Important Concepts

Adjustable peg:                             A system in which acountry tries to keep its exchange rate fixed for long periods of time and onlychanges the pegged rate when there is a substantial payments disequilibrium atthat rate.

Beggar‑thy‑neighborpolicies:       Policies such asdevaluations or tariffs intended to benefit one country’s economy at theexpense of another. Such policies were widespread during the Great Depressionof the 1930s.

Bretton Woodssystem:                  Under this post‑WorldWar II agreement organizing international financial affairs between 1944 and1971, countries were allowed devaluations and revaluations of an adjustable pegexchange rate when faced with fundamental disequilibria that would otherwiserequire drastic domestic adjustment to keep the exchange rate fixed. Keynes wasone of the architects of the Bretton Woods system.

Capital controls:                            Government limitsplaced on the use of the foreign exchange market to make payments related tointernational financial activity (as opposed to payments for goods andservices).

Clean float:                                    Exchangerates determined by a freely-functioning foreign exchange market.

Crawling peg:                                An exchange ratesystem in which the pegged rate is changed frequently according to a set ofindicators or in response to monetary authority direction.

Deficits withouttears:                    A situation inwhich a country’s currency is considered an international reserve so that thecountry can finance its official settlements deficit by issuing its owncurrency. TheU.S.had extraordinary leeway to finance its payments deficits by issuing dollars inthe 1950s and 1960s.

Dirty float:                                     Also known asmanaged float. An exchange rate which is generally floating but with governmentwillingness to intervene to attempt to influence the equilibrium value of therate.

Dollar crisis:                                  Denotes thesituation prevailing toward the end of the Bretton Woods era, with theexcessive build‑up of dollar reserves in the hands of foreign central banks dueto the large and persistentU.S.payments deficits. The gold backing of the dollar was questioned, andultimately the dollar was allowed to float freely starting in 1973.

Domesticadjustment:                    Refers to thenecessary changes in the level of a country’s aggregate demand to ensure thatsupply and demand for foreign exchange are back to equilibrium at the fixedexchange rate, thus avoiding any further pressure on the exchange rate.

Euro:                                             Thecurrency of the European Union. As of 2008, 15 of 27 EU countries have replacedtheir national currencies with the euro.

ERM of the EMS:                          Predecessorto the euro zone, the exchange rate mechanism (ERM) of the European MonetarySystem (EMS) maintained pegged exchange rates among ERM members’ currencieswith currencies floating as a bloc against outside currencies such as the U.S.dollar. Some EU member states participate in a modified ERM in which theircurrencies are pegged to the euro.

Foreign exchangecontrols:            Restrictions onthe ability of individuals to freely dispose of foreign exchange earned abroadand to acquire foreign exchange for spending abroad. For example, the excessdemand for an officially undervalued foreign currency is dealt with byrationing the scarce supply available through exchange controls.

Fundamentaldisequilibrium:       A balance of paymentssurplus or deficit too great and/or enduring to be financed. It is easy todetect with hindsight, but difficult to detect at the outset.

“Gnomes of Zurich”:                     Epithet coined byBritain’sChancellor of the Exchequer for the speculators he thought were abandoning theBritish pound and making it increasingly difficult to defend a pegged exchangerate in the mid‑1960s.

Gold Standardera:                        From about 1870to WWI, most nations tied their currency values to gold and allowedunrestricted import and export of gold. Officials were expected to adjust thewhole economy to defend the exchange rate.

International Monetary Fund:       An institution created by the Bretton Woodsagreement in 1944, the IMF aims to promote orderly foreign exchange arrangementsand to limit exchange rate manipulation. It also lends reserves to its members (185 countries as of 2008) tofinance temporary international payments difficulties.

Leaning againstthe wind:              Governmentintervention in the foreign exchange market to moderate current movements infloating exchange rates.

Officialintervention:                     Governmentattempts to influence the market exchange rate by buying or selling foreigncurrency in exchange for the domestic currency.

One‑wayspeculative gamble:       A betwhich entails minimal or zero risk of loss for the gambler. A persistentpayments imbalance under the Bretton Woods system, for example, clearlysignaled the likelihood of a devaluation in the case of a deficit or arevaluation in the case of a surplus. There was, therefore, little risk oflosing money by moving funds away from the currency to be devalued and towardthe one to be revalued. At worst, speculators had to shoulder the transactioncosts.

Par value:                                      The valueof the exchange rate that government officials try to target. Often thegovernment will allow some flexibility of the actual exchange rate in a “band”around the par value.

Parallel market:                            A rather nice wayof saying “black market.”  In countrieswith exchange controls, economic agents often find it profitable to circumventofficial restrictions on buying and selling foreign currencies through the useof parallel markets. 

Pegged exchangerate:                   Term used inplace of “fixed exchange rate” because, in practice, no exchange rate staysfixed forever, but can be changed by government action. This is a commonexchange rate regime in developing countries.

Price discipline effect:                    The argument that a fixed exchange ratesystem results in reduced inflation rates globally, largely becausehigh-inflation countries become less competitive and run out of reserves neededto finance payments deficits.  Thosecountries ultimately must tighten their domestic money supply to maintain thefixed exchange rate.  As a result,inflation decreases.

“The snake in thetunnel”:             A system set upby members of the EEC in 1971, whereby each currency would float inside aspecified band against every other member currency (the snake), and a maximumlimit was set on the difference between the most appreciating and mostdepreciating currencies (the tunnel). This was a predecessor to the EMS.

Special drawingrights (SDRs):      Reserve assets created bythe IMF, beginning in 1970 as a supplement to existing reserve assets. Thevalue of one SDR is determined by the weighted average of a basket of thecurrencies of the five countries with the largest share of world exports ofgoods and services—the U.S. dollar, the Japanese yen, the British pound, andthe Euro (representingFranceandGermany).

Sterilization:                                  Using monetarypolicy to offset the impact of official intervention on the domestic moneysupply. For example, a government might purchase its own currency to supportits exchange value, but then purchase domestic bonds to restore the domesticmoney supply. The intent is to manipulate currency values without affecting thedomestic economy.