The modern economy is highly globalized. Goods, services, and capital can flow between countries in a highly efficient manner. The price of a country’s currency relative to other currencies greatly affects that country’s economy.
The currencies of most industrial economies trade freely against one another. The foreign exchange market is the market where currencies are bought and sold. This market is integral to the functioning of a modern economy.
The foreign exchange market is the largest and most liquid trading market in the world, with trading dominated by large financial institutions and central banks. The two basic types of foreign exchange transactions are spot transactions and forward transactions. Spot transactions are trades in which currencies are exchanged immediately. Forward transactions are agreements to exchange currencies at a specified rate at a future date.
Basic Foreign Exchange Concepts
A currency’s exchange rate refers to the amount of that currency needed for conversion into a single unit of another currency. For example, we may see that the exchange rate between the euro (the common European currency) and the U.S. dollar is 1.34, meaning that 1.34 dollars will “purchase” one euro.
Currency quotes are generally made two ways: currency A per unit of currency B, and currency B per unit of currency A. So, a quote of 1.34 dollars to the euro is also 1 / 1.34 = .75 euros to the dollar.
When a currency exchange rate changes such that fewer units of that currency are needed to purchase another currency, the first currency is said to have appreciated relative to the second currency. Likewise, the second currency is said to have depreciated relative to the first currency, in that more units of the second currency are needed to purchase one unit of the first currency. The concepts of appreciation and depreciation are related: for every change in the exchange rate, one currency appreciates and the other depreciates. In the above example, if the dollar-euro rate changed from 1.34 dollars per euro to 1.20 dollars per euro (.83 euros per dollar), we would say the dollar appreciated relative to the euro, or conversely, that the euro depreciated relative to the dollar. Compared to the previous exchange rate, the new exchange rate requires fewer dollars to purchase one euro and more euros to purchase one dollar.
To calculate the amount of appreciation or depreciation of a currency in terms of one-unit of another currency, we use the following formula:
(New price of currency A – Old price of currency A) / Old price of currency A
In the above example, we say that the euro depreciated against the dollar by approximately 10.5% [(1.2 – 1.34) / 1.34]. Conversely, we say that the dollar appreciated against the euro by approximately 10.5% [(.83 – .75) / .75)] (any differences are due to rounding).
Exchange rates impact domestic prices relative to foreign prices. The price of a foreign good is a function of (a) the price of the good in the foreign currency and (b) the exchange rate between the foreign currency and the domestic currency. So, the exchange rate will influence demand for imported goods versus domestic goods. As an example, suppose that a consumer in the U.S. wants to buy an Italian sports car. Since the car must be imported, the price to the consumer will reflect the euro-dollar exchange rate. Suppose the car lists for 166,667 euros when the euro-dollar rate is 1.2 dollars per euro. Thus, the price in dollars is 1.2 x 166,667 = 200,000 dollars.
If the euro appreciated against the dollar so that the exchange rate was 1.3 dollar per euro, the same 166,667 euro car would cost the American buyer 216,667 dollars (1.3 x 166,667). The euro’s appreciation has increased the price to the American buyer by 16,667 dollars. Likewise, if the euro depreciated against the dollar so the exchange rate was 1.10 dollars per euro, the car would cost the American buyer 183,334 dollars (1.10 x 166,667). The euro’s depreciation lowered the relative price of the car by 16,667 dollars. Conversely, the appreciation of the euro would make American goods relatively cheaper in Europe.
To generalize the observations in the above example, depreciation in country A’s currency is good for country A’s exports, while making imports more expensive. Conversely, appreciation in country A’s currency is bad for exports, but makes imports less expensive.
Basic Determinants of Exchange Rates
An exchange rate represents the price of one currency relative to another. When exchange rates are free to float, the exchange rate is subject to the same forces of supply and demand as any other commodity.
Over the last several decades, the world has seen a drastic increase in capital mobility. Central banks and global financial institutions can quickly purchase short-term securities in whatever country offers the highest real (inflation-adjusted) interest rates. Thus, real short-term interest rates are a crucial factor driving short-term currency demand. However, these capital flows can be potentially destabilizing, as short-term capital can flow out of a country just as easily as it can flow in. In a world of high capital mobility, a country which attracts short-term capital through higher rates can easily face a run on its currency.
Another important concept for understanding exchange rates is the law of one price. This concept states that the foreign price of a good should equal the exchange-rate adjusted price of that good in the domestic country. One variant of the law of one price is the purchasing power parity (PPP) model, which recognizes that exchange rates should be such that purchasing power is roughly equal among countries. One interesting and widely reported variant of PPP is the Big Mac Index. This index, created The Economist magazine, tracks the price of the McDonald’s Big Mac across countries.
The PPP model has several shortcomings, however. First, PPP only applies to goods, not services. Second, PPP only applies to similar goods. When goods differ in quality, prestige, etc., their prices will differ, rendering PPP a less useful measure for dissimilar goods. Finally, PPP assumes that goods can move across countries with little or no transactions costs, which is often an unrealistic assumption.
Despite its shortcomings, many economists and currency traders view the PPP as an imprecise, but useful measure of long-run exchange rates.
Another source of demand for a country’s currency is its level of foreign direct investment. Foreign direct investment refers to a foreign entity’s direct purchases of businesses or assets in another country. For example, a Japanese car company building a manufacturing plant in the U.S. represents foreign direct investment in the U.S. Foreign direct investment represents a much more stable form of currency flows than demand based on short-term interest rates.
Overview of Exchange Rate and Monetary Regimes
Economic historians refer to the period from the late 1800’s to 1914 as the “classical gold standard” period. During these years, most major countries fixed the price of their currencies relative to gold. In the U.S., for example, the dollar was fixed at a rate of 20.67 dollars per ounce of gold.
The classical gold standard functioned as a fixed-exchange rate mechanism in that the exchange rates equaled the per-ounce price of one currency relative to the per-ounce price of another currency. During this period, for example, the U.S. dollar – British pound exchange rate was 4.867 dollars per British pound, a ratio which reflected each country’s currency price of gold.
The gold standard also had an imbedded mechanism for adjusting a country’s balance of payments. The balance of payments is an accounting identity which captures the relationship between a country’s net flow of capital and its net flow of trade payments and financial transactions. The balance of payments has three components: the current account, the capital account, and the financial account. The current account measures payments and receipts from foreign trade, plus net foreign income and direct transfers. The capital account and the financial account measure flows of financial capital and investments, respectively. Adjusting for statistical discrepancies (mostly due to the various sources used to measure the individual components) the balance of payments must balance.
When a country imports more goods and services than it exports, the country has a trade deficit. Conversely, a country which exports more than it imports has a trade surplus. The gold standard had an embedded mechanism for bringing trade into equilibrium. The mechanism was referred to as the price-specie flow mechanism. A country in deficit would see an outflow of gold to the surplus country. The gold inflow to the surplus country would increase the money supply, causing an increase in prices. Likewise, the gold outflow from the deficit country would decrease the money supply, causing a decrease in prices. Thus, the flow of gold would change the relative prices between the countries and restore the trade balance.
The outbreak of World War I caused countries to suspend gold convertibility, thus ending the international gold standard. The war also had important implications for the global balance of power. By the end of the war, the U.S. was a major creditor nation and held the largest stock of monetary gold.
After the war, countries began to slowly restore gold convertibility. France was the last of the major countries to restore the gold standard, doing so in 1926. But the international gold standard proved short-lived. Britain was insistent on restoring convertibility at pre-war rates and had to implement harsh deflationary measures to bring down prices. The global depression of the early 1930’s led many countries to suspend gold convertibility. By 1932, France and the U.S. were the only major economies committed to the gold standard. Protecting gold stocks required a country to engage in tight monetary and fiscal policies, which is the opposite of what a country should do to combat a weak economy.
In April of 1933, President Franklin D. Roosevelt issued Executive Order 6102 requiring American citizens to turn their gold holdings in to the Federal government. This action not only prohibited Americans from owning physical gold (with a few exceptions) but also ended the gold standard in the U.S. This action also put monetary policy in the hands of the President and the U.S. Treasury.
During the depression, countries sought to boost exports by engaging in competitive currency devaluation and enacting trade tariffs. By the end of the war, many nations believed that these actions had both exacerbated the depression and furthered wartime resentments.
To avoid destructive trade policies and to further post-war cooperation, representatives from the U.S. and Great Britain engaged in discussions to create a new global monetary system. These discussions culminated in a conference of delegates from forty-four countries held at the Mount Washington hotel in Bretton Woods, New Hampshire in July 1944. The agreement finalized at the conference became known as the Bretton Woods system.
The Bretton Woods system was an arrangement of fixed exchange rates in which global currencies were pegged to the U.S. dollar. The U.S. dollar was, in turn, anchored to gold. Foreign governments and central banks could convert their U.S. dollar holdings into gold at 35 dollars per ounce. The role of the U.S. dollar as the world’s reserve currency reflected the U.S. position as the world’s strongest economy. The U.S. also possessed the world’s largest stock of monetary gold, much of which was accumulated during the war as the European Allies purchased war materials and borrowed funds from the U.S.
The Bretton Woods system also established the World Bank and the International Monetary Fund (IMF). The IMF was established primarily to help stabilize exchange rates by lending to countries with balance of payment deficits, while the World Bank would provide funding to developing nations.
The post-war recovery of the European and Japanese economies and increased trade between those countries and the U.S. led to large foreign-held dollar reserves. These dollar reserves represented claims on the U.S. gold stock, and the increase in dollar reserves strained the ability of the U.S. to support convertibility of $35 per ounce. As early as October 1960, oversees private gold markets were quoting gold at $40 per ounce, implying that the U.S. dollar was overvalued.
By the mid 1960’s, U.S. monetary and fiscal policy was conducted in a manner counter to the needs of maintaining convertibility. Many countries began to doubt the U.S. commitment to gold convertibility. Foreign dollar reserves, mostly accumulated from the U.S. trade deficit, had exceeded the value of U.S. gold stocks.
In 1961, several governments agreed to form a “gold pool” to buy and sell gold as needed to support the 35 dollar per ounce conversion rate. In 1968 the gold pool was dismantled, thus creating an unimpeded market for gold alongside the dollar-reserve market of 35 dollars per ounce. This two-tiered market created a further problem for the Bretton Woods arrangement, as foreign central banks could earn generous profits by converting their dollar reserves into gold at the official conversion rate and then selling their gold at the higher private-market rate. In addition, U.S. economic policy had eroded confidence in the dollar, further encouraging dollar-to-gold conversion and depleting U.S. gold stocks. On August 15, 1971, President Richard Nixon announced that the U.S. would suspend convertibility.
In December of 1971, officials from the world’s leading industrial economies met at the Smithsonian Institution in Washington, D.C. The purpose of this meeting was to restore the system of fixed exchange rates which collapsed after the U.S. suspended gold convertibility earlier in the year. During the meeting, the U.S. agreed to devaluation of the dollar but did not reinstate gold convertibility. The system instead relied on the intervention of central banks to support exchange rate bands. The Smithsonian Agreement, however, proved unsustainable. By early 1973, major currencies began to freely float their currencies against the dollar.
Even before the collapse of Bretton Woods, European countries began taking steps towards the creation of a monetary union. This process began with a post-Bretton Woods arrangement of exchange rate banks known as the “Snake.” The Snake was dissolved in 1977 and was replaced in 1979 with a more formal regional exchange rate regime known as the European Exchange Rate Mechanism (ERM). The German mark served as the anchor to this system. Various European countries pegged their currencies to the mark and agreed to maintain the exchange rates within a narrow range.
Great Britain was a late entrant to the ERM, having joined in 1990. Britain’s involvement in the ERM, however, was short-lived. The unification of East and West Germany had led to levels of inflation which the austere Germans found unacceptable. To combat rising inflation, the German central bank (the Bundesbank) tightened credit through higher interest rates, an action which strengthened the German mark. The British were faced with a difficult choice. To avoid a decline in their exchange rate (with the Mark) to below acceptable levels in the ERM, the Bank of England would have to raise interest rates to attract capital. However, Britain was facing a weak economy and was in no position to accept tighter credit conditions.
Currency speculators sensed the need for a currency devaluation and began to aggressively sell British pounds. The British government, under the leadership of Prime Minister John Major, fought to defend the pound. The Bank of England went as far as to announce two rate increases in a single day. However, these efforts were not enough, and the British were forced to leave the ERM with other countries soon following.
The Euro
Throughout the 1970’s and 1980’s, the countries of Europe continued towards monetary union. The culmination of these efforts was the Maastricht Treaty of 1991. This treaty provided a timetable for the integration of a single currency. The treaty also stated that certain conditions regarding a country’s public finances (particularly concerning deficits and national debt levels) must be met as a condition of entry into the monetary union. However, these conditions were greatly relaxed prior to the final draft.
By 2002, countries had replaced their currencies with a new single currency, the euro. In addition, all member countries were subject to a single monetary policy conducted by the newly established European Central Bank (ECB). This single monetary policy has raised problems for the Eurozone. Each member country retained political sovereignty, and thus independent fiscal policies. As economic historical Barry Eichengreen has stated, “Slow growing economies like Italy, which completed head-to-head with China in the production of specialty goods, would have preferred a looser ECB policy and weaker euro exchange rate. Fast-growing economies like Ireland, whose English-speaking population and hospitable foreign-investment climate enabled it to make the most of the high-tech boom, experienced rapid increases in property and other asset prices; they would have preferred a tighter ECB policy to cool down their overheated economies.”
The problem with a one-size-fits-all monetary policy was revealed when the global financial crisis exposed and exacerbated the fiscal problems of certain euro member countries. As these countries teetered on the brink of default, the European Union (EU) was forced to put together large rescue packages. For the more austere countries in the EU (such as Germany) who were forced to subsidize the high-deficit countries, the rescue packages were as unpopular as bank bailouts had been in the U.S. In addition, austerity measures forced on the high-deficit countries as conditions of the rescue packages were proving highly unpopular in these countries. The entire EU was facing waves of anti-EU populism, creating a great deal of political uncertainty around the future of the euro. Given the amount of euro-dominated debt held by financial institutions and global central banks, a collapse of the EU would have triggered an international financial crisis easily rivaling the 2008 crisis.
Economic recovery in Europe and highly accommodative monetary policy had greatly lessened the risks of a collapse of Europe’s single currency. However, the underlying conflict of a single monetary policy and independent fiscal policies remain. The future of the euro is still highly uncertain.
Conclusion
From the “classical gold standard” to a system of (mostly) free floating rate, the international monetary system has substantially evolved over the course of the twentieth century.
One vestige of the Bretton Woods system is the U.S. dollar’s role as the world’s reserve currency. Thus, the dollar remains the most widely used currency in international transactions and the currency most widely held by foreign central banks. The international role of the dollar has given the U.S. certain privileges. Most notably, large foreign dollar reserves have allowed the U.S. Treasury to finance its debts at rates lower than would prevail if the dollar did not have this status. U.S. asset markets have also seen higher prices due to foreign demand.
The future of the dollar’s role as the world’s reserve currency is uncertain. Large and persistent fiscal and current account deficits threaten the attractiveness of the U.S. dollar. China’s rise as an economic superpower is also a continuous threat to the dollar’s predominance.
Sources:
Eichengreen, Barry. Globalizing Capital: A History of the International Monetary System, 2nd ed. Princeton: Princeton University Press, 2008.
Kwarteng, Kwasi. War and Gold: A 500-Year History of Empires, Adventures, and Debt. New York: PublicAffairs, 2014.
Lerdbetter, James. One Nation Under Gold: How One Precious Metal Had Dominated the American Imagination for Four Centuries. New York: Liveright, 2017.
Walton, Gary M, and Hugh Rockoff. History of the American Economy, 12th ed. Mason: South-Western, 2014.
