EXCHANGE RATES

Exchange Rates

Implications for an economy of a rising exchange rate

Introduction

Globalization has been influenced by economic factors (trade, foreign direct investment, capital flows, and migration); by the spread of technology; and by increasing transnational circulation of ideas, languages, and popular culture. Trade links have long forged stronger connections between many societies and regions. Extensive trade hastened the decline of feudal society; the European economy shifted from a system primarily based on the exchange of goods and products (barter) to one primarily based on the exchange of currency.

With Britain a global economic superpower during the 19th century because of its superior manufacturing technology and naval power, its leadership also provided a number of measures that influenced the international economy during the 20th century and beyond. Britain, as the largest creditor, promoted financial stability through its pound sterling and the gold standard, which made multilateral convertibility and adjustment easier to achieve. Choosing not to further accumulate gold stocks, Britain encouraged further economic activity by making the surpluses available for additional investments and loans, thus making the international economy function more smoothly than otherwise would have been the case if Britain had taken a more protectionist stance.

Exchange Rate

Exchange rates play a major role in international trade but also affect the domestic economy. Governments and central banks look so sharp on the operation of the currency markets, the market where exchange rates are established. Talking about what exchange rate is, it is the price of one currency expressed in terms of another currency.

Exchange Rate Regimes and Regime Choice

Over the past 150 years, the world has seen two extended intervals when countries followed fixed exchange rate policies. The first of these was known as the gold standard; it prevailed from about 1870 to the start of World War I in 1914 and then was revived for a few years in the late 1920s. Individual countries set fixed prices of gold in terms of their currencies and then took actions to maintain those prices. Because all of the currencies in the system were fixed to gold, they were also fixed to each other. Virtually every major country and many of the then developing countries in the world participated in this system, so that fixed exchange rates prevailed worldwide.

The second period of fixed exchange rates was known as the Bretton Woods system. The Bretton Woods era lasted from 1946 to early 1973. This system was administered in part by the International Monetary Fund (IMF). IMF member countries declared par values for the dollar in terms of their currencies and took steps to maintain those values. In the process, each country's currency was linked to all others in the system.

In both cases, the worldwide system of fixed rates collapsed as individual countries came under pressure to change their exchange rates. Depending on the country and the era, fixed exchange rate policies were replaced by a variety of alternative policies, including floating rates or managed floats. Some countries have continued to fix the value of their currency in ...