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# Choosing an exchange rate system

## 1. Choosing an exchange rate system

One of the oldest debates in economics is whether a currency should have a fixed or floating exchange rate. There is no single solution that fits all economies. The choice of an exchange rate system depends on many factors, including the openness to international trade, maturity of the financial system, inflation, labor market flexibility, and credibility of policy makers.
Consider two countries, Etonia and Tukistan. Etonia has a central bank with a weak reputation. Tukistan has a strong central bank but much higher inflation than its trading partners.
Indicate the exchange rate system that would be more beneficial for each country in the following table.
Country
Pegged (Fixed) Exchange Rates
Flexible Exchange Rates
Etonia
Tukistan
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Explanation:
The weaker the reputation of the central bank, the stronger the case for pegging the exchange rate to build confidence that inflation will be controlled. Therefore, Etonia would be better off adopting fixed exchange rates.
A country with much higher inflation than its trading partners, such as Tukistan, needs flexible exchange rates to prevent its goods from becoming uncompetitive in world markets. If inflation differentials are more modest, a fixed rate is less troublesome.

## 2. Characteristics of fixed and floating exchange rates

Complete the following table by indicating whether each property represents a fixed or flexible exchange rate system.
Property
Fixed Exchange Rate System
Flexible Exchange Rate System
Automatic rule to conduct monetary policies
Independent monetary and fiscal policies
Simplicity of exchange rate target
Controllable inflation
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Explanation:
Fixed exchange rates are used primarily by small, developing nations whose currencies are anchored to a key currency, such as the U.S. dollar. Until the industrialized nations adopted managed floating exchange rates in the 1970s, the practice generally was to maintain a pattern of relatively fixed exchange rates among national currencies. Changes in national exchange rates were initiated presumably by domestic monetary authorities when long-term market forces warranted it.
Therefore, by adopting fixed exchange rates, a country would gain an automatic rule to conduct monetary policies, simplicity of exchange rate target, and the ability to control inflation. Note that disadvantages of a fixed exchange rate system include loss of independent policies and vulnerability to speculative attacks.
Floating rates respond quickly to changing supply and demand conditions, clearing the market of shortages or surpluses of a given currency. Floating rates fluctuate throughout the day and, thus, permit continuous adjustment in the balance-of-payments.
Therefore, by adopting flexible (or floating) exchange rates, a country would gain independent monetary and fiscal policies, an adjustable balance-of-payments, and simplified institutional arrangements. Disadvantages include susceptibility to price inflation and reckless financial policies on the part of government, as well as susceptibility to the disruptive effect of disorderly exchange markets on trade.

## 3. The impossible trinity

Suppose the government of Iraq is deciding what kind of monetary policy and exchange rate regime to choose. The government wants to ensure stability in international trade and investment by pegging the Iraqi dinar to the U.S. dollar.
Which of the following policy choices will achieve this goal? Check all that apply.
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Explanation:
The choice of an exchange rate system depends on many variables such as capital mobility. Because capital tends to flow where returns are the highest, the impossible trinity shows how a country can maintain only two of the following three policies at a time:
 • Free capital flows • Independent monetary policy • Fixed exchange rate
When the Iraqi government pegs the dinar to the U.S. dollar and allows capital mobility, the interest rate in Iraq will follow that in the United States. Therefore, the Iraqi government won’t be able to conduct its own monetary policy by controlling the country’s interest rate or money supply. The only way to achieve monetary policy autonomy with a fixed exchange rate regime is to impose capital controls (that is, restrictions on foreign exchange trading).

## 4. Bretton Woods

Suppose that after World War II, the United States and Great Britain agree to peg their currencies to each other under the Bretton Woods system at an exchange rate of $1.00 per pound. Suppose American demand for pounds increases, and the equilibrium dollar price of a pound rises to$2.00 per pound.
Which of the following actions could the U.S. government use under Bretton Woods to help eliminate the balance-of-payments imbalance at the pegged exchange rate?
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Explanation:
To eliminate the balance-of-payments deficit, the U.S. government must increase the supply of pounds or decrease the demand for pounds.
By using its official reserves of pounds to buy dollars, the U.S. government increases the supply of pounds (shifts the supply-of-pounds curve to the right) in the foreign exchange market. Similarly, borrowing pounds from the International Monetary Fund (IMF) and using them to purchase dollars will increase the supply of pounds as well.
What was used to settle international debts and denominate international trade contracts under the Bretton Woods system?
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Explanation:
In 1944, delegates from 44 member nations of the United Nations met at Bretton Woods, New Hampshire, to create a new international monetary system. The founders felt that neither completely fixed exchange rates nor floating rates were optimal; instead, they adopted a kind of semifixed exchange rate system known as adjustable pegged exchange rates. The Bretton Woods system lasted from 1946 until 1973.
The U.S. dollar was the reserve currency of the Bretton Woods system. It was used to settle international debts and denominate international trade contracts. The U.S. dollar was chosen because the United States had the strongest economy and the largest financial system, and its currency already was the dominant world currency.
True or False: With either dollarization or currency boards, interest rates must be different from the reserve currency country’s prevailing rates.
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Explanation:
With dollarization, unequal interest rates would cause investments to flow into or out of the country as it seeks higher returns. With currency boards, the interest paid on currency board notes must be equal to what can be earned on the reserve currency. Otherwise, arbitrage will equalize the interest rates, as investors borrow the cheaper currency to earn the higher interest of the other currency. Therefore, this statement is false.

## 4. Bretton Woods

Suppose that after World War II, the United States and Germany agree to peg their currencies to each other under the Bretton Woods system at an exchange rate of $2.00 per mark. Suppose American demand for marks decreases, and the equilibrium dollar price of a mark falls to$1.00 per mark.
Which of the following actions could the U.S. government use under Bretton Woods to help eliminate the balance-of-payments imbalance at the pegged exchange rate?
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0 / 1
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Explanation:
To eliminate the balance-of-payments surplus, the U.S. government must decrease the supply of marks or increase the demand for marks.
By using dollars to purchase marks, the U.S. government increases the demand for marks (shifts the demand-for-marks curve to the right) in the foreign exchange market. Similarly, the U.S. government could buy gold from Germany. In order to buy gold from Germany, the United States must first purchase marks, increasing American demand for marks.
Which of the following is the reason the Bretton Woods system was officially dissolved in 1971?
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Explanation:
In August 1971, the United States suspended the dollar’s convertibility into gold, due to continuing and growing balance-of-payments deficits. This effectively terminated U.S. commitment to exchange gold for dollars at \$35 per ounce. As a result, the international value of the dollar was no longer tied to gold, which permitted the dollar exchange rate to be set by market forces. The floating of the dollar led to the demise of the Bretton Woods system of fixed exchange rates.
True or False: With either dollarization or currency boards, interest rates must be equal to the reserve currency country’s prevailing rates.
Points:
1 / 1
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Explanation:
With dollarization, unequal interest rates would cause investments to flow into or out of the country as it seeks higher returns. With currency boards, the interest paid on currency board notes must be equal to what can be earned on the reserve currency. Otherwise, arbitrage will equalize the interest rates, as investors borrow the cheaper currency to earn the higher interest of the other currency. Therefore, this statement is true.

## 5. Changes in the foreign exchange market

The following questions focus on the exchange rate between the Malaysian ringgit and the Danish krone. Assume the exchange rate is flexible. The exchange rate is defined as the number of ringgit you must pay for one krone.
Suppose a recession in Malaysia causes Malaysian incomes to decrease, while incomes in Denmark remain the same.
Shift the appropriate curve or curves on the following graph to illustrate how this affects the market for Danish kroner if all other things remain equal.
Note: Select and drag one or both of the curves to the desired position. Curves will snap into position, so if you try to move a curve and it snaps back to its original position, just drag it a little farther.
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1 / 1
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Explanation:
Falling incomes in Malaysia cause Malaysians to purchase fewer goods, including foreign goods. The decrease in the demand for Danish goods causes the demand for kroner to shift to the left. As a result, the ringgit price of kroner decreases.
The decrease in Malaysian incomes causes the Danish krone toappreciate   relative to the Malaysian ringgit and causes the Malaysian ringgit todepreciate   relative to the Danish krone.
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Explanation:
The decrease in the demand for kroner causes the ringgit price of kroner to decline. After the change, it costs fewer ringgit to purchase one Danish krone. Conversely, it will cost Danes more kroner to purchase one Malaysian ringgit. Since the value of the Danish krone declines, and the value of the Malaysian ringgit increases, the Danish krone depreciates while the ringgit appreciates.
Suppose the price level in Denmark rises by 5%, while the price level in Malaysia remains the same. That is, the inflation rate in Denmark is higher than in Malaysia.
Shift the appropriate curve or curves on the following graph to illustrate how this affects the market for Danish kroner.
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Explanation:
An increase in the Danish price level will make Malaysian goods relatively cheap for Danes and Danish goods relatively expensive for Malaysians. Danish demand for Malaysian goods will rise, and Malaysian demand for Danish goods will decline.
The demand for Danish kroner decreases (shirts to the left) as Malaysians purchase fewer Danish goods. The supply of kroner increases (shifts to the right) as Danes purchase more Malaysian goods. The krone depreciates, and the ringgit appreciates.
Suppose the real interest rates in Malaysia and Denmark are initially the same. Then the real interest rate in Denmark rises, while the real interest rate in Malaysia remains the same. This will cause the supply of kroner todecrease   and the demand for kroner toincrease   , which causes the Malaysian ringgit todepreciate   relative to the Danish krone.
Points:
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Explanation:
After the real interest rate in Denmark rises, Malaysians will want to purchase more Danish assets, since they now pay a higher real interest rate than Malaysian assets. The demand for kroner rises. Danes will demand fewer ringgit with which to buy Malaysian assets now that Danish assets offer a higher rate of return. As a result, Danes supply fewer kroner in the foreign exchange market.
The decrease in the supply of kroner and the increase in the demand for kroner cause the ringgit price of one krone to rise. The value of the Malaysian ringgit (measured by the number of kroner it can purchase) decreases, or depreciates.

## 3. The impossible trinity

Suppose the government of Iraq is deciding what kind of monetary policy and exchange rate regime to choose. The government wants to control the interest rate in the country.
Which of the following policy choices will achieve this goal? Check all that apply.
Points:
0.67 / 1
Close Explanation
Explanation:
The choice of an exchange rate system depends on many variables such as capital mobility. Because capital tends to flow where returns are the highest, the impossible trinity shows how a country can maintain only two of the following three policies at a time:
 • Free capital flows • Independent monetary policy • Fixed exchange rate
To control the interest rate in the country, the Iraqi government must allow the exchange rate to float or impose capital controls (that is, restrictions on foreign exchange trading) or do both. If the Iraqi government pegs the dinar to the U.S. dollar and allows capital mobility, the interest rate in Iraq will follow that in the United States, so the Iraqi government won’t be able to control it.

## 6. Exchange rate crisis

The following graph shows the market for euros in terms of the Thai baht. The market is initially in equilibrium at 1 baht per euro and 30 billion euros traded per day. Suppose the baht falls in value, causing investors to sell their baht-denominated assets and to sell baht for euros in order to buy euro-denominated assets. As a result, the demand for euros shifts to the right, from D0D0 to D1D1.

If Thailand wants to maintain a fixed exchange rate of 1 baht per euro, it shouldsell   euros in the foreign exchange market. To be successful, this policy would have toincrease the supply of   euros by

12

billion euros at any given exchange rate.

Points:
1 / 1
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Explanation:
After the demand for euros shifts to the right from D0D0 to D1D1, the quantity of euros demanded will exceed the quantity of euros supplied at an exchange rate of 1 baht per euro. To keep the exchange rate from increasing, either the supply of euros must increase or the demand for euros must decrease. The Thai government can, therefore, maintain the exchange rate by increasing the supply of euros through selling its euro reserves in a foreign exchange market.
To maintain the exchange rate of 1 baht per euro, the supply curve must shift to the right until it intersects D1D1 at this rate. This requires a €12 billion increase in the supply of euros at every exchange rate.
If investors believe the baht is going to bedevalued   as a result of the change in demand, a speculative attack may occur.
Points:
1 / 1
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Explanation:
A speculative attack occurs when private investors sell one currency and buy another because they believe that the currency they are selling is going to lose value. This is likely to occur if investors believe the central bank of Thailand will be forced to devalue the baht. In this case, investors want to get rid of their baht before a loss of value; thus, they sell baht for euros, increasing euro demand. Even if the central bank is committed to maintaining a fixed exchange rate, it may be unable to do so if it runs out of euro reserves and can no longer prop up the supply of euros.
Thus, if speculators believe that the Thai bank’s euro reserve supply is running low, their decision to sell baht and buy euros will force the central bank of Thailand to supply more and more euros until it runs out of reserves and is forced to devalue the currency.
True or False: In the event of a successful speculative attack, foreign investors tend to suffer because Thai businesses are less able to pay their foreign debts.
Points:
1 / 1
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Explanation:
This statement is true. As a result of a speculative attack that devalues the baht relative to the euro, more baht will be required to purchase euros (and euro-denominated goods or assets). This also means that any debt borrowed from Europeans will also be more expensive to repay. Both local businesses that borrowed euros and foreign investors who acted as lenders are, therefore, hurt by the sudden devaluation, because many local businesses will be driven into bankruptcy.

## 7. Signs of a currency crisis

The following table describes economic conditions in two countries, Etonia and Tukistan.
Complete the table by indicating for each country whether the risk of a currency crisis is high or low.
Country
Condition 1
Condition 2
Risk
Tukistan The stock market and export growth are rising, whereas the unemployment rate is falling. The government finances its budget deficits through taxes and borrowing. Low
Etonia The central bank increasingly finances the budget deficit by creating money. An increase in foreign interest rates causes funds to flow out of Etonia’s currency into a foreign currency. High
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Explanation:
Budget deficits financed by inflation are one source for a currency crisis. Apparently, Etonia’s government cannot easily finance its budget deficits by raising taxes or borrowing. Etonia pressures the central bank to finance the nation by creating money. If the money supply in Etonia increases faster than demand is growing, it may cause rapid inflation. Also, external factors are one of the most important reasons underlying currency crises. For example, an increase in interest rates in major international currencies can trigger a currency crisis if a central bank resists increasing the interest rate it charges. Funds may flow out of the local currency into foreign currency, decreasing the central bank’s reserves to unacceptably low levels, thereby putting pressure on the government to devalue its currency if the currency is pegged. Moreover, a big external shock that disrupts the economy, such as war or a spike in the price of imported oil, can likewise trigger a currency crisis. External shocks have been key features in many currency crises historically. Therefore, Etonia has a high risk of a currency crisis.
In the case of Tukistan, a rising stock market and falling unemployment rates are characteristic of a healthy economy. In addition, because the government revenue is financed by taxes or borrowing, there is no additional pressure on the central bank to create money. Therefore, Tukistan has a low risk of a currency crisis.

## 8. Exchange rate regimes

In Nicaragua, the national currency is adjusted periodically in small amounts, following a simple trend.
Nicaragua’s exchange rate regime is classified ascrawling pegged   . Moreover, the exchange rate regime that best classifies Nicaragua is typical fordeveloping   countries.
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Explanation:
Different patterns of exchange rate behavior are grouped into categories known as exchange rate regimes. The two major categories of exchange rate regimes are fixed (or pegged) regimes and floating (or flexible) regimes. To define the exchange rate regime in a particular country, economists usually refer to the IMF’s De Facto Classification based on actual government policies and exchange rate behavior. This classification distinguishes the following types of exchange rate regimes:
 1 Floating exchange rate: The exchange rate is determined by the market, with government intervention aimed at moderating fluctuations in the exchange rate rather than at establishing a level for it. 2 Managed floating exchange rate: The monetary authority attempts to influence the exchange rate without having a specific exchange rate path or target; indicators for managing the rate are broadly judgmental. 3 Conventional pegged (fixed) exchange rate: The country pegs its currency within margins of ±1% or less against another currency or a basket of currencies formed from the currencies of major trading or financial partners. 4 Crawling pegged exchange rate: The currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators. 5 Pegged within a horizontal band: The value of the currency is maintained within certain margins of fluctuation of more than ±1% around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2%.
Floating exchange rates are typical for advanced economies. Until the industrialized nations adopted managed floating exchange rates in the 1970s, the practice generally was to maintain a pattern of relatively fixed exchange rates among national currencies. The other regimes are more prevalent in developing countries.
Therefore, Nicaragua is best classified as a crawling pegged exchange rate, which is typical for developing countries.