Exchange Rates

Essay by EssaySwap ContributorUniversity, Master's February 2008

download word file, 8 pages 3.0

Introduction Beginning with the Gold Standard of the 1800s, the fixed, or pegged exchange rate system was the dominant regime for most of the twentieth century. During the time, currencies were linked to gold, meaning that the value of a local currency was fixed to a set exchange rate to gold ounces, known as the Gold Standard. The Gold Standard was first started by the UK in 1819, and being the predominant power at the time, by 1870, many countries, including the United States (adopted the Standard in 1879), have joined the Standard in an attempt to emulate the success of the UK. Flaws became apparent in the exchange rate system as many countries began abandoning the system at the start of World War I. The system undoubtedly had its advantages as the abandoning countries were later seen reverting back to the system after the war. Obvious advantages and disadvantages were associated with the system as many countries were seen joining, abandoning, re-joining and re-abandoning the system within the twentieth century.

Nevertheless, historical evidence, particularly the Bretton Woods exchange rate system and the European Exchange Rate Mechanism, suggests that the advantages are significantly outweighed by the disadvantages. By 1971, major governments have begun adopting a flexible exchange rate system, and all attempts to revert back to the global peg were eventually abandoned in 1985. (Heakal) Advantages of the Fixed Exchange Regime Fixed exchange rates require that a nation match its macroeconomic policies to those of the country or countries to which its currency is pegged, this limits a country's ability to set its own policies, thereby exposing the advantages and disadvantages of the system. Fixing the value of an emerging market's currency to that of a sounder currency, which is exactly what an exchange-rate peg involves, provides a nominal anchor...