Current Exchange Rate Agreements

Now suppose the British choose to buy more American goods and services. The supply curve for sterling is increasing, and the equilibrium price of the pound (in dollars) is noticeable, say, 3 dollars. Under the Bretton Woods agreement, Britain and the United States would be required to intervene in the market to reduce the exchange rate to the $4 exchange rate set in the agreement. If the British Central Bank, the Bank of England, made the adjustment, it would have to buy books. It would do so by exchanging dollars it had previously purchased in other transactions for books. Since he was selling dollars, he`d earn checks in pounds. When a central bank sells an asset, cheques entering the central bank reduce the money supply and bank reserves in that country. We have seen in the chapter how the money supply has been explained, for example, that the fed`s bond sales are reducing the U.S. money supply.

Similarly, the sale of dollars by the Bank of England would reduce the British money supply. To bring its exchange rate back to the agreed level, Britain would have to pursue a contractive monetary policy. The concept of a totally free exchange rate system is theoretical. In practice, all governments or central banks intervene in foreign exchange markets to influence exchange rates. Some countries, such as the United States, intervene only to a small extent, so the idea of a floating exchange rate system is close to what actually exists in the United States. If exchange rates are fixed but fiscal and monetary policy is not coordinated, equilibrium exchange rates may deviate from their fixed level. Once exchange rates begin to diverge, efforts to force currencies up or down through market interventions can be extremely disruptive. And if countries suddenly decide to abandon these efforts, exchange rates can vary sharply one way or the other.

If this happens, the most important fixed exchange rate, their predictability, is lost. These include the implementation of monetary policy and exchange rates under a framework that sets limits on international reserves and the central bank`s ceilings on net domestic assets. Indicative targets for reserve funds can be attached to this system. The managed Float system has been criticized for allowing governments to manipulate exchange rates for the benefit of their countries at the expense of others. For example, a government could weaken its currency to attract foreign demand in order to revive its stagnant economy. The commitment to keep the exchange rate within the range limits monetary policy, with the degree of political independence depending on the range.