The Rise and Evotution of

Exchange Rate Mechanism

PPT Presented By Pr: H . Melhaoui
 Defining an Exchange Rate
.The price of a nation’s currency in terms of
another currency.
-- An exchange rate thus has two components,
the domestic currency and a foreign currency.
For example our domestic currency is the
Moroccan Dirham and the Foreign Currency can
be United States Dollars (USD) or Euros (EUR)
just to name a few.
 Types of Exchange Rates

We will be exploring three types of

Exchange Rates which are:
1. Fixed Exchange Rate
2. Floating/Flexible Exchange Rate
3. Managed Floating ER
 Historical background of Fixed
Exchange Rate
• - The Bretton Woods agreements of 1944 established
fixed exchange rates defined in terms of gold and the
US dollar.
• -Between 1944 & 1971,many world
currencies were pegged against the US dollar
• - Parities with the Dollar were fixed and the US
dollar was a promissory note issued by the
United States treasury.
 Fixed ER Mechanism & The role of
International Monetary Fund
Under the fixed E R system, the US treasury had to exchange
a 1 dollar banknote for ounce of gold.

• Consequences=

• -Under this system, overvalued or undervalued currencies

could only be adjusted with the intervention of the
International Monetary Fund (IMF)
• -The IMF proceeded to currencies devaluations or
revaluations in case the rate diverged from the deviation
at + or – 2,25;
 Fixed Exchanged Rates

This is where a Government maintains agiven

exchange rate over a period of time.
This could be for a few months or even years.
In order to maintain the exchange rate at the
stated level government uses fiscal and
monetary policies to control aggregate
demand.
Determination of Fixed Exchange Rate
In a fixed exchange rate system the XR is set by
the government or central bank at a particular
rate.

The forces of supply and demand do not

determine the rate. The central bank holds
reserves of US dollars and intervenes in order to
keep the exchange rate pegged at that level
known as the Official Rate.
 Advantages of Fixed Exchange Rate
1. Reduce the risk and uncertainty of trade and
promoting foreign direct investment (FDI) is reduced
thus making business and investment planning possible.

2. Reduced Currency Speculation.

3. Creates a stability in knowing the

exchange rate
Disadvantages of Fixed Exchange Rate
1. Protecting the exchange rate requires
domestic economic policies to be frequently
adjusted. Monetary policy focuses on
keeping the rate stable.
2. Reserves are needed to protect the value.
3. An improvement in an economy’s
competiveness that results in lower prices will
not be fully passed on to export customers if the
exchange rate remains unchanged.
4. Exchange rate may be undervalued or
overvalued.
 A floating exchange rate regime is
where the rate of exchange is
determined purely by the demand and
supply of that currency on the foreign
exchange market.
Historical Background of the Floating
Exchange Rate
• Gold convertibility and pegging against the
dollar was abandoned in 1971, because
following inflation,the American federal
reserve did not have enough gold to
guarantee the American currency.
• That explains how international community
and the USA moved (evolved) towards
floating Exchange Rates .
The value of a currency is allowed to bedetermined by the forces of
supply and demand on the foreign exchange market without any
intervention of the Government.
-Theoretically in the absence of speculation exchange rates
should reflect purchasing power parity that is the cost of a given
selection of goods and services in different countries.
--Proponents of floating ER such as Milton Friedman, argued that
currencies would automatically establish stable exchange rates
that reflect economic realities more precisely than calculations bu
central bank officials
Any change in supply or demand for acurrency
will cause a depreciation or appreciation in
the exchange rate.
An increase in demand for the local currency
causes it to appreciate or rise.
However, if there is a greater demand for the
foreign currency the value of the local currency
falls or depreciates to the foreign currency.
An appreciation means an increase in the value of
a currency. It means a currency is worth more in
terms of foreign currency.
A rise or appreciation in the economy in the
country’s currency will mean that the price of
imports into the country will fall and the price of
the country’s exports will rise.
This is represented by a shift in the supply curve
to the left.
 This could be caused by:
1. A decrease in the number of foreign goods
and services imported into the economy.
2. A decrease in the number of the
economy’s investors who want to place their
funds in foreign economies.
 Lower inflation
An appreciation of currency tends to cause lower
inflation because:

1. import prices are cheaper. The cost of imported goods

and raw materials will fall after an appreciation, e.g.
imported oil will decrease, leading to cheaper petrol
prices.
2. Lower AD leads to lower demand pull inflation.
3. With export prices being more expensive
manufacturers will have greater incentives to cut
costs to try and remain competitive.
A depreciation means a decrease in the value of a
currency. It means a currency is worth less in
terms of a foreign currency.
A fall or depreciation in the value of the exchange
rate will mean the opposite, that is the price of
imports into the country will
rise and the price of the country’s export will
fall.
 This could be caused by:
1. A reduction in the number of the
economy’s goods and services sold
abroad.
2. A reduction in the number of international
investors who wish to place their funds in the
economy.
1. Exports cheaper. A devaluation of the
exchange rate will make exports more
competitive and appear cheaper to foreigners.
This will increase demand for exports
2. Imports more expensive. A devaluation
means imports will become more expensive.
This will reduce demand for imports.
3. Increased AD. Devaluation could cause higher
economic growth. Therefore higher exports and
lower imports should increase AD (agregate
demand). Higher agregate demand is likely to cause
higher real GDP(gross domestic product) and
inflation.
4. Inflation is likely to occur because:
Imports are more expensive causing cost push
inflation.
AD is increasing causing demand pull
inflation
With exports becoming cheaper manufacturers
may have less incentive to cut costs and become
more efficient.
Therefore over time, costs may increase.
5. Improvement in the current account. With exports
more competitive and imports more expensive, we
should see higher exports and lower imports, which
will reduce the current account deficit.
They are market determined and so more
efficient
- No need for reserves to intervene
- Exchange rate would reflect its true value
-Absorbs economic shocks
- Better freedom of government to pursue
internal policies
- Automatic BOP adjustment a less
likelihood of a BOP crisis
- large depreciation may occur
- Instability of exchange has a negative impact
on domestic economy
- Terms of trade may decline with fall in
exchange rate
- Uncertainty of currency
- Speculation of currency
- Reduced investment as this would be too risky
The Fixed exchange rate is the rate which is
officially fixed in terms of gold or any other
currency by the government. It does not change
with change in demand and supply of foreign
currency.
As against it, flexible exchange rate is the rate
which, like price of a commodity, is determined by
forces of demand and supply in the foreign
exchange market. It changes according to change
in demand and supply of foreign currency. There is
no government intervention.
 This is where the currency is broadly
managed by the forces of demand and
supply but the government takes action
to influence the rate of change in the
exchange rate.
The Central Bank seeks to stabilize the exchange
rate within a predetermined range for a given
period of time, but DOES NOT FIX IT at any
particular level. This allows for policy makers
the benefit of planning with some degree of
certainty, for the macroeconomic affairs of a
country.
Central bank intervenes to smoothen out ups and
downs in the exchange rate of home currency to
its own advantage.
 How did we move to a managed
floating Exchange Rate?
• Speculation& financial deregulation:
• In the late 1970s and early 80s the American,British and other governments deregulated
their financial systems and abolished all exchange controls .

• What is financial deregulation?

• It is the process of removing government rules controlling the way that banks& other
financial oeganizations operate.

• What are exchange controls?

• They refer to government-imposed limitations on the purchase and/or sale of currencies.
These controls allow countries to better stabilize their economies by limiting in-flows and
out-flows of currencies which can create exchange rate volatility.

• Financial deregulation has led to the situation in which 95% of world currency transactions
were unrelated to transactions in goods but were purely speculative.

• Speculation is identified by the fact that enormous amounts of money move round the world
chasing high interest rates or capital gains as all investors(individuals,companies and pension
funds seek to maximize the value of their assets including banks that make profits from the
spread between a currency’s buying and selling prices.
 Government intervention in ERM
• Few governments leave exchange rates at the
mercy of market forces . Most of them
Attempt to influence the level of their
currency when necessary.( central banks
buying or selling in order to increase or
decrease the value of their currency)
The managed float attempts to combine the
advantages of both the fixed and flexible
exchange rate systems, depending on the degree
of instability.
The less instability, the less intervention is
necessary by central banks and they can pursue
quasi-independent domestic monetary policies
to stabilize their own economies.
The greater the instability, the more
intervention is necessary by central banks
and the less free they are to pursue
independent domestic monetary policies
because they are frequently required to use
their money supplies to calm disturbances in
the foreign exchange markets.
The big problem with a managed floating
exchange rate comes in determining the timing
and magnitude of the instability and the
necessary intervention. Does a one day drop
(rise) in a currency warrant intervention? A
week? A month? A year? Five years? Is a 1%
drop (rise) in a currency's exchange rate
destabilizing?
A 2% change? A 5% change? A 10%
change?
If the central banks are too quick to
respond or if the amount of
intervention is inappropriate, their
actions may be further destabilizing.
This increased instability has a
tendency to dampen international
flows and contract world trade. If they
wait too long, permanent damage may
be done to some countries' trade and
investment balances.
 Changes in the exchange rate will cause an
Appreciation or Depreciation in the local
currency as explained earlier.
If the currency is devalued then:
1. The price effect – goods become cheaper and
imports become more expensive. The devaluation
worsens the BOP.( balance of payments)
2. the volume effect – cheaper exports mean that
more will be sold and less imports will be bought
thus improving the BOP.
 The devaluation worsens thecurrent
account balance initially, and then it
improves. Reasons being:
❖ Time lag in consumer response – people
may still want the expensive good.
Consumers may be concerned about the
quality and quantity of the local good and
may continue buying the foreign goods in
the short-run.
❖ Time lag in producer response – producers
may take a long time to adapt to say
changing their plant size to accommodate
the increase in demand.
The End
Thank you
for your
attention