The International Financial System (part C)
by
Charles Lamson
The Managed Float Exchange Rate System since 1973
The demise of the Bretton Woods Accord initiated a new era in which the exchange rate of major industrialized countries are no longer fixed. Rather, these countries participate in a floating (flexible) exchange rate system wherein exchange rates fluctuate by the minute and the hour as the market forces change.
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Like other major currencies, the exchange rate of the U.S. dollar is determined by demand and supply in international markets. The supply of dollars/month reflects the U.S. demand for foreign goods, services, and securities. Ceteris paribus, the quantity of dollars supplied is a positive function of the exchange rate. The demand for dollars reflects the foreign demand for U.S. goods, services, and securities. Ceteris paribus, the quantity demanded is a negative function of the exchange rate. The market gravitates to the equilibrium change rate where quantity demanded is equal to quantity supplied.
From an initial equilibrium, if U.S. incomes, U.S. inflation, or foreign interest rates rise, ceteris paribus, foreign demand for U.S. goods, services, and securities will increase, and so will the supply of dollars. The market will gravitate to a new equilibrium at a lower exchange rate that corresponds to a depreciation of the dollar.
Likewise, if foreign incomes, foreign inflation, or U.S. interest rates, ceteris paribus, foreign demand for U.S. goods, services, and securities will increase, and so will the demand for dollars. The market will gravitate to a new equilibrium at a higher exchange rate that corresponds to an appreciation of the dollar.
To summarize, factors such as domestic and foreign incomes, inflation rates, and interest rates affect exchange rates and "flexible" exchange rates immediately adjust to changing market conditions and expectations.
Our story does not end here, however. Market forces are not the only factor that affects exchange rates. In addition, central banks may intervene in the foreign exchange market by buying and selling currencies to influence exchange rates. Thus, the present international monetary system can be more correctly characterized as a managed float exchange rate system because exchange rates are allowed to fluctuate in accordance with supply and demand; but central banks may intervene if a currency is thought to be over- or undervalued. This system is distinctly different from the fixed rate exchange system under the Bretton Woods Accord.
Interestingly, central banks have intervened more often under the managed float than under the previous fixed exchange rate system, which required them to intervene to maintain the agreed-upon exchange rate. Sometimes central banks have intervened more frequently than at other times. Often central banks of major countries have agreed to pursue similar exchange rate policies and have coordinated their interventions as part of the implementation of monetary policy.
One final point, needs to be made. Under the managed float exchange rate system, many smaller countries peg the value of their currencies to the U.S. dollar or some other major currency or basket of currencies. By doing so, a small country reduces the risk that the value of its currency will fluctuate unpredictably. A financial crisis can result, however, if the country cannot maintain the fixed exchange rate. Both the Mexican peso crisis of 1994 and the Asian crisis of 1997-1998 occurred when the affected countries were unable to maintain an exchange rate that they had fixed in terms of the dollar. In both cases, the eventual depreciation of the currencies triggered widespread losses, the failure of many financial and nonfinancial firms, and financial crises.
Managing Exchange Rate Risk under the Managed Float
Under flexible exchange rates, when market participants enter into contracts to receive or supply so much foreign currency on a future date there is an exchange rate risk because the future spot exchange rate is unknown. Market participants may be importers or exporters who will receive or who need so much foreign exchange on a future date, or they may be investors who have purchased or who plan to purchase foreign financial securities that will mature in the future. If the exchange rate changes unexpectedly between now and the future date, the anticipated profits of an exporter, importer, or investor could be reduced. Worse yet, a loss could be incurred. Thus, under flexible exchange rate systems, market participants are exposed to substantial exchange rate risk.
In recent years, international financial markets have developed hybrid instruments including foreign exchange forward, futures, options and swap agreements to hedge exchange rate risk. These instruments, which are all forms of derivatives, can be used to reduce the risk of unforeseen price changes. In this case, the prices are exchange rates. Thus, these markets reduce exchange rate risk.
Forward, futures, options, and swap agreements effectively lock in today an exchange rate for a transaction that may or will occur in the future, thus reducing the risk that changes in the exchange rate will alter expected outcomes.
The development of foreign exchange forward, futures, options, and swap agreements coincides with the tremendous growth in trade and capital flows, coupled with the increased volatility of exchange rates under the managed float exchange rate system. Because these instruments reduce exchange rate risks, they facilitate trade in goods, services, and financial claims.
The Role of the Dollar under the Managed Float
Under the Bretton Woods Accord, the dollar played a dominant role in the international financial system because it served as the official reserve currency. Under the managed float system, the dollar has continued to play an important role in the international financial system. Because of its relative stability, the dollar continues to serve as the major reserve currency.
In addition to serving as a reserve asset, the dollar is sometimes used as a medium of exchange and a unit of account in international markets. Exchanges between two currencies of smaller countries often take place through dollars. For example, Peru might convert its currency to dollars and use the dollars to purchase the currency of South Africa rather than using its own currency to purchase the currency of South Africa directly. Prices of standardized contracts of raw materials and commodities are often quoted in dollars. For example, the price of oil from the Middle East is quoted in dollars, and the dollar is also the medium of exchange through which oil is bought and sold around the world. The dollar is accepted for payments in many faraway places, and has been widely used in countries experiencing political and economic unrest.
The dollar also acts as a store of value. As we have seen, 50 to 60 percent of all U.S. currency and over 70 percent of $100 bills are held abroad. The dollar is demanded as a store of value because of the political stability of the United States and the dollar's acceptance over time.
Although the dollar is no longer the official reserve asset, the demand for dollars to be used in international financial markets (either as reserves or for other uses) has continued to grow. Indeed, the demand for dollars has grown faster than domestic real incomes due to the increase in trade, capital flows, and real incomes around the world.
Despite its many roles, the dollar is less important in relative terms today than under the Bretton Woods Accord. Despite this, it has gained in relative importance since 1990. Other currencies such as the euro, the Japanese yen, and the British pound are now also used as international reserves.
Within this changing environment, several international organizations are developing unique roles in the international financial system. These organizations include the International Monetary Fund, the World Bank, and the Bank for International Settlements. They seek to foster stability in the international financial system so that the benefits of trade and cross-border trading of financial instruments can be realized. Just as the financial system has evolved to deal with the growth in trade and capital flow, these organizations are redefining their roles in the increasingly globalized economy. It is to these organizations that I will turn in the next part.
Recap
Since 1973, major industrialized countries have participated in a managed float exchange rate system. The value of a currency is determined by supply and demand, but governments intervene by buying and selling (demanding and supplying) currencies to affect currency values. Smaller countries often tie the value of their currencies to the dollar or some other major currency. Foreign exchange forward, futures, options and swap agreements have been developed to allow market participants to hedge exchange rate risks. Under the managed float, the dollar is still the major international reserve asset, although other currencies also serve as international reserve. In addition, the dollar is demanded in international financial markets because of its stability. It serves as a medium of exchange, a unit of account, and a store of value in some international markets
*SOURCE: THE FINANCIAL SYSTEM AND THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 465-471*
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