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why do some nations today still fix their exchange rates? The answer is that floating
exchange rates also pose problems.
Chief among these worries is the possibility that freely floating rates might prove
to be highly variable rates, thereby adding an unwanted element of risk to foreign
trade. For example, if the exchange rate is $1.50 to the euro, then a Parisian dress
priced at 400 euros will cost $600. But should the euro appreciate to $1.75, that same
dress would cost $700. An American department store thinking of buying the dress
may need to place its order far in advance and will want to know the cost in dollars. It
may be worried about the possibility that the value of the euro will rise, making the
dress cost more than $600. And such worries might inhibit trade.
“Then it™s agreed. Until the
There are two responses to this concern. First, freely floating rates might prove to
dollar firms up, we let the
be fairly stable in practice. Prices of most ordinary goods and services, for example,
clamshell float.”

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Chapter 18 373
The International Monetary System: Order or Disorder?

are determined by supply and demand in free markets and do not fluctuate unduly.
Unfortunately, experience since 1973 has dashed this hope. Exchange rates have proved
to be extremely volatile, which is why some observers now favor greater fixity in
exchange rates.
A second possibility is that speculators might relieve business firms of exchange rate
risks”for a fee, of course. Consider the department store example. If each euro costs $1.50
today, the department store manager can assure herself of paying exactly $600 for the
dress several months from now by arranging for a speculator to deliver 400 euros to her at
$1.50 per euro on the day she needs them. If the euro appreciates in the interim, the spec-
ulator, not the department store, will take the financial beating. Of course, if the euro
depreciates, the speculator will pocket the profits. Thus, speculators play an important
role in a system of floating exchange rates.
The widespread fears that speculative activity in free markets will lead to wild gyra-
tions in prices, although occasionally valid, are often unfounded. The reason is simple.
To make profits, international currency speculators must buy a currency when its value
is low (thus helping to support the currency by pushing up its demand curve) and sell it
when its value is high (thus holding down the price by adding to the supply curve). This
means that successful speculators must come into the market as buyers when demand is
weak (or when supply is strong) and come in as sellers when demand is strong (or supply
is scant). In doing so, they help limit price fluctuations. Looked at the other way around,
speculators can destabilize prices only if they are systematically willing to lose money.5
Notice the stark”and ironic”contrast to the system of fixed exchange rates in which
speculation often leads to wild “runs” on currencies that are on the verge of devaluation”
as happened in Mexico in 1995, several Southeast Asian countries in 1997“1998, Brazil in
1999, and Argentina in 2001. Speculative activity, which may well be destabilizing under
fixed rates, is more likely to be stabilizing under floating rates.6
We do not mean to imply that speculation makes floating rates trouble-free. At the very
least, speculators will demand a fee for their services”a fee that adds to the costs of trading
across national borders. In addition, speculators will not assume all exchange rate risks. For
example, few contracts on foreign currencies last more than, say, a year or two. Thus, a busi-
ness cannot easily protect itself from exchange rate changes over periods of many years.
Finally, speculative markets can and do get carried away from time to time, moving currency
rates in ways that are difficult to understand, that frustrate the intentions of governments, and
that devastate some people”as happened in Mexico in 1995 and in Southeast Asia in 1997.
Despite all of these problems, international trade has flourished under floating
exchange rates. So perhaps exchange rate risk is not as burdensome as some people think.

The international financial system today is an eclectic blend of fixed and floating exchange
rates, with no grand organizing principle. Indeed, it is so diverse that it is often called a
Some currencies are still pegged in the old Bretton Woods manner. The most prominent
example is probably China, which for years maintained a fixed value for its currency (the
yuan) by standing ready to buy or sell U.S. dollars as necessary. Over the years, the peg-
ging policy required the Chinese to buy dollars steadily and in large volume. So China has
acquired over $1 trillion in foreign currency reserves. Lately, the Chinese authorities seem
to be backing away from their currency peg, albeit in small steps, and the yuan has appre-
ciated relative to the dollar.

See Test Yourself Question 4 at the end of the chapter.

After their respective currency crises in 1995 and 1999, both Mexico and Brazil floated their currencies. Each

weathered the subsequent international financial storms rather nicely. But Argentina, with its fixed exchange
rate, struggled.

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374 The United States in the World Economy

A few small countries, such as Panama and Ecuador, have taken the more extreme step
of actually adopting the U.S. dollar as their domestic currencies. Other nations tie their cur-
rencies to a hypothetical “basket” of several foreign currencies, rather than to just one.
More nations, however, let their exchange rates float, although not always freely. Such
floating rates change slightly on a day-to-day basis, and market forces determine the basic
trends, up or down. But governments do not hesitate to intervene to moderate exchange
movements whenever they feel such actions are appropriate. Typically, interventions are
aimed at ironing out what are deemed to be transitory fluctuations. But sometimes central
banks oppose basic exchange rate trends. For example, the Federal Reserve and other
central banks sold dollars aggressively in 1985 to push the dollar down and then bought
dollars in 1994 and 1995 to push the dollar up. As we will discuss in the next chapter, the
Japanese acquired hundreds of billions of dollars earlier in this decade trying to prevent
the yen from floating up too much. The terms dirty float or managed float have been coined
to describe this mongrel system.

The Role of the IMF
The International Monetary Fund (IMF), which was established at Bretton Woods in 1944,
examines the economies of all its member nations on a regular basis. When a country runs
into serious financial difficulties, it may turn to the Fund for financial assistance. The IMF
typically provides loans, but with many strings attached. For example, if the country has
a large current account deficit”as is normally the case when countries come to the IMF”
the Fund will typically insist on contractionary fiscal and monetary policies to curb the
country™s appetite for imports. Often, this mandate spells recession.
During the 1990s, the IMF found itself at the epicenter of a series of very visible eco-
nomic crises: in Mexico in 1995, in Southeast Asia in 1997, in Russia in 1998, and in Brazil
in 1999. In 2001, Turkey and Argentina ran into trouble and appealed to the IMF for help.
Although each case was different, they shared some common elements.
Most of these crises were precipitated by the collapse of a fixed exchange rate pegged
to the U.S. dollar. In each case, the currency plummeted, with ruinous consequences.
Questions were raised about the country™s ability to pay its bills. In each case, the IMF
arrived on the scene with lots of money and lots of advice, determined to stave off default.
In the end, each country suffered through a severe recession”or worse.
The IMF™s increased visibility naturally brought it increased criticism. Some critics com-
plained that the Fund set excessively strict conditions on its client states, requiring them, for
example, to cut their government budgets and raise interest rates during recessions”which
made bad economic situations even worse.
Other critics worried that the Fund was serving as a bill collector for banks and other
financial institutions from the United States and other rich countries. Because the banks
loaned money irresponsibly, these critics argued, they deserved to lose some of it. By
bailing them out of their losses, the IMF simply encouraged more reckless behavior in
the future.
Numerous suggestions for reform were offered, and some minor changes in the IMF™s
policies and procedures were made. While the debate over IMF reform rages on to this
day, it is mostly behind the scenes. The reason is simple. As the world economy improved,
and the nations that formerly needed IMF help no longer required it, the Fund™s list of
client states diminished and so did the prominence of the IMF. Whether this placid situa-
tion will continue is anyone™s guess.

The Volatile Dollar
As mentioned earlier, floating exchange rates have proven to be volatile exchange rates.
No currency illustrates this point better than the U.S. dollar (see Figure 7). As Table 1
showed, in July 1980 a U.S. dollar bought less than 2 German marks, about 4 French
francs, and about 830 Italian lire. Then it started rising like a rocket (see Figure 7). By the
time it peaked in February 1985, the mighty dollar could buy more than 3 German marks,

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Chapter 18 375
The International Monetary System: Order or Disorder?

F I GU R E 7
140 The Ups and Downs
of the Dollar
Exchange Rate


SOURCE: Federal Reserve System.


1974 1978 1982 1986 1990 1994 1998 2002 2006

NOTE: Exchange rate relative to major currencies, March 1973 5 100.

about 10 French francs, and more than 2,000 Italian lire. Such major currency changes
affect world trade dramatically.
The rising dollar was a blessing to Americans who traveled abroad or who bought
foreign goods”because foreign prices, when translated to dollars by the exchange
rate, looked cheap to Americans.7 But the arithmetic worked just the other way around
for U.S. firms seeking to sell their goods abroad; foreign buyers found everything
American very expensive.8 It was no surprise, therefore, that as the dollar climbed our
exports fell, our imports rose, and many of our leading manufacturing industries were
decimated by foreign competition. An expensive currency, Americans came to learn,
is a mixed blessing.
From early 1985 until early 1988, the value of the dollar fell even faster than it had
risen. The cheaper dollar curbed American appetites for imports and alleviated the
plight of our export industries, many of which boomed. However, rising prices for im-
ported goods and foreign vacations were a source of consternation to many American
Over the following seven years, the overall value of the dollar did not change very
much”although there was a small downward drift. Then, in the spring of 1995, the
dollar began another sizable ascent which lasted until early 2002. After that, as we
noted earlier in this chapter, the dollar fell for about two years and then was pretty
stable until 2007“2008, when it tumbled again. All in all, the behavior of the dollar has
been anything but boring. Fortunes have been made and lost speculating on what it
will do next.

The Birth and Adolescence of the Euro
As noted earlier, floating exchange rates are no panacea. One particular problem con-
fronted the members of the European Union (EU). As part of their long-range goal to
create a unified market like that of the United States, they perceived a need to establish a
single currency for all member countries”a monetary union.
The process of convergence to a single currency took place in steps, more or less as
prescribed by the Treaty of Maastricht (1992), over a period of years. Member nations en-
countered a number of obstacles along the way. But to the surprise of many skeptics, all
such obstacles were overcome, and the euro became a reality on schedule. Electronic and
checking transactions in 11 EU nations were denominated in euros rather than in national
currencies in 1999, euro coins and paper money were introduced successfully in 2002, and

Exercise: How much does a 100-euro hotel room in Paris cost in dollars when the euro is worth $1.25? $1?

80 cents?
Exercise: How much does a $55 American camera cost a German consumer when the euro is worth $1.20? $1?

80 cents?

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376 The United States in the World Economy

the number of participating countries has since risen in stages to 15. All of these transfor-
mations went remarkably smoothly.
That said, the euro did not spring into life as a fully grown adult. In its earlier years,
there were still plenty of doubters. And perhaps for that reason, the new European
currency, which made its debut at $1.18 in January 1999, fell to a low point of $0.83 in
October 2000”a stunning 30 percent decline in less than two years. Since then, however,
the euro has mostly been climbing in value relative to the dollar, reaching about $1.57 in
April 2008.
The establishment of the euro was a great economic experiment that marked a giant
step beyond merely fixing exchange rates. A government can end a fixed exchange rate
regime at any time. And, as we have seen, speculators sometimes break fixed exchange
rates even when governments want to maintain them. But the single European currency
was created by an international treaty and is more or less invulnerable to speculative at-
tack because it abolished exchange rates among the participating nations. Just as there has
long been no exchange rate between New York and New Jersey, now there is no exchange
rate between Germany and France. Monetary unions may create other problems, but ex-
change rate instability should not be one of them.



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