CountriesSupport or do not oppose interventions by the G-3 to keep the dollar within its target zone limits.Indeed, policy makers have had to adjust the central rate of the implied target zone and be flexible about the precise location of the tar get zone boundary. Intervention under the Louvre accord seems to be more successful when accompanied by macroeconomic policy changes, and less successful when domestic monetary is preserved through sterilized intervention. Sterilized intervention in the foreign exchange market leaves the domestic monetary base unaffected27(Krugman, P and Maurice, O, 2000).The Louvre accord began a dish up towards greater and, it was hoped, better policy co-ordination. Progress in the coordination process is essential to fundamentally affect the stability of exchange rates in the longer run.8. The Spirit of the European Monetary System (1979)Following the collapse of the Bretton Woods, European wedlock (EU) nations looked for a system that could stabilise currencies and reduce exchange-rate risk. In 1979, the created the European Monetary System (EMS) to stabilize exchange rates subject to the following guidelines-Rules of the Game V The Spirit of the European Monetary System (1979)Applicable to All Member Countries.Fix a par value for each exchange rate in terms of the European Currency unit, a basket weighted according to country size.Keep exchange rate stable in the short run by limiting movements in the isobilateral rates to 2.25% on either side of the central rate.When exchange rate threatens to breach a bilateral limit, the strong currency Central Bank must lend freely to the weak currency Central Bank to support the exchange rate.Adjust the par value in the intermediate term only if necessary to realign price levels, and only with the collective agreement of other EMS countries.Work toward a carrefour of national macroeconomic policies that would lead to stable long run par value for exchange rates.Maintain free currency convertibility for current account transactionsHold foreign exchange reserve primarily in ECUs with he European Fund for Monetary Co-operation (EFMC), and reduce U.S. dollar reserves.Repay Central Bank debts quickly from exchange reserves or by bo rrowing from the EFMC within strict long-term credit limits.No single countrys money serves as a reserve currency nor does its natural monetary policy serve (asymmetrically) as the nominal price anchor for the group.The EMS was successful, currency realignments were infrequent and inflation was controlled. Problems arose in 1992 and the EMS was revise in 1993 to allow currencies fluctuate in a wider band from the mid-point of the target zone. The system ceased to exist in 1999 when the EU adopted a single currency.8(a) The European Monetary System as a Greater DM Area (1979-1998)As earlier proposed, the EMS appears to enshrine the symmetry of the EU member nations in a co-operative process. In practice, the DM was the centrepiece of the Exchange Rate Mechanism (ERM), and German monetary policy formed anchor for the EMS price level.As a consequence, the operation of the EMS was subject to more strains than might have been foreseen, as the strongest country with the least inflation c alled the Policy Tune, rather than some equally weighted average of all the policy presumptions of the member countries. Most of the strains in the EMS over the period arose from the desire by some European leaders to achieve still closer economic and social union.In 1989, a European Council headed by European Commission President Jacque Delors, presented a plan to establish a European Economic and Monetary Union (EMU). Under the EMU proposal, a single European Central Bank was to set up the monetary policy for a single European money thereby abolishing national monies and an independent role for national central banks.The Delors Plan28recommended a three-stage plan process to phase in the EMU as follows-Stage 1- Bring all 12 members EC countries into the ERM while bringing tighter convergence of monetary policies to secure the ERMStage 2- Narrow the permissible bands of the ERM and permit a new European Central Bank to exercise more control of national monetary policies.Stage 3- Re place national monies with a common currency, placing debt instrument for the European Central Banks that reflect the interests of all EC countries.The EMS Crisis of 1992 1993The Delors Plan called for a transfer of national sovereign power over monetary policy and national monies to a new EC institutions. In December, 1991, the EC drafted the Maastricht Treaty a 250 page document that laid out the procedure for transferring policy making billet and the approval by all the twelve EC countries was required either by national referendum or parliamentary vote. For reason that substantial parts of the agreement were contentious, most of the sponsoring countries became sceptical and the document could not be approved by member nations contrary to expectation, As a result, currency tension persisted throughout 1993.In the summer of 1993, speculative attacks continued on the French franc and other currencies. This caused Central Banks to intervene heavily but the French resisted deval uation29. (Richard Cooper, 1984).The Path to European Monetary UnionNotwithstanding the shocks suffered by the Delors Plan, voting on the Maastricht treaty continued and by November, 1992, it was adopted and the European Union (EU) was born. However, many countries had negotiated the right to opt out of certain key provisions, including the EUs common monetary and defence institutions.According to the Delors Plan, countries had to meet various economic targets before joining the EMU30.These criteria were very stringent to fulfil that as at February 1997, only Luxembourg satisfied them. Despite the difficulty in meeting the criteria, undaunted EU policymakers proceeded by designing and unveiling new natural coins and notes. Private firms and banks were compelled to follow suit, redesigning their accounting systems and functional software to accommodate the new euro.8(b) The Spirit of the European Economic Monetary Union 1999In May 1998, the European Council met to make two critica l decisions-To determine which countries would participate in the launch of the EMU set for January 1, 1999 andWho would be elected as the President of the European Central Bank.Many observers had expected a narrow EMU with only six countries going in at the start because requirements on fiscal budget deficits and national debt level. Surprisingly, the European Council elected eleven countries virtually all EU except countries, those that desired to opt out of the pioneer team such as Denmark, Sweden and the United Kingdom. Greece actually wanted to join but clearly had not met the convergence requirements31.On 1st January, 1999, the final and irrevocable conversion rates of the eleven bequest currencies versus the euro were announced. The transition went hitch-free in terms of transaction execution in the foreign exchange market and the operation of the EMU payment and settlement system. Financial markets in the EMU countries redenominated all traded financial securities and instr uments from their national currencies into euros. A new market for bonds denominated in euros is thriving. The trend toward trans-national mergers and acquisition across firm within the euro started growing.The last flavor on the path to monetary union is the introduction of physical euro notes and coins and the withdrawal of legacy currency notes and coins. This process was scheduled to begin January 1, 2002 and to be accomplished not later than July 1, 2002.Empirical Evidences of Recent Currency CrisesDespite nations best efforts to head off financial crises within the international monetary system, the world has witnessed several acrid crises some of which are summarised below-Developing Nations Debt CrisisBy the early 1980s, developing countries (especially in Latin America) had amassed huge debts payable to large international commercial banks, the IMF, and the World Bank. To prevent a meltdown of the entire financial system, international agencies revised repayment schedules . In 1989, the Brady Plan called for large-scale reduction of poor nations debt, exchange of high-interest loans, and debt instruments tradable on world financial markets.Mexicos Peso CrisisRebellion and political assassination shook investors, faith in Mexicos financial system in 1993 and 1994. Mexicos government responded slowly to the fledge of portfolio investment capital. In the late 199