OF FOREIGN EXCHANGE MARKET
the end of World War II, the major countries
of the world set up the International Monetary
Fund (IMF). The IMF is an international organization
that monitors balance of payments and exchange
rate activities. In July 1944, at Bretton Woods,
New Hampshire, 44 countries signed the Articles
of Agreement of the IMF. At the centerpiece
of those agreements was the establishment of
a worldwide system of fixed exchange rates between
countries. The anchor for this fixed exchange
rate system was gold. One-ounce of gold was
defined to be worth 35 U.S. dollars. All other
currencies were pegged to the U.S. dollar at
a fixed exchange rate. For example the Japanese’s
Yen was set at 360 yen to a dollar, the British
Pound was set at $ 4.80.
the fixed exchange system served well during the 1950
and early 1960, it came under increasing strain in
the late 1960s and by 1971 the order was almost collapsed.
Most economists trace the break up of the fixed exchange
rate system to the US macroeconomic policy package
of 1965-68 to finance both the Vietnam conflict and
its welfare programs, President Johnson backed an
increase in US government spending that was not financed
by an increase in taxes. Instead, it was financed
by an increase in money supply, which in turn, led
to rise in price inflation from less then 4 percent
in 1966 to close to 9 percent by 1968. With more money
in their pockets the American spent more, particularly
on imports, from here the US trade balance started
to deteriorate rapidly.
rise in inflation and the worsening of US trade position gave
support to the speculation in the foreign exchange market
that the dollar would be devalued. Things came to a head on
spring 1971, when US trade figures were released, which showed
that for the first time since 1945, the United States was
importing more then it was exporting. This set off the massive
purchases of deutsche marks by the speculators who guessed
that the DM would revalue against the dollar. On a single
day May, 4, 1971 the Bundesbank had to buy $ 1 billion to
hold the dollar/DM rate at its fixed exchange rate given the
great demand for DMs. On the morning of May 5, the Bundesbank
purchased another $ 1 billion during the first hour of trading.
At that point, the Bundesbank faced the inevitable and allowed
its currency to float.
the weeks following the decision to float the DM, the market
became increasingly convinced that the dollar would have to
be devalued. However, devaluation of the dollar was not an
easy matter. Under the Bretton Woods provisions, any other
country could change its exchange rates against all currencies
simply by fixing its dollar rate at a new level. But as the
key currency in the system, the dollar could be devalued only
if all countries agreed to simultaneously revalue against
the dollar. And many countries did not want this since it
would make their products more expensive relative to US products.
Nixon in August 1971 announced that dollar was no longer convertible
in to gold. He also announced that a new 10% tax on imports
would remain in effect until the US’s trading partners
agreed to revalue their currencies against the dollar. This
brought the partners on the bargaining table, and in December
1971 an agreement was reached to devalue the dollar by 8 percent
against the foreign currencies. The import tax was than removed.
problem was not solved, however. The US balance of Payment
position continued to deteriorate throughout 1972, while the
money supply continued to expand at inflationary rate. Given
the more solid reason to believe that the dollar was overvalued.
After a massive wave of speculation in February, which culminated
with European Central banks spending upto $3.6 billion. On
March 1 to try to prevent their currencies form appreciating,
the foreign exchange market was close down. When the market
reopened on March 19, the currencies of Japan and most European
countries were floating against the dollar.
Switching away form the fixed currency system after 27 years
out of necessity, not by choice was a difficult task. The
Smithsonian agreement reached in Washington in December 1971
had a transactional role to the free-floating markets. This
agreement failed to address the real cause behind the international
economic and financial pressure, focusing instead on increasing
the range of currency fluctuation. From 1 percent the band
of foreign currencies fluctuation was expanded to 4.5 percent.
to Washington’s efforts, the European Economic Community,
established in 1957, tried to move away from the US dollar
block toward the Deutsche mark block, by designing its own
monetary system. In April 1972, West Germany, France, Italy,
the Netherlands, Belgium and Luxembourg developed the European
joint Float. Under this system the member countries were allowed
to move between 2.25 percent band, known as the snake, against
each other, and collectively within 4.5 percent band, known
as the tunnel, against the US dollar.
both the Smithsonian Institution Agreement and the European
Joint Float did not address the independent domestic problems
of the member countries from the bottom up, attempting instead
to focus solely on the large international picture and maintain
it by artificially enforcing the intervention points. By 1973,
both systems collapsed under heavy market pressures.
idea of regional currency stability with the goal of financial
independence form the US dollar block persisted. By July 1978,
the members of the European Community approved the plans for
the European Monetary System: West Germany, France, Italy,
Netherlands, Belgium, Great Britain, Denmark, Ireland and
Luxembourg. The system was launched in March 1979, as a revamped
European Joint Float, or a MINI Bretton Woods Accord. Additional
features, such as the threshold of divergence, were designed
to protect this monetary system from the fate of the previous
ones. Judging from its expended life span, until 1993 at least
the EMS was obviously better. Until it proved to be devastating
in 1992, when the Pound fell against the dollar form 2.01
to 1.4000 with days.
Floating Exchange Rate Regime
The floating exchange rate regime that followed the collapse
of the fixed exchange rate system was formalized in January
1976 when IMF members met in Jamaica and agreed to the rules
for the international monetary system that are in place today.
The purpose of the Jamaica meeting was to revise the IMF’s
Articles of Agreement to reflect the new reality of floating
exchange rate. The main elements of the Jamaica agreement
include the following:
rates were declared acceptable. IMF members were permitted
to enter the foreign exchange market to even out “unwarranted”
was abandoned as reserve assets. The IMF returned its gold
reserve to members at the current market price, placing
the proceeds in a help fund to help poor nations.
IMF quotas- the amount member countries contributes to IMF
– were increased to $41 billion. Since then they have
been increased to $180 billion.
Rates since 1973
Since March 1973 exchange rates have become much more volatile
and far less predictable than they were between 1945 and 1973.
This volatility has been partly due to a number of unexpected
shocks to the world monetary system, including:
oil crisis in 1971, when OPEC quadrupled the price of oil.
The harmful effect of this on the US inflation rate and
trade position resulted in further decline in the value
of the dollar.
loss of confidence in the dollar that followed the rise
of US inflation in 1977 and 1978.
oil crisis of 1979, when OPEC once again increased the price
of oil dramatically- this time it was doubled.
unexpected rise in the dollar between 1980 and 1985, despite
a worsening balance of payment picture.
rapid fall of the US dollar between 1985 and 1987.
The major currencies such as US dollar move independently
of the other currencies. The currency may be traded by anybody
so inclined. Its value is a function of the current supply
and demand forces in the market, and there are no specific
intervention points that have to be observed. Of course, the
Federal Reserve Bank irregularly intervenes to change the
value of the US dollar, but specific levels are ever imposed.
Naturally, free-floating currencies are in the heaviest trading
This system of free floating of currencies against the dollar
provides ample opportunities to the investors to judge and
trade these currencies. This system of free floating proves
to be the best market available all around the world with
same kind of exposure and opportunities to trade and make
full use of foreign exchange market.