Does the Type of Money Matter for the Exchange Rate? - dummies

Does the Type of Money Matter for the Exchange Rate?

By Ayse Evrensel

A close relationship exists between the type of money and the exchange rate regime. A monetary system based on a metallic standard such as the gold standard leads to a fixed exchange rate regime. For a good part in human history, some kind of a metallic standard governed.

However, don’t assume that the reign of the metallic standard was continuous throughout history. Mostly because a metallic standard such as the gold standard doesn’t allow monetary policy, countries left the metallic standard whenever they had to endure a war or a military conflict so that they could print money and finance the war effort.

Money that’s not backed by a precious metal has no intrinsic value. It’s called fiat money. Therefore, the type of money used during the gold- (and/or silver-) standard periods interrupted by wars or revolutions was fiat money. This type of money has been used from 1971 through today.

A metallic standard, such as the gold standard, leads to fixed exchange rates. What kind of exchange rates would we have when currencies are fiat? The answer is that fiat money doesn’t imply a certain kind of exchange rate regime.

It’s up to countries to decide what kind of an exchange rate regime they want to have. In fact, following the end of the metallic era in 1973, developed and developing countries decided differently about this matter. While all developed countries adopted a floating exchange rate regime, most developing countries adopted some kind of pegged exchange rate regime.

In a pegged exchange rate regime, governments announce the exchange rates between the domestic currency and other major currencies. Pegging is done for a variety of reasons. First, pegging can support the country’s development strategy. For example, if a country wants to industrialize and needs to import a variety of intermediate goods, it can make its imports cheaper by overvaluing its currency.

On the other hand, if a country wants to promote its export sector as the engine of growth, undervaluation of the currency can accomplish this goal. In addition, a pegged currency can function as a nominal anchor to signal economic stability.

In particular, developing countries used the pegged regime to attract foreign investors. In this case, the investment in question is portfolio investment and implies investing other countries’ equity and debt securities.

Unilaterally pegged exchange rates in developing countries, especially in emerging markets with a potential to grow, sounded like an ingenious plan. These countries needed hard currency in large amounts, and international investors wanted to have higher nominal returns with virtually no exchange rate risk.

But this kind of hot money comes in fast and leaves fast. When investors became anxious that these countries couldn’t continue with the peg, they cashed in their portfolio in return for hard currency, leaving the countries in a currency crisis.

When talking about exchange rate regimes and currency crises, the International Monetary Fund (IMF) has to be included in the discussion. The IMF was introduced during the Bretton Woods conference in 1944 as the coordinator of the post–World War II international monetary system.

The post–World War II system was a variation of the metallic standard and was called the reserve currency system. The dollar was pegged to gold, and all other currencies were pegged to the dollar.

As in the case of any metallic standard, an agency such as the IMF needed to keep an eye on current account imbalances and redistribute funds from countries with a current account surplus to countries with a current account deficit. As early as the late 1940s, it became clear that the IMF didn’t have enough funds to fulfill its objective.

Following the end of the Bretton Woods era in 1973, the IMF remained in business even though there was no metallic standard and therefore fixed exchange rates. However, as developed countries adopted floating exchange rates, most developing countries believed that if they adopted a floating exchange rate regime, their countries’ fiscal and monetary problems would depreciate their currency too much.

Therefore, after 1973, most developing countries unilaterally pegged their currency to the currencies of major developed countries. But pegged currencies experience crisis, meaning that countries lose their international reserves when fiscal and monetary policies aren’t consistent with the peg.

Therefore, the IMF remained in business, this time to provide balance of payments support to developing countries. Over the decades, the IMF has been criticized for providing financial support to countries that implement macroeconomic policies inconsistent with their currency peg.