Foreign Exchange
Senior 6 · Economics
Foreign Exchange
Lesson 2 of 4
25 min
For most of modern history, exchange rates were not set by markets but tied to gold or to another currency. Rwanda's franc itself had official, announced rates until 1995. The timeline shows the main systems.
Definition
Gold standard: a system in which each country defines its currency as a fixed weight of gold and will exchange notes for gold at that price. Gold moves freely between countries.
Mint parity: the exchange rate between two gold-standard currencies, found by dividing their gold contents.
Worked example 1: mint parity before 1914
The British pound was defined as 113.0016 grains of pure gold and the US dollar as 23.22 grains. So one pound was worth
If the market rate moved far from $4.87, it became profitable to ship gold instead of buying currency, so the rate stayed within narrow limits (the "gold points", set by the cost of shipping and insuring gold).
A country with a trade deficit paid for it by sending gold abroad. Its money supply, backed by gold, shrank, so its prices fell; the surplus country gained gold, and its prices rose. The deficit country's goods became cheaper and the surplus country's dearer, so the deficit closed by itself. This is the price–specie flow mechanism, described by David Hume in 1752.
| Merits of the gold standard | Demerits |
|---|---|
| Stable exchange rates encouraged trade and lending | The money supply depended on gold discoveries, not on the needs of the economy |
| Governments could not print money freely, so inflation was low in the long run | Deficit countries had to accept falling prices and unemployment |
| Automatic correction of imbalances | Countries without gold mines were at a disadvantage |
| Confidence in the currency | It broke down in wars and depressions, when governments needed to spend |
Definition
Gold exchange standard: a system in which currencies are fixed not to gold directly but to a currency that is itself convertible into gold.
Bretton Woods system (1944–1971): the gold exchange standard agreed by 44 countries at Bretton Woods, New Hampshire, in July 1944. The US dollar was fixed at US$35 per troy ounce of gold; other currencies were pegged to the dollar and could move only within 1% of their par value, with changes allowed only to correct a "fundamental disequilibrium". The conference also created the International Monetary Fund and the World Bank (Unit 4).
The system ended when the United States, whose gold reserves no longer covered the dollars held abroad, stopped exchanging dollars for gold on 15 August 1971. By 1973 the major currencies were floating. Many smaller countries, however, still fix their currencies today.
Definition
Fixed exchange rate (pegged rate): an exchange rate set by the government or central bank at an official value, against one currency (such as the US dollar or the euro), a basket of currencies, or gold, and held there by the central bank.
Devaluation: an official reduction in the fixed value of a currency. Revaluation: an official increase.
Example: the CFA franc used by 14 African countries is fixed at 655.957 CFA francs per euro.
If the official rate makes the franc worth more than the market would (the dollar is "too cheap"), more dollars are demanded than supplied. The central bank must fill the gap from its reserves, raise interest rates to attract inflows, or ration dollars. If reserves run low, it must devalue.
Worked example 2: measuring devaluations
(a) The pound, November 1967. The United Kingdom devalued the pound from US$2.80 to US$2.40:
The pound lost 14.3% of its dollar value. Seen from the other side, a dollar now cost pounds instead of pounds, about 16.7% more.
(b) The CFA franc, January 1994. The rate moved from 50 to 100 CFA francs per French franc. The number of CFA francs needed to buy a French franc doubled, so each CFA franc lost half its value:
(c) A conversion at a fixed rate. At 655.957 CFA francs per euro, €200 is worth CFA francs, and it will stay so as long as the peg holds.
| Advantages | Disadvantages |
|---|---|
| Certainty for traders and investors: prices and costs abroad are known | The central bank needs large reserves to defend the rate |
| No speculation as long as the peg is believed | If markets doubt the peg, speculators can force a sudden devaluation |
| Discipline: the government must keep inflation low to hold the rate | Monetary policy is tied to defending the rate, not to jobs or growth |
| Imported inflation is limited if the anchor currency is stable | An overvalued peg hurts exports and encourages imports |
| Rationing dollars leads to black markets (Lesson 4) |
A government devalues to correct a persistent deficit, to stop the loss of reserves, or to make exports competitive. The effects are those of any fall in the currency (Unit 2): exports become cheaper abroad and imports dearer at home, and the trade balance improves only if the Marshall–Lerner condition holds, often after a J-curve. The costs are imported inflation and a heavier burden of foreign-currency debt.
Warning
Devaluation or depreciation? Use devaluation only when a government or central bank officially lowers a fixed rate. When a floating currency falls because of market forces, it is a depreciation. The effects on trade are similar; the cause is different.
Tip
Percentage change needs the right base. "The pound fell from $2.80 to $2.40" is a 14.3% fall in the pound's value, but the dollar's price in pounds rose by 16.7%. Always divide by the starting value of the currency you are talking about.
Important
Discuss. Until 1995 Rwanda's franc had official, announced exchange rates. What problems would a small, aid-dependent, landlocked economy face in trying to keep a fixed rate against the US dollar today?
EconplusDal, "Fixed Exchange Rates - How Do They Work?" (about 7 minutes). How a central bank buys and sells its currency and changes interest rates to hold a peg. Compare his diagram with the one above.
Practice
Sources and credits
Written by Ganzaa: the timeline, the diagram, the tables, the worked examples and the practice items. This lesson adapts CC BY-SA material and is shared under CC BY-SA 4.0.
