INTERNATIONAL FINANCE:

Dr. Uwe Walz

Topic 5:

International Parity Conditions

A short appendix:
fixed versus flexible exchange rates

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 Fixed vs flexible exchange rates

Fixed versus flexible exchange rates

Background:
our discussion on parity conditions was mainly taking
place against the background of flexible exchange

In a fixed exchange rate system exchange rates do not

move (by definition ...)

But central banks/governments have to obey the same

economic rules as carved out with the parity conditions

Hence, it makes sense do have a short discussion of this

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 Fixed vs flexible exchange rates

Fixed versus flexible exchange rates

a) Historical overview

b) Contemporary currency regimes (in more detail)

c) Pros and Cons of fixed/flexible exchange rate

d) Some currency crisis

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 Fixed vs flexible exchange rates

A) (Brief) History
The Gold-Standard, 1876-1913
currencies were pegged to gold
each currency was convertible into gold at a fixed rate
=> exchange rates were defined via the cross rate
(USD20.67/ounce and BPound4.27/ounce => USD
4.8665/Bpound)
advantage: very stable, fixed exchange rates;
automatic equilibrating forces
disadvantage: highly inflexible, limitation to money
growth; no responses to adverse economic shocks,
requires price flexibility
revival of gold-standard: a substantial number of
politicians and economists want to go back to this

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 Fixed vs flexible exchange rates

1914-1944:

Rather flexible exchange rates, relative to

gold and other currency

led to excessive destabilizing speculation

convertibility was reduced in the Great

Depression and in World War II

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 Fixed vs flexible exchange rates

Bretton Woods and the IMF (1945-1973)

Emerged from the lessons of the previous period

Basically fixed exchange rates, with some flexibility

(adjustable pegs)

Coordinated by an international monetary agency

The task of this agency was: to help countries in cases

of short-term balance of payments problems (!)

Central currency: US Dollar (asymmetric design of the

system)

oil crisis and Vietnamese war led to a break-down of

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 Fixed vs flexible exchange rates

Towards flexible exchange rates; 1973-present

After 1973 exchange were allowed to float

exchange rates became more and more

volatile

two movements in opposite directions

in more and more parts of the world exchange
rates became more and more flexible
especially in Europe: movements towards less
flexible exchange rates (common currency)

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 Fixed vs flexible exchange rates

b) Contemporary currency regimes

Two basic regimes (defining the extremes):

Fixed exchange rates (a currency board (Hongkong, Argentina))
Flexible exchange rates
Main difference between the two:
with flexible exchange rates, exchange rate is determined
purely by supply and demand forces
with fixed exchange rates, central bank has the obligation to
buy or sell at fixed rate (R becomes positive or negative)

e Central bank intervention

Fixed rate supply

demand

Foreign currency 8
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 Fixed vs flexible exchange rates

In addition, a number of hybrid systems exist

dirty float (flexible system + eventual interventions)

crawling peg (automatic revisions)

target zones (EMS in the 1990s)

cooperative interventions

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 Fixed vs flexible exchange rates

c) Pros and Cons of flexible exchange rates

Main Arguments in favor of flexible exchange

rates

better and faster adjustment

avoids too overvalued currency => currency

crisis; or competitive devaluations

Avoiding the Peso-problem

higher indepence of (monetary) policy

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 Fixed vs flexible exchange rates

Main Arguments against flexible exchange rates

flexible rates cause uncertainty and reduce

international investment and trade (highly
debatable: which regime is in essence more
volatile, ways to solve the problem via future
markets)

Destabilizing speculation

Flexible rates allow for more inflation

(empirically doubtful)

Dutch disease 11
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 Fixed vs flexible exchange rates

d) Some rather recent currency crisis: in particular

the 1990s

EMS crisis (1992)

Peso crisis (1994) => tequila effect
Yen peak (08/1995)
Asian crisis (2nd half 1997) => contagion
Russian crisis (August 1998) => contagion
Launch of Euro: January 1999
Brazilian crisis (January 1999)
Argentinian crisis (2002): no contagion

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