Currency war, also known as competitive devaluations, is a condition in international

affairs where countries seek to gain a trade advantage over other countries by causing the exchange
rate of their currency to fall in relation to other currencies. As the exchange rate of a country's
currency falls, exports become more competitive in other countries, and imports into the country
become more and more expensive. Both effects benefit the domestic industry, and thus
employment, which receives a boost in demand from both domestic and foreign markets. However,
the price increases for import goods (as well as in the cost of foreign travel) are unpopular as they
harm citizens' purchasing power; and when all countries adopt a similar strategy, it can lead to a
general decline in international trade, harming all countries.
Historically, competitive devaluations have been rare as countries have generally preferred to
maintain a high value for their currency. Countries have generally allowed market forces to work, or
have participated in systems of managed exchanges rates. An exception occurred when a currency
war broke out in the 1930s when countries abandoned the gold standard during the Great
Depression and used currency devaluations in an attempt to stimulate their economies. Since this
effectively pushes unemployment overseas, trading partners quickly retaliated with their own
devaluations. The period is considered to have been an adverse situation for all concerned, as
unpredictable changes in exchange rates reduced overall international trade.
According to Guido Mantega, former Brazilian Minister for Finance, a global currency war broke out
in 2010. This view was echoed by numerous other government officials and financial journalists from
around the world. Other senior policy makers and journalists suggested the phrase "currency war"
overstated the extent of hostility. With a few exceptions, such as Mantega, even commentators who
agreed there had been a currency war in 2010 generally concluded that it had fizzled out by mid-
2011.
States engaging in possible competitive devaluation since 2010 have used a mix of policy tools,
including direct government intervention, the imposition of capital controls, and,
indirectly, quantitative easing. While many countries experienced undesirable upward pressure on
their exchange rates and took part in the ongoing arguments, the most notable dimension of the
2010–11 episode was the rhetorical conflict between the United States and China over the valuation
of the yuan. In January 2013, measures announced by Japan which were expected to devalue its
currency sparked concern of a possible second 21st century currency war breaking out, this time
with the principal source of tension being not China versus the US, but Japan versus the Eurozone.
By late February, concerns of a new outbreak of currency war had been mostly allayed, after
the G7 and G20 issued statements committing to avoid competitive devaluation. After the European
Central Bank launched a fresh programme of quantitative easing in January 2015, there was once
again an intensification of discussion about currency war.
In the absence of intervention in the foreign exchange market by national government authorities,
the exchange rate of a country's currency is determined, in general, by market forces of supply and
demand at a point in time. Government authorities may intervene in the market from time to time to
achieve specific policy objectives, such as maintaining its balance of trade or to give its exporters a
competitive advantage in international trade.

Reasons for intentional devaluation[edit]

Cumulative current account balance 1980–2008 (US$ Billions) based on International Monetary Fund data

Devaluation, with its adverse consequences, has historically rarely been a preferred strategy.
According to economist Richard N. Cooper, writing in 1971, a substantial devaluation is one of the
most "traumatic" policies a government can adopt – it almost always resulted in cries of outrage and
calls for the government to be replaced.[1] Devaluation can lead to a reduction in citizens' standard of
living as their purchasing power is reduced both when they buy imports and when they travel
abroad. It also can add to inflationary pressure. Devaluation can make interest payments on
international debt more expensive if those debts are denominated in a foreign currency, and it can
discourage foreign investors. At least until the 21st century, a strong currency was commonly seen
as a mark of prestige, while devaluation was associated with weak governments.[2]
However, when a country is suffering from high unemployment or wishes to pursue a policy of
export-led growth, a lower exchange rate can be seen as advantageous. From the early 1980s
the International Monetary Fund (IMF) has proposed devaluation as a potential solution for
developing nations that are consistently spending more on imports than they earn on exports. A
lower value for the home currency will raise the price for imports while making exports cheaper.
[3]
This tends to encourage more domestic production, which raises employment and gross domestic
product (GDP). Such a positive impact is not guaranteed however, due for example to effects from
the Marshall–Lerner condition.[4] Devaluation can be seen as an attractive solution to unemployment
when other options, like increased public spending, are ruled out due to high public debt, or when a
country has a balance of payments deficit which a devaluation would help correct. A reason for
preferring devaluation common among emerging economies is that maintaining a relatively low
exchange rate helps them build up foreign exchange reserves, which can protect against future
financial crises.[5][6][7]

Mechanism for devaluation[edit]

A state wishing to devalue, or at least check the appreciation of its currency, must work within the
constraints of the prevailing International monetary system. During the 1930s, countries had
relatively more direct control over their exchange rates through the actions of their central banks.
Following the collapse of the Bretton Woods system in the early 1970s, markets substantially
increased in influence, with market forces largely setting the exchange rates for an increasing
number of countries. However, a state's central bank can still intervene in the markets to effect a
devaluation – if it sells its own currency to buy other currencies[8] then this will cause the value of its
own currency to fall – a practice common with states that have a managed exchange rate regime.
Less directly, quantitative easing (common in 2009 and 2010), tends to lead to a fall in the value of
the currency even if the central bank does not directly buy any foreign assets.
A third method is for authorities simply to talk down the value of their currency by hinting at future
action to discourage speculators from betting on a future rise, though sometimes this has little
discernible effect. Finally, a central bank can effect a devaluation by lowering its base rate of
interest; however this sometimes has limited effect, and, since the end of World War II, most central
banks have set their base rate according to the needs of their domestic economy. [9][7]
If a country's authorities wish to devalue or prevent appreciation against market forces exerting
upwards pressure on the currency, and retain control of interest rates, as is usually the case, they
will need capital controls in place—due to conditions that arise from the impossible trinity trilemma.[10]

Quantitative easing[edit]
Quantitative easing (QE) is the practice in which a central bank tries to mitigate a potential or
actual recession by increasing the money supply for its domestic economy. This can be done by
printing money and injecting it into the domestic economy via open market operations. There may be
a promise to destroy any newly created money once the economy improves in order to avoid
inflation.
Quantitative easing was widely used as a response to the financial crises that began in 2007,
especially by the United States and the United Kingdom, and, to a lesser extent, the Eurozone.
[11]
The Bank of Japan was the first central bank to claim to have used such a policy.[12][13]
Although the U.S. administration has denied that devaluing their currency was part of their objectives
for implementing quantitative easing, the practice can act to devalue a country's currency in two
indirect ways. Firstly, it can encourage speculators to bet that the currency will decline in value.
Secondly, the large increase in the domestic money supply will lower domestic interest rates, often
they will become much lower than interest rates in countries not practising quantitative easing. This
creates the conditions for a carry trade, where market participants can engage in a form of arbitrage,
borrowing in the currency of the country practising quantitative easing, and lending in a country with
a relatively high rate of interest. Because they are effectively selling the currency being used for
quantitative easing on the international markets, this can increase the supply of the currency and
hence push down its value. By October 2010 expectations in the markets were high that the United
States, UK, and Japan would soon embark on a second round of QE, with the prospects for the
Eurozone to join them less certain.[14]
In early November 2010 the United States launched QE2, the second round of quantitative easing,
which had been expected. The Federal Reserve made an additional $600 billion available for the
purchase of financial assets. This prompted widespread criticism from China, Germany, and Brazil
that the United States was using QE2 to try to devalue its currency without consideration to the
effect the resulting capital inflows might have on emerging economies.[15][16][17]
Some leading figures from the critical countries, such as Zhou Xiaochuan, governor of the People's
Bank of China, have said the QE2 is understandable given the challenges facing the United States.
Wang Jun, the Chinese Vice Finance Minister suggested QE2 could "help the revival of the global
economy tremendously".[18] President Barack Obama has defended QE2, saying it would help the
U.S. economy to grow, which would be "good for the world as a whole". [19] Japan also launched a
second round of quantitative easing though to a lesser extent than the United States; Britain and the
Eurozone did not launch an additional QE in 2010.

International conditions required for currency war[edit]

For a widespread currency war to occur a large proportion of significant economies must wish to
devalue their currencies at once. This has so far only happened during a global economic downturn.
An individual currency devaluation has to involve a corresponding rise in value for at least one other
currency. The corresponding rise will generally be spread across all other currencies[20] and so unless
the devaluing country has a huge economy and is substantially devaluing, the offsetting rise for any
individual currency will tend to be small or even negligible. In normal times other countries are often
content to accept a small rise in the value of their own currency or at worst be indifferent to it.
However, if much of the world is suffering from a recession, from low growth or are pursuing
strategies which depend on a favourable balance of payments, then nations can begin competing
with each other to devalue. In such conditions, once a small number of countries begin intervening
this can trigger corresponding interventions from others as they strive to prevent further deterioration
in their export competitiveness.[21]

Currency war in the Great Depression[edit]

During the Great Depression of the 1930s, most countries abandoned the gold standard. With
widespread high unemployment, devaluations became common, a policy that has frequently been
described as "beggar thy neighbour",[28] in which countries purportedly compete to export
unemployment. However, because the effects of a devaluation would soon be offset by a
corresponding devaluation and in many cases retaliatory tariffs or other barriers by trading partners,
few nations would gain an enduring advantage.
The exact starting date of the 1930s currency war is open to debate.[21] The three principal parties
were Britain, France, and the United States. For most of the 1920s the three generally had
coinciding interests; both the US and France supported Britain's efforts to raise Sterling's value
against market forces. Collaboration was aided by strong personal friendships among the nations'
central bankers, especially between Britain's Montagu Norman and America's Benjamin Strong until
the latter's early death in 1928. Soon after the Wall Street Crash of 1929, France lost faith in Sterling
as a source of value and begun selling it heavily on the markets. From Britain's perspective both
France and the US were no longer playing by the rules of the gold standard. Instead of allowing gold
inflows to increase their money supplies (which would have expanded those economies but reduced
their trade surpluses) France and the US began sterilising the inflows, building up hoards of gold.
These factors contributed to the Sterling crises of 1931; in September of that year Britain
substantially devalued and took the pound off the gold standard. For several years after this global
trade was disrupted by competitive devaluation and by retaliatory tariffs. The currency war of the
1930s is generally considered to have ended with the Tripartite monetary agreement of 1936.[21][29][30][31]
[32][33]

Bretton Woods era[edit]

From the end of World War II until about 1971, the Bretton Woods system of semi-fixed exchange
rates meant that competitive devaluation was not an option, which was one of the design objectives
of the systems' architects. Additionally, global growth was generally very high in this period, so there
was little incentive for currency war even if it had been possible.[34]

1973 to 2000[edit]
While some of the conditions to allow a currency war were in place at various points throughout this
period, countries generally had contrasting priorities and at no point were there enough states
simultaneously wanting to devalue for a currency war to break out.[35] On several occasions countries
were desperately attempting not to cause a devaluation but to prevent one. So states were striving
not against other countries but against market forces that were exerting undesirable downwards
pressure on their currencies. Examples include The United Kingdom during Black Wednesday and
various tiger economies during the Asian crises of 1997. During the mid-1980s the United States did
desire to devalue significantly, but were able to secure the cooperation of other major economies
with the Plaza Accord. As free market influences approached their zenith during the 1990s,
advanced economies and increasingly transition and even emerging economies moved to the view
that it was best to leave the running of their economies to the markets and not to intervene even to
correct a substantial current account deficit.[36][34]

2000 to 2008[edit]
During the 1997 Asian crisis several Asian economies ran critically low on foreign reserves, leaving
them forced to accept harsh terms from the IMF, and often to accept low prices for the forced sale of
their assets. This shattered faith in free market thinking among emerging economies, and from about
2000 they generally began intervening to keep the value of their currencies low. [37] This enhanced
their ability to pursue export led growth strategies while at the same time building up foreign
reserves so they would be better protected against further crises. No currency war resulted because
on the whole advanced economies accepted this strategy—in the short term it had some benefits for
their citizens, who could buy cheap imports and thus enjoy a higher material standard of living.
The current account deficit of the US grew substantially, but until about 2007, the consensus view
among free market economists and policy makers like Alan Greenspan, then Chairman of the
Federal Reserve, and Paul O'Neill, US Treasury secretary, was that the deficit was not a major
reason for worry.[38]
This is not say there was no popular concern; by 2005 for example a chorus of US executives along
with trade union and mid-ranking government officials had been speaking out about what they
perceived to be unfair trade practices by China.[39]
Economists such as Michael P. Dooley, Peter M. Garber, and David Folkerts-Landau described the
new economic relationship between emerging economies and the US as Bretton Woods II.[40][41]

Competitive devaluation after 2009[edit]

Main article: Currency War of 2009–2011

As the world's leading Reserve currency, the US dollar was central to the 2010–2011 outbreak of currency war.

By 2009 some of the conditions required for a currency war had returned, with a severe economic
downturn seeing global trade in that year decline by about 12%. There was a widespread concern
among advanced economies about the size of their deficits; they increasingly joined emerging
economies in viewing export led growth as their ideal strategy. In March 2009, even before
international co-operation reached its peak with the 2009 G-20 London Summit, economist Ted
Truman became one of the first to warn of the dangers of competitive devaluation. He also coined
the phrase competitive non-appreciation.[42][43][44]
On 27 September 2010, Brazilian Finance Minister Guido Mantega announced that the world is "in
the midst of an international currency war."[45][46] Numerous financial journalists agreed with Mantega's
view, such as the Financial Times' Alan Beattie and The Telegraph's Ambrose Evans-Pritchard.
Journalists linked Mantega's announcement to recent interventions by various countries seeking to
devalue their exchange rate including China, Japan, Colombia, Israel and Switzerland. [47][48][49][50][51]
Other analysts such as Goldman Sach's Jim O'Neill asserted that fears of a currency war were
exaggerated.[52] In September, senior policy makers such as Dominique Strauss-Kahn, then
managing director of the IMF, and Tim Geithner, US Secretary of the Treasury, were reported as
saying the chances of a genuine currency war breaking out were low; however by early October,
Strauss-Kahn was warning that the risk of a currency war was real. He also suggested the IMF could
help resolve the trade imbalances which could be the underlying casus belli for conflicts over
currency valuations. Mr Strauss-Kahn said that using currencies as weapons "is not a solution [and]
it can even lead to a very bad situation. There's no domestic solution to a global problem." [53]
Considerable attention had been focused on the US, due to its quantitative easing programmes, and
on China.[54][55] For much of 2009 and 2010, China was under pressure from the US to allow the yuan
to appreciate. Between June and October 2010, China allowed a 2% appreciation, but there were
concerns from Western observers that China only relaxed its intervention when under heavy
pressure. The fixed peg was not abandoned until just before the June G20 meeting, after which the
yuan appreciated by about 1%, only to devalue slowly again, until further US pressure in September
when it again appreciated relatively steeply, just prior to the September US Congressional hearings
to discuss measures to force a revaluation.[56]
Reuters suggested that both China and the United States were "winning" the currency war, holding
down their currencies while pushing up the value of the Euro, the Yen, and the currencies of many
emerging economies.[57]
Martin Wolf, an economics leader writer with the Financial Times, suggested there may be
advantages in western economies taking a more confrontational approach against China, which in
recent years had been by far the biggest practitioner of competitive devaluation. Although he
advised that rather than using protectionist measures which may spark a trade war, a better tactic
would be to use targeted capital controls against China to prevent them buying foreign assets in
order to further devalue the yuan, as previously suggested by Daniel Gros, Director of the Centre for
European Policy Studies.[58][59]
A contrasting view was published on 19 October, with a paper from Chinese economist Huang
Yiping arguing that the US did not win the last "currency war" with Japan,[60] and has even less of a
chance against China; but should focus instead on broader "structural adjustments" at the
November 2010 G-20 Seoul summit.[61]
Discussion over currency war and imbalances dominated the 2010 G-20 Seoul summit, but little
progress was made in resolving the issue.[62][63][64][65][66]
In the first half of 2011 analysts and the financial press widely reported that the currency war had
ended or at least entered a lull,[67][68][69][70] though speaking in July 2011 Guido Mantega told
the Financial Times that the conflict was still ongoing.[71]
As investor confidence in the global economic outlook fell in early August, Bloomberg suggested the
currency war had entered a new phase. This followed renewed talk of a possible third round of
quantitative easing by the US and interventions over the first three days of August by Switzerland
and Japan to push down the value of their currencies.[72][73]
In September, as part of her opening speech for the 66th United Nations Debate, and also in an
article for the Financial Times, Brazilian president Dilma Rousseff called for the currency war to be
ended by increased use of floating currencies and greater cooperation and solidarity among major
economies, with exchange rate policies set for the good of all rather than having individual nations
striving to gain an advantage for themselves.[74][75]
In March 2012, Rousseff said Brazil was still experiencing undesirable upwards pressure on its
currency, with its Finance Minister Guido Mantega saying his country will no longer "play the fool"
and allow others to get away with competitive devaluation, announcing new measures aimed at
limiting further appreciation for the Real.[76] By June however, the Real had fallen substantially from
its peak against the Dollar, and Mantega had been able to begin relaxing his anti-appreciation
measures. [77]

Currency war in 2013[edit]

In mid January 2013, Japan's central bank signalled the intention to launch an open ended bond
buying programme which would likely devalue the yen. This resulted in short lived but intense period
of alarm about the risk of a possible fresh round of currency war.
Numerous senior central bankers and finance ministers issued public warnings, the first being Alexei
Ulyukayev, the first deputy chairman at Russia's central bank. He was later joined by many others
including Park Jae-wan, the finance minister for South Korea, and by Jens Weidmann, president of
the Bundesbank. Weidmann held the view that interventions during the 2009–11 period were not
intense enough to count as competitive devaluation, but that a genuine currency war is now a real
possibility.[78] Japan's economy minister Akira Amari has said that the Bank of Japan's bond buying
programme is intended to combat deflation, and not to weaken the yen. [79]
In early February, ECB president Mario Draghi agreed that expansionary monetary policy like QE
have not been undertaken to deliberately cause devaluation. Draghi's statement did however hint
that the ECB may take action if the Euro continues to appreciate, and this saw the value of the
European currency fall considerably.[80] A mid February statement from the G7 affirmed the advanced
economies commitment to avoid currency war. It was initially read by the markets as an
endorsement of Japan's actions, though later clarification suggested the US would like Japan to tone
down some of its language, specifically by not linking policies like QE to an expressed desire to
devalue the Yen.[81] Most commentators have asserted that if a new round of competitive devaluation
occurs it would be harmful for the global economy. However some analysts have stated that Japan's
planned actions could be in the long term interests of the rest of the world; just as he did for the
2010–11 incident, economist Barry Eichengreen has suggested that even if many other countries
start intervening against their currencies it could boost growth worldwide, as the effects would be
similar to semi-coordinated global monetary expansion. Other analysts have expressed skepticism
about the risk of a war breaking out, with Marc Chandler, chief currency strategist at Brown Brothers
Harriman, advising that: "A real currency war remains a remote possibility."[82] [83] [84] [85]
On 15 February, a statement issued from the G20 meeting of finance ministers and central bank
governors in Moscow affirmed that Japan would not face high level international criticism for its
planned monetary policy. In a remark endorsed by US Fed chairman Ben Bernanke, the IMF's
managing director Christine Lagarde said that recent concerns about a possible currency war had
been "overblown".[86] Paul Krugman has echoed Eichengreen's view that central
bank's unconventional monetary policy is best understood as a shared concern to boost growth, not
as currency war. Goldman Sachs strategist Kamakshya Trivedi has suggested that rising stock
markets imply that market players generally agree that central bank's actions are best understood as
monetary easing and not as competitive devaluation. Other analysts have however continued to
assert that ongoing tensions over currency valuation remain, with currency war and even trade war
still a significant risk. Central bank officials ranging from New Zealand and Switzerland to China
have made fresh statements about possible further interventions against their currencies. [87][88][89][90]
Analyses has been published by currency strategists at RBS, scoring countries on their potential to
undertake intervention, measuring their relative intention to weaken their currency and their capacity
to do so. Ratings are based on the openness of a country's economy, export growth and real
effective exchange rate (REER) valuation, as well as the scope a country has to weaken its currency
without damaging its economy. As of January 2013, Indonesia, Thailand, Malaysia, Chile and
Sweden are the most willing and able to intervene, while the UK and New Zealand are among the
least.[91]
From March 2013, concerns over further currency war diminished, though in November several
journalists and analysts warned of a possible fresh outbreak. The likely principal source of tension
appeared to shift once again, this time not being the U.S. versus China or the Eurozone versus
Japan, but the U.S. versus Germany. In late October U.S. treasury officials had criticized Germany
for running an excessively large current account surplus, thus acting as a drag on the global
economy.[92] [93]

Currency war in 2015[edit]

A €60bn per month quantitative easing programme was launched in January 2015 by the European
Central Bank. While lowering the value of the Euro was not part of the programme's official
objectives, there was much speculation that the new Q.E. represents an escalation of currency war,
especially from analysts working in the FX markets. David Woo for example, a managing director
at Bank of America Merrill Lynch, stated there was a "growing consensus" among market
participants that states are indeed engaging in a stealthy currency war. A Financial Times editorial
however claimed that rhetoric about currency war was once again misguided. [94] [95]
In August 2015, China devalued the yuan by just under 3%, partially due to a weakening export
figures of −8.3% in the previous month.[96] The drop in export is caused by the loss of
competitiveness against other major export countries including Japan and Germany, where the
currency had been drastically devalued during the previous quantitative easing operations. It
sparked a new round of devaluation among Asian currencies, including the Vietnam dong and the
Kazakhstan tenge.[97]
Comparison between 1932 and 21st-century currency wars[edit]

Migrant Mother by Dorothea Lange (1936). This portrait of a 32-year-old farm-worker with seven children
became an iconic photograph symbolising defiance in the face of adversity. A currency war contributed to the
worldwide economic hardship of the 1930s Great Depression.

Both the 1930s and the outbreak of competitive devaluation that began in 2009 occurred during
global economic downturns. An important difference with the 2010s is that international traders are
much better able to hedge their exposures to exchange rate volatility because of more sophisticated
financial markets. A second difference is that the later period's devaluations were invariably caused
by nations expanding their money supplies by creating money to buy foreign currency, in the case of
direct interventions, or by creating money to inject into their domestic economies, with quantitative
easing. If all nations try to devalue at once, the net effect on exchange rates could cancel out,
leaving them largely unchanged, but the expansionary effect of the interventions would remain.
There has been no collaborative intent, but some economists such as Berkeley's Barry
Eichengreen and Goldman Sachs's Dominic Wilson have suggested the net effect will be similar to
semi-coordinated monetary expansion, which will help the global economy.[48][98][99] James Zhan of
the United Nations Conference on Trade and Development (UNCTAD), however, warned in October
2010 that the fluctuations in exchange rates were already causing corporations to scale back their
international investments.[100]
Comparing the situation in 2010 with the currency war of the 1930s, Ambrose Evans-
Pritchard of The Daily Telegraph suggested a new currency war may be beneficial for countries
suffering from trade deficits. He noted that in the 1930s, it was countries with a big surplus that were
severely impacted once competitive devaluation began. He also suggested that overly-
confrontational tactics may backfire on the US by damaging the status of the dollar as a global
reserve currency.[101]
Ben Bernanke, chairman of the US Federal Reserve, also drew a comparison with competitive
devaluation in the interwar period, referring to the sterilisation of gold inflows by France and
America, which helped them sustain large trade surpluses but also caused deflationary pressure on
their trading partners, contributing to the Great Depression. Bernanke stated that the example of the
1930s implies that the "pursuit of export-led growth cannot ultimately succeed if the implications of
that strategy for global growth and stability are not taken into account." [102]
In February 2013, Gavyn Davies for The Financial Times emphasized that a key difference between
the 1930s and the 21st-century outbreaks is that the former had some retaliations between countries
being carried out not by devaluations but by increases in import tariffs, which tend to be much more
disruptive to international trade.[33][103]
The Bretton Woods system of monetary management established the rules for commercial and
financial relations among the United States, Canada, Western European countries, Australia,
and Japan after the 1944 Bretton Woods Agreement. The Bretton Woods system was the first
example of a fully negotiated monetary order intended to govern monetary relations among
independent states. The Bretton Woods system required countries to guarantee convertibility of their
currencies into U.S. dollars to within 1% of fixed parity rates, with the dollar convertible to gold
bullion for foreign governments and central banks at US$35 per troy ounce of fine gold (or 0.88867
gram fine gold per dollar). It also envisioned greater cooperation among countries in order to prevent
future competitive devaluations, and thus established the International Monetary Fund (IMF) to
monitor exchange rates and lend reserve currencies to nations with balance of payments deficits.[1]
Preparing to rebuild the international economic system while World War II was still being fought, 730
delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New
Hampshire, United States, for the United Nations Monetary and Financial Conference, also known
as the Bretton Woods Conference. The delegates deliberated from 1 to 22 July 1944, and signed the
Bretton Woods agreement on its final day. Setting up a system of rules, institutions, and procedures
to regulate the international monetary system, these accords established the IMF and
the International Bank for Reconstruction and Development (IBRD), which today is part of the World
Bank Group. The United States, which controlled two-thirds of the world's gold, insisted that the
Bretton Woods system rest on both gold and the US dollar. Soviet representatives attended the
conference but later declined to ratify the final agreements, charging that the institutions they had
created were "branches of Wall Street".[2] These organizations became operational in 1945 after a
sufficient number of countries had ratified the agreement. According to Barry Eichengreen, the
Bretton Woods system operated successfully due to three factors: "low international capital mobility,
tight financial regulation, and the dominant economic and financial position of the United States and
the dollar."[3]
On 15 August 1971, the United States terminated convertibility of the US dollar to gold, effectively
bringing the Bretton Woods system to an end and rendering the dollar a fiat currency.[4] Shortly
thereafter, many fixed currencies (such as the pound sterling) also became free-floating,[5] and the
subsequent era has been characterized by floating exchange rates.[6] The end of Bretton Woods was
formally ratified by the Jamaica Accords in 1976.
Free trade relied on the free convertibility of currencies. Negotiators at the Bretton Woods
conference, fresh from what they perceived as a disastrous experience with floating rates in the
1930s, concluded that major monetary fluctuations could stall the free flow of trade.
The new economic system required an accepted vehicle for investment, trade, and payments. Unlike
national economies, however, the international economy lacks a central government that can issue
currency and manage its use. In the past this problem had been solved through the gold standard,
but the architects of Bretton Woods did not consider this option feasible for the postwar political
economy. Instead, they set up a system of fixed exchange rates managed by a series of newly
created international institutions using the U.S. dollar (which was a gold standard currency for
central banks) as a reserve currency.

Informal regimes[edit]
Previous regimes[edit]
In the 19th and early 20th centuries gold played a key role in international monetary transactions.
The gold standard was used to back currencies; the international value of currency was determined
by its fixed relationship to gold; gold was used to settle international accounts. The gold standard
maintained fixed exchange rates that were seen as desirable because they reduced the risk when
trading with other countries.
Imbalances in international trade were theoretically rectified automatically by the gold standard. A
country with a deficit would have depleted gold reserves and would thus have to reduce its money
supply. The resulting fall in demand would reduce imports and the lowering of prices would boost
exports; thus the deficit would be rectified. Any country experiencing inflation would lose gold and
therefore would have a decrease in the amount of money available to spend.
This decrease in the amount of money would act to reduce the inflationary pressure. Supplementing
the use of gold in this period was the British pound. Based on the dominant British economy, the
pound became a reserve, transaction, and intervention currency. But the pound was not up to the
challenge of serving as the primary world currency, given the weakness of the British economy after
the Second World War.
The architects of Bretton Woods had conceived of a system wherein exchange rate stability was a
prime goal. Yet, in an era of more activist economic policy, governments did not seriously consider
permanently fixed rates on the model of the classical gold standard of the 19th century. Gold
production was not even sufficient to meet the demands of growing international trade and
investment. Further, a sizable share of the world's known gold reserves were located in the Soviet
Union, which would later emerge as a Cold War rival to the United States and Western Europe.
The only currency strong enough to meet the rising demands for international currency transactions
was the U.S. dollar.[clarification needed] The strength of the U.S. economy, the fixed relationship of the dollar to
gold ($35 an ounce), and the commitment of the U.S. government to convert dollars into gold at that
price made the dollar as good as gold. In fact, the dollar was even better than gold: it earned interest
and it was more flexible than gold.

Fixed exchange rates[edit]

US Dollar Index (DXY)

In the early 1970s, this graph shows some currencies at fixed exchange rates before floating against each
other:

USD/GBP exchange rate

USD/Canadian dollar exchange rate

EUR/USD (inverted) exchange rate

USD/JPY exchange rate

USD/SEK exchange rate

USD/CHF exchange rate

The rules of Bretton Woods, set forth in the articles of agreement of the International Monetary
Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), provided for a
system of fixed exchange rates. The rules further sought to encourage an open system by
committing members to the convertibility of their respective currencies into other currencies and to
free trade.
What emerged was the "pegged rate" currency regime. Members were required to establish a parity
of their national currencies in terms of the reserve currency (a "peg") and to maintain exchange rates
within plus or minus 1% of parity (a "band") by intervening in their foreign exchange markets (that is,
buying or selling foreign money).
In theory, the reserve currency would be the bancor (a World Currency Unit that was never
implemented), proposed by John Maynard Keynes; however, the United States objected and their
request was granted, making the "reserve currency" the U.S. dollar. This meant that other countries
would peg their currencies to the U.S. dollar, and—once convertibility was restored—would buy and
sell U.S. dollars to keep market exchange rates within plus or minus 1% of parity. Thus, the U.S.
dollar took over the role that gold had played under the gold standard in the international financial
system.[29]
Meanwhile, to bolster confidence in the dollar, the U.S. agreed separately to link the dollar to gold at
the rate of $35 per ounce. At this rate, foreign governments and central banks could exchange
dollars for gold. Bretton Woods established a system of payments based on the dollar, which defined
all currencies in relation to the dollar, itself convertible into gold, and above all, "as good as gold" for
trade. U.S. currency was now effectively the world currency, the standard to which every other
currency was pegged. As the world's key currency, most international transactions were
denominated in U.S. dollars.[citation needed]
The U.S. dollar was the currency with the most purchasing power and it was the only currency that
was backed by gold. Additionally, all European nations that had been involved in World War II were
highly in debt and transferred large amounts of gold into the United States, a fact that contributed to
the supremacy of the United States. Thus, the U.S. dollar was strongly appreciated in the rest of the
world and therefore became the key currency of the Bretton Woods system.
Member countries could only change their par value by more than 10% with IMF approval, which
was contingent on IMF determination that its balance of payments was in a "fundamental
disequilibrium". The formal definition of fundamental disequilibrium was never determined, leading to
uncertainty of approvals and attempts to repeatedly devalue by less than 10% instead. [30] Any country
that changed without approval or after being denied approval was denied access to the IMF.

Formal regimes[edit]
The Bretton Woods Conference led to the establishment of the IMF and the IBRD (now the World
Bank), which remain powerful forces in the world economy as of the 2020s.
A major point of common ground at the Conference was the goal to avoid a recurrence of the closed
markets and economic warfare that had characterized the 1930s. Thus, negotiators at Bretton
Woods also agreed that there was a need for an institutional forum for international cooperation on
monetary matters. Already in 1944 the British economist John Maynard Keynes emphasized "the
importance of rule-based regimes to stabilize business expectations"—something he accepted in the
Bretton Woods system of fixed exchange rates. Currency troubles in the interwar years, it was felt,
had been greatly exacerbated by the absence of any established procedure or machinery for
intergovernmental consultation.
As a result of the establishment of agreed upon structures and rules of international economic
interaction, conflict over economic issues was minimized, and the significance of the economic
aspect of international relations seemed to recede.
International Monetary Fund[edit]
Main article: International Monetary Fund

Officially established on 27 December 1945, when the 29 participating countries at the conference of
Bretton Woods signed its Articles of Agreement, the IMF was to be the keeper of the rules and the
main instrument of public international management. The Fund commenced its financial operations
on 1 March 1947. IMF approval was necessary for any change in exchange rates in excess of 10%.
It advised countries on policies affecting the monetary system and lent reserve currencies to nations
that had incurred balance of payment debts.
Design[edit]
The big question at the Bretton Woods conference with respect to the institution that would emerge
as the IMF was the issue of future access to international liquidity and whether that source should be
akin to a world central bank able to create new reserves at will or a more limited borrowing
mechanism.

John Maynard Keynes (right) and Harry Dexter White at the inaugural meeting of the International Monetary
Fund's Board of Governors in Savannah, Georgia, U.S., 8 March 1946

Although attended by 44 nations, discussions at the conference were dominated by two rival plans
developed by the United States and Britain. Writing to the British Treasury, Keynes, who took the
lead at the Conference, did not want many countries. He believed that those from the colonies and
semi-colonies had "nothing to contribute and will merely encumber the ground." [31]
As the chief international economist at the U.S. Treasury in 1942–44, Harry Dexter White drafted the
U.S. blueprint for international access to liquidity, which competed with the plan drafted for the
British Treasury by Keynes. Overall, White's scheme tended to favor incentives designed to create
price stability within the world's economies, while Keynes wanted a system that encouraged
economic growth. The "collective agreement was an enormous international undertaking" that took
two years prior to the conference to prepare for. It consisted of numerous bilateral and multilateral
meetings to reach common ground on what policies would make up the Bretton Woods system.
At the time, gaps between the White and Keynes plans seemed enormous. White basically wanted a
fund to reverse destabilizing flows of financial capital automatically. White proposed a new monetary
institution called the Stabilization Fund that "would be funded with a finite pool of national currencies
and gold… that would effectively limit the supply of reserve credit". Keynes wanted incentives for the
U.S. to help Britain and the rest of Europe rebuild after WWII. [32] Outlining the difficulty of creating a
system that every nation could accept in his speech at the closing plenary session of the Bretton
Woods conference on 22 July 1944, Keynes stated:
We, the delegates of this Conference, Mr President, have been trying to accomplish something very
difficult to accomplish.[...] It has been our task to find a common measure, a common standard, a
common rule acceptable to each and not irksome to any.

— The Collected Writings of John Maynard Keynes[Notes 3]

Keynes' proposals would have established a world reserve currency (which he thought might be
called "bancor") administered by a central bank vested with the power to create money and with the
authority to take actions on a much larger scale.
In the case of balance of payments imbalances, Keynes recommended that both debtors and
creditors should change their policies. As outlined by Keynes, countries with payment surpluses
should increase their imports from the deficit countries, build factories in debtor nations, or donate to
them—and thereby create a foreign trade equilibrium.[14] Thus, Keynes was sensitive to the problem
that placing too much of the burden on the deficit country would be deflationary.
But the United States, as a likely creditor nation, and eager to take on the role of the world's
economic powerhouse, used White's plan but targeted many of Keynes's concerns. White saw a role
for global intervention in an imbalance only when it was caused by currency speculation.
Although a compromise was reached on some points, because of the overwhelming economic and
military power of the United States the participants at Bretton Woods largely agreed on White's plan.
White’s plan was designed not merely to secure the rise and world economic domination of the
United States, but to ensure that as the outgoing superpower Britain would be shuffled even further
from centre stage.[33]
Subscriptions and quotas[edit]
What emerged largely reflected U.S. preferences: a system of subscriptions and quotas embedded
in the IMF, which itself was to be no more than a fixed pool of national currencies and gold
subscribed by each country, as opposed to a world central bank capable of creating money. The
Fund was charged with managing various nations' trade deficits so that they would not produce
currency devaluations that would trigger a decline in imports.
The IMF is provided with a fund composed of contributions from member countries in gold and their
own currencies. The original quotas were to total $8.8 billion. When joining the IMF, members are
assigned "quotas" that reflect their relative economic power—and, as a sort of credit deposit, are
obliged to pay a "subscription" of an amount commensurate with the quota. They pay the
subscription as 25% in gold or currency convertible into gold (effectively the dollar, which at the
founding, was the only currency then still directly gold convertible for central banks) and 75% in their
own currency.
Quota subscriptions form the largest source of money at the IMF's disposal. The IMF set out to use
this money to grant loans to member countries with financial difficulties. Each member is then
entitled to withdraw 25% of its quota immediately in case of payment problems. If this sum should be
insufficient, each nation in the system is also able to request loans for foreign currency.
Trade deficits[edit]
In the event of a deficit in the current account, Fund members, when short of reserves, would be
able to borrow foreign currency in amounts determined by the size of its quota. In other words, the
higher the country's contribution was, the higher the sum of money it could borrow from the IMF.
Members were required to pay back debts within a period of 18 months to five years. In turn, the IMF
embarked on setting up rules and procedures to keep a country from going too deeply into debt year
after year. The Fund would exercise "surveillance" over other economies for the U.S. Treasury in
return for its loans to prop up national currencies.
IMF loans were not comparable to loans issued by a conventional credit institution. Instead, they
were effectively a chance to purchase a foreign currency with gold or the member's national
currency.
The U.S.-backed IMF plan sought to end restrictions on the transfer of goods and services from one
country to another, eliminate currency blocs, and lift currency exchange controls.
The IMF was designed to advance credits to countries with balance of payments deficits. Short-run
balance of payment difficulties would be overcome by IMF loans, which would facilitate stable
currency exchange rates. This flexibility meant a member state would not have to induce
a depression to cut its national income down to such a low level that its imports would finally fall
within its means. Thus, countries were to be spared the need to resort to the classical medicine of
deflating themselves into drastic unemployment when faced with chronic balance of payments
deficits. Before the Second World War, European nations—particularly Britain—often resorted to
this.
Par value[edit]
The IMF sought to provide for occasional discontinuous exchange-rate adjustments (changing a
member's par value) by international agreement. Member nations were permitted to adjust their
currency exchange rate by 1%. This tended to restore equilibrium in their trade by expanding their
exports and contracting imports. This would be allowed only if there was a fundamental
disequilibrium. A decrease in the value of a country's money was called a devaluation, while an
increase in the value of the country's money was called a revaluation.
It was envisioned that these changes in exchange rates would be quite rare. However, the concept
of fundamental disequilibrium, though key to the operation of the par value system, was never
defined in detail.
Operations[edit]
Never before had international monetary cooperation been attempted on a permanent institutional
basis. Even more groundbreaking was the decision to allocate voting rights among governments, not
on a one-state one-vote basis, but rather in proportion to quotas. Since the United States was
contributing the most, U.S. leadership was the key. Under the system of weighted voting, the United
States exerted a preponderant influence on the IMF. The United States held one-third of all IMF
quotas at the outset, enough on its own to veto all changes to the IMF Charter.
In addition, the IMF was based in Washington, D.C., and staffed mainly by U.S. economists. It
regularly exchanged personnel with the U.S. Treasury. When the IMF began operations in 1946,
President Harry S. Truman named White as its first U.S. Executive Director. Since no Deputy
Managing Director post had yet been created, White served occasionally as Acting Managing
Director and generally played a highly influential role during the IMF's first year. Truman had to
abandon his original plan of naming White as IMF Executive Director when FBI Director J. Edgar
Hoover submitted a report to the president, asserting that White was "a valuable adjunct to an
underground Soviet espionage organization", who was placing individuals of high regard to Soviet
intelligence inside the government.[34]
International Bank for Reconstruction and Development [edit]
Main article: International Bank for Reconstruction and Development

The agreement made no provisions to create international reserves. It assumed new gold production
would be sufficient. In the event of structural disequilibria, it expected that there would be national
solutions, for example, an adjustment in the value of the currency or an improvement by other
means of a country's competitive position. The IMF was left with few means, however, to encourage
such national solutions.
Economists and other planners recognized in 1944 that the new system could only commence after
a return to normality following the disruption of World War II. It was expected that after a brief
transition period of no more than five years, the international economy would recover and the system
would enter into operation.
To promote growth of world trade and finance postwar reconstruction of Europe, the planners at
Bretton Woods created another institution, the International Bank for Reconstruction and
Development (IBRD), which is one of five agencies that make up the World Bank Group, and is
perhaps now the most important agency of the Group. The IBRD had an authorized capitalization of
$10 billion and was expected to make loans of its own funds to underwrite private loans and to issue
securities to raise new funds to make possible a speedy postwar recovery. The IBRD was to be a
specialized agency of the United Nations, charged with making loans for economic development
purposes.

Readjustment[edit]
Dollar shortages and the Marshall Plan[edit]
The Bretton Woods arrangements were largely adhered to and ratified by the participating
governments. It was expected that national monetary reserves, supplemented with necessary IMF
credits, would finance any temporary balance of payments disequilibria. But this did not prove
sufficient to get Europe out of its conundrum.
Postwar world capitalism suffered from a dollar shortage. The United States was running large
balance of trade surpluses, and U.S. reserves were immense and growing. It was necessary to
reverse this flow. Even though all nations wanted to buy U.S. exports, dollars had to leave the United
States and become available for international use so they could do so. In other words, the United
States would have to reverse the imbalances in global wealth by running a balance of trade deficit,
financed by an outflow of U.S. reserves to other nations (a U.S. financial account deficit). The U.S.
could run a financial deficit by either importing from, building plants in, or donating to foreign nations.
Speculative investment was discouraged by the Bretton Woods agreement, and importing from other
nations was not appealing in the 1950s, because U.S. technology was cutting edge at the time. So,
multinational corporations and global aid that originated from the U.S. burgeoned. [35]
The modest credit facilities of the IMF were clearly insufficient to deal with Western Europe's huge
balance of payments deficits. The problem was further aggravated by the reaffirmation by the IMF
Board of Governors of the provision in the Bretton Woods Articles of Agreement that the IMF could
make loans only for current account deficits and not for capital and reconstruction purposes. Only
the United States contribution of $570 million was actually available for IBRD lending. In addition,
because the only available market for IBRD bonds was the conservative Wall Street banking market,
the IBRD was forced to adopt a conservative lending policy, granting loans only when repayment
was assured. Given these problems, by 1947 the IMF and the IBRD themselves were admitting that
they could not deal with the international monetary system's economic problems. [36]
The United States set up the European Recovery Program (Marshall Plan) to provide large-scale
financial and economic aid for rebuilding Europe largely through grants rather than loans. Countries
belonging to the Soviet bloc, e.g., Poland were invited to receive the grants, but were given a
favorable agreement with the Soviet Union's COMECON.[37] In a speech at Harvard University on 5
June 1947, U.S. Secretary of State George Marshall stated:
The breakdown of the business structure of Europe during the war was complete. … Europe's
requirements for the next three or four years of foreign food and other essential products …
principally from the United States … are so much greater than her present ability to pay that she
must have substantial help or face economic, social and political deterioration of a very grave
character.
— "Against Hunger, Poverty, Desperation and Chaos"[Notes 4]

From 1947 until 1958, the U.S. deliberately encouraged an outflow of dollars, and, from 1950 on, the
United States ran a balance of payments deficit with the intent of providing liquidity for the
international economy. Dollars flowed out through various U.S. aid programs: the Truman
Doctrine entailing aid to the pro-U.S. Greek and Turkish regimes, which were struggling to suppress
communist revolution, aid to various pro-U.S. regimes in the Third World, and most importantly, the
Marshall Plan. From 1948 to 1954 the United States provided 16 Western European countries with
$17 billion in grants.
To encourage long-term adjustment, the United States promoted European and Japanese trade
competitiveness. Policies for economic controls on the defeated former Axis countries were
scrapped. Aid to Europe and Japan was designed to rebuild productivity and export capacity. In the
long run it was expected that such European and Japanese recovery would benefit the United States
by widening markets for U.S. exports, and providing locations for U.S. capital expansion.

Cold War[edit]
In 1945, Roosevelt and Churchill prepared the postwar era by negotiating with Joseph
Stalin at Yalta about respective zones of influence; this same year Germany was divided into four
occupation zones (Soviet, American, British, and French).
Roosevelt and Henry Morgenthau insisted that the Big Four (United States, United Kingdom, the
Soviet Union, and China) participate in the Bretton Woods conference in 1944, [38] but their plans were
frustrated when the Soviet Union would not join the IMF. The reasons why the Soviet Union chose
not to subscribe to the articles by December 1945 have been the subject of speculation. But since
the release of the relevant documents from the Soviet archives, it is clear that the Soviet calculation
was based on the behavior of the parties that had given their assent to the Bretton Woods
Agreements.[citation needed] The extended debates about ratification that had taken place both in the UK
and the U.S. were read in Moscow as evidence of the quick disintegration of the wartime alliance.
[citation needed]

Facing the Soviet Union, whose power had also strengthened and whose territorial influence had
expanded, the U.S. assumed the role of leader of the capitalist camp. The rise of the postwar U.S.
as the world's leading industrial, monetary, and military power was rooted in the fact that the
mainland U.S. was untouched by the war, in the instability of the nation states of postwar Europe,
and the wartime devastation of the Soviet and European economies.
Despite the economic cost implied by such a policy, being at the center of the international market
gave the U.S. unprecedented freedom of action in pursuing its foreign affairs goals. A trade surplus
made it easier to keep armies abroad and to invest outside the U.S., and because other nations
could not sustain foreign deployments, the U.S. had the power to decide why, when and how to
intervene in global crises. The dollar continued to function as a compass to guide the health of the
world economy, and exporting to the U.S. became the primary economic goal of developing or
redeveloping economies. This arrangement came to be referred to as the Pax Americana, in analogy
to the Pax Britannica of the late 19th century and the Pax Romana of the first. (See Globalism)

Late application[edit]
U.S. balance of payments crisis[edit]
After the end of World War II, the U.S. held $26 billion in gold reserves, of an estimated total of $40
billion (approx 65%). As world trade increased rapidly through the 1950s, the size of the gold base
increased by only a few percentage points. In 1950, the U.S. balance of payments swung negative.
The first U.S. response to the crisis was in the late 1950s when the Eisenhower
administration placed import quotas on oil and other restrictions on trade outflows. More drastic
measures were proposed, but not acted upon. However, with a mounting recession that began in
1958, this response alone was not sustainable. In 1960, with Kennedy's election, a decade-long
effort to maintain the Bretton Woods System at the $35/ounce price began.
The design of the Bretton Woods System was such that nations could only enforce convertibility to
gold for the anchor currency—the United States dollar. Conversion of dollars to gold was allowed but
was not required. Nations could forgo converting dollars to gold, and instead hold dollars. Rather
than full convertibility, the system provided a fixed price for sales between central banks. However,
there was still an open gold market. For the Bretton Woods system to remain workable, it would
either have to alter the peg of the dollar to gold, or it would have to maintain the free market price for
gold near the $35 per ounce official price. The greater the gap between free market gold prices and
central bank gold prices, the greater the temptation to deal with internal economic issues by buying
gold at the Bretton Woods price and selling it on the open market.
In 1960 Robert Triffin, a Belgian-American economist, noticed that holding dollars was more
valuable than gold because constant U.S. balance of payments deficits helped to keep the system
liquid and fuel economic growth. What would later come to be known as Triffin's Dilemma was
predicted when Triffin noted that if the U.S. failed to keep running deficits the system would lose its
liquidity, not be able to keep up with the world's economic growth, and, thus, bring the system to a
halt. But incurring such payment deficits also meant that, over time, the deficits would erode
confidence in the dollar as the reserve currency created instability.[39]
The first effort was the creation of the London Gold Pool on 1 November 1961 between eight
nations. The theory behind the pool was that spikes in the free market price of gold, set by
the morning gold fix in London, could be controlled by having a pool of gold to sell on the open
market, that would then be recovered when the price of gold dropped. Gold's price spiked in
response to events such as the Cuban Missile Crisis, and other less significant events, to as high as
$40/ounce. The Kennedy administration drafted a radical change of the tax system to spur more
production capacity and thus encourage exports. This culminated with the 1963 tax cut program,
designed to maintain the $35 peg.
In 1967, there was an attack on the pound and a run on gold in the sterling area, and on 18
November 1967, the British government was forced to devalue the pound. [40] U.S. President Lyndon
Baines Johnson was faced with a difficult choice, either institute protectionist measures, including
travel taxes, export subsidies and slashing the budget—or accept the risk of a "run on gold" and the
dollar. From Johnson's perspective: "The world supply of gold is insufficient to make the present
system workable—particularly as the use of the dollar as a reserve currency is essential to create
the required international liquidity to sustain world trade and growth."[41]
He believed that the priorities of the United States were correct, and, although there were internal
tensions in the Western alliance, that turning away from open trade would be more costly,
economically and politically, than it was worth: "Our role of world leadership in a political and military
sense is the only reason for our current embarrassment in an economic sense on the one hand and
on the other the correction of the economic embarrassment under present monetary systems will
result in an untenable position economically for our allies."[citation needed]
While West Germany agreed not to purchase gold from the U.S., and agreed to hold dollars instead,
the pressure on both the dollar and the pound sterling continued. In January 1968 Johnson imposed
a series of measures designed to end gold outflow, and to increase U.S. exports. This was
unsuccessful, however, as in mid-March 1968 a dollar run on gold ensued through the free market in
London, the London Gold Pool was dissolved, initially by the institution of ad hoc UK bank
holidays at the request of the U.S. government. This was followed by a full closure of the London
gold market, also at the request of the U.S. government, until a series of meetings were held that
attempted to rescue or reform the existing system.[42]
All attempts to maintain the peg collapsed in November 1968, and a new policy program attempted
to convert the Bretton Woods system into an enforcement mechanism of floating the gold peg, which
would be set by either fiat policy or by a restriction to honor foreign accounts. The collapse of the
gold pool and the refusal of the pool members to trade gold with private entities—on 18 March 1968
the Congress of the United States repealed the 25% requirement of gold backing of the dollar[43]—as
well as the U.S. pledge to suspend gold sales to governments that trade in the private markets, [44] led
to the expansion of the private markets for international gold trade, in which the price of gold rose
much higher than the official dollar price.[45][46] U.S. gold reserves remained depleted due to the
actions of some nations, notably France,[46] which continued to build up their own gold reserves.

Structural changes[edit]
Return to convertibility[edit]
In the 1960s and 1970s, important structural changes eventually led to the breakdown of
international monetary management. One change was the development of a high level of monetary
interdependence. The stage was set for monetary interdependence by the return to convertibility of
the Western European currencies at the end of 1958 and of the Japanese yen in 1964. Convertibility
facilitated the vast expansion of international financial transactions, which deepened monetary
interdependence.
Growth of international currency markets[edit]
Another aspect of the internationalization of banking has been the emergence of international
banking consortia. Since 1964 various banks had formed international syndicates, and by 1971 over
three-quarters of the world's largest banks had become shareholders in such syndicates.
Multinational banks can and do make large international transfers of capital not only for investment
purposes but also for hedging and speculating against exchange rate fluctuations.
These new forms of monetary interdependence made large capital flows possible. During the
Bretton Woods era, countries were reluctant to alter exchange rates formally even in cases of
structural disequilibria. Because such changes had a direct impact on certain domestic economic
groups, they came to be seen as political risks for leaders. As a result, official exchange rates often
became unrealistic in market terms, providing a virtually risk-free temptation for speculators. They
could move from a weak to a strong currency hoping to reap profits when a revaluation occurred. If,
however, monetary authorities managed to avoid revaluation, they could return to other currencies
with no loss. The combination of risk-free speculation with the availability of large sums was highly
destabilizing.

Decline[edit]
U.S. monetary influence[edit]
A second structural change that undermined monetary management was the decline of U.S.
hegemony. The U.S. was no longer the dominant economic power it had been for more than two
decades. By the mid-1960s, the E.E.C. and Japan had become international economic powers in
their own right. With total reserves exceeding those of the U.S., higher levels of growth and trade,
and per capita income approaching that of the U.S., Europe and Japan were narrowing the gap
between themselves and the United States.
The shift toward a more pluralistic distribution of economic power led to increasing dissatisfaction
with the privileged role of the U.S. dollar as the international currency. Acting effectively as the
world's central banker, the U.S., through its deficit, determined the level of international liquidity. In
an increasingly interdependent world, U.S. policy significantly influenced economic conditions in
Europe and Japan. In addition, as long as other countries were willing to hold dollars, the U.S. could
carry out massive foreign expenditures for political purposes—military activities and foreign aid—
without the threat of balance-of-payments constraints.
Dissatisfaction with the political implications of the dollar system was increased by détente between
the U.S. and the Soviet Union. The Soviet military threat had been an important force in cementing
the U.S.-led monetary system. The U.S. political and security umbrella helped make American
economic domination palatable for Europe and Japan, which had been economically exhausted by
the war. As gross domestic production grew in European countries, trade grew. When common
security tensions lessened, this loosened the transatlantic dependence on defence concerns, and
allowed latent economic tensions to surface.
Dollar[edit]
Reinforcing the relative decline in U.S. power and the dissatisfaction of Europe and Japan with the
system was the continuing decline of the dollar—the foundation that had underpinned the post-1945
global trading system. The Vietnam War and the refusal of the administration of U.S.
President Lyndon B. Johnson to pay for it and its Great Society programs through taxation resulted
in an increased dollar outflow to pay for the military expenditures and rampant inflation, which led to
the deterioration of the U.S. balance of trade position. In the late 1960s, the dollar was overvalued
with its current trading position, while the German Mark and the yen were undervalued; and,
naturally, the Germans and the Japanese had no desire to revalue and thereby make their exports
more expensive, whereas the U.S. sought to maintain its international credibility by avoiding
devaluation.[47] Meanwhile, the pressure on government reserves was intensified by the new
international currency markets, with their vast pools of speculative capital moving around in search
of quick profits.[46]
In contrast, upon the creation of Bretton Woods, with the U.S. producing half of the world's
manufactured goods and holding half its reserves, the twin burdens of international management
and the Cold War were possible to meet at first. Throughout the 1950s Washington sustained a
balance of payments deficit to finance loans, aid, and troops for allied regimes. But during the 1960s
the costs of doing so became less tolerable. By 1970 the U.S. held under 16% of international
reserves. Adjustment to these changed realities was impeded by the U.S. commitment to fixed
exchange rates and by the U.S. obligation to convert dollars into gold on demand.

The Bretton Woods system in the 21st century[edit]

2008 crisis[edit]
In the wake of the Global financial crisis of 2008, some policymakers, such as Chace[52] and others
have called for a new international monetary system that some of them also dub Bretton Woods II.
On the other side, this crisis has revived the debate about Bretton Woods II. [Notes 5]
On 26 September 2008, French President Nicolas Sarkozy said, "we must rethink the financial
system from scratch, as at Bretton Woods."[53]
In March 2010, Prime Minister Papandreou of Greece wrote an op-ed in the International Herald
Tribune, in which he said, "Democratic governments worldwide must establish a new global financial
architecture, as bold in its own way as Bretton Woods, as bold as the creation of the European
Community and European Monetary Union. And we need it fast." In interviews coinciding with his
meeting with President Obama, he indicated that Obama would raise the issue of new regulations
for the international financial markets at the next G20 meetings in June and November 2010.
Over the course of the crisis, the IMF progressively relaxed its stance on "free-market" principles
such as its guidance against using capital controls. In 2011, the IMF's managing director Dominique
Strauss-Kahn stated that boosting employment and equity "must be placed at the heart" of the IMF's
policy agenda.[54] The World Bank indicated a switch towards greater emphases on job creation. [55][56]

2020 crisis[edit]
Following the 2020 Economic Recession, the managing director of the IMF announced the
emergence of "A New Bretton Woods Moment" which outlines the need for coordinated fiscal
response on the part of central banks around the world to address the ongoing economic crisis. [57]
Pegged rates[edit]
Dates are those when the rate was introduced; "*" indicates floating rate mostly taken prior to the
introduction of the euro on 1 January 1999.[58]
Currency substitution is the use of a foreign currency in parallel to or instead of a domestic
currency.[1] The process is also known as dollarization or euroization when the foreign currency is
the dollar or the euro, respectively.
Currency substitution can be full or partial. Full currency substitution can occur after a major
economic crisis, such as in Ecuador, El Salvador, and Zimbabwe. Some small economies, for whom
it is impractical to maintain an independent currency, use the currencies of their larger neighbours;
for example, Liechtenstein uses the Swiss franc.
Partial currency substitution occurs when residents of a country choose to hold a significant share of
their financial assets denominated in a foreign currency. It can also occur as a gradual conversion to
full currency substitution; for example, Argentina and Peru were both in the process of converting to
the U.S. dollar during the 1990s.

Effects[edit]
On trade and investment[edit]
One of the main advantages of adopting a strong foreign currency as sole legal tender is to reduce
the transaction costs of trade among countries using the same currency.[12] There are at least two
ways to infer this impact from data. The first is the significantly negative effect of exchange rate
volatility on trade in most cases, and the second is an association between transaction costs and the
need to operate with multiple currencies.[13] Economic integration with the rest of the world becomes
easier as a result of lowered transaction costs and stabler prices.[14] Rose (2000) applied the gravity
model of trade and provided empirical evidence that countries sharing a common currency engage
in significantly increased trade among them, and that the benefits of currency substitution for trade
may be large.[15]
Countries with full currency substitution can invoke greater confidence among international
investors, inducing increased investments and growth. The elimination of the currency crisis risk due
to full currency substitution leads to a reduction of country risk premiums and then to lower interest
rates.[14] These effects result in a higher level of investment. However, there is a positive association
between currency substitution and interest rates in a dual-currency economy.[16]

On monetary and exchange rate policies[edit]

Official currency substitution helps to promote fiscal and monetary discipline and thus greater
macroeconomic stability and lower inflation rates, to lower real exchange rate volatility, and possibly
to deepen the financial system.[13] Firstly, currency substitution helps developing countries, providing
a firm commitment to stable monetary and exchange rate policies by forcing a passive monetary
policy. Adopting a strong foreign currency as legal tender will help to "eliminate the inflation-bias
problem of discretionary monetary policy".[17] Secondly, official currency substitution imposes stronger
financial constraint on the government by eliminating deficit financing by issuing money. [18] An
empirical finding suggests that inflation has been significantly lower in economies with full currency
substitution than nations with domestic currencies.[19] The expected benefit of currency substitution is
the elimination of the risk of exchange rate fluctuations and a possible reduction in the country's
international exposure. Currency substitution cannot eliminate the risk of an external crisis but
provides steadier markets as a result of eliminating fluctuations in exchange rates. [14]
On the other hand, currency substitution leads to the loss of seigniorage revenue, the loss of
monetary policy autonomy, and the loss of the exchange rate instruments. Seigniorage revenues are
the profits generated when monetary authorities issue currency. When adopting a foreign currency
as legal tender, a monetary authority needs to withdraw the domestic currency and give up future
seigniorage revenue. The country loses the rights to its autonomous monetary and exchange
rate policies, even in times of financial emergency.[14][20] For example, former chairman of the Federal
Reserve Alan Greenspan has stated that the central bank considers the effects of its decisions only
on the US economy.[21] In a full currency substituted economy, exchange rates are indeterminate and
monetary authorities cannot devalue the currency.[22] In an economy with high currency
substitution, devaluation policy is less effective in changing the real exchange rate because of
significant pass-through effects to domestic prices.[14] However, the cost of losing an independent
monetary policy exists when domestic monetary authorities can commit an effective counter-cyclical
monetary policy, stabilizing the business cycle. This cost depends adversely on the correlation
between the business cycle of the client country (the economy with currency substitution) and the
business cycle of the anchor country.[12] In addition, monetary authorities in economies with currency
substitution diminish the liquidity assurance to their banking system.[14][23]

On banking systems[edit]
In an economy with full currency substitution, monetary authorities cannot act as lender of last
resort to commercial banks by printing money. The alternatives to lending to the bank system may
include taxation and issuing government debt.[24] The loss of the lender of last resort is considered a
cost of full currency substitution. This cost depends on the initial level of unofficial currency
substitution before moving to a full currency substituted economy. This relation is negative because
in a heavily currency substituted economy, the central bank already fears difficulties in providing
liquidity assurance to the banking system.[25] However, literature points out the existence of
alternative mechanisms to provide liquidity insurance to banks, such as a scheme by which the
international financial community charges an insurance fee in exchange for a commitment to lend to
a domestic bank.[26]
Commercial banks in countries where saving accounts and loans in foreign currency are allowed
may face two types of risks:

1. Currency mismatch risk: Assets and liabilities on the balance sheets may be in different
denominations. This may arise if the bank converts foreign currency deposits into local
currency and lends in local currency or vice versa.
2. Default risk: Arises if the bank uses the foreign currency deposits to lend in foreign currency.
[27]

However, currency substitution eliminates the probability of a currency crisis that negatively affects
the banking system through the balance sheet channel. Currency substitution may reduce the
possibility of systematic liquidity shortages and the optimal reserves in the banking system.
[28]
Research has shown that official currency substitution has played a significant role in improving
bank liquidity and asset quality in Ecuador and El Salvador.[29]

Determinants of the currency substitution process[edit]

The dynamics of the flight from domestic money[edit]
High and unanticipated inflation rates decrease the demand for domestic money and raise the
demand for alternative assets, including foreign currency and assets dominated by foreign currency.
This phenomenon is called the "flight from domestic money". It results in a rapid and sizable process
of currency substitution.[30] In countries with high inflation rates, the domestic currency tends to be
gradually displaced by a stable currency. At the beginning of this process, the store-of-value function
of the domestic currency is replaced by the foreign currency. Then, the unit-of-account function of
the domestic currency is displaced when many prices are quoted in a foreign currency. A prolonged
period of high inflation will induce the domestic currency to lose its function as medium of
exchange when the public carries out many transactions in foreign currency.[31]: 1
Ize and Levy-Yeyati (1998) examine the determinants of deposit and credit currency substitution,
concluding that currency substitution is driven by the volatility of inflation and the real exchange rate.
Currency substitution increases with inflation volatility and decreases with the volatility of the real
exchange rate.[32]

Institutional factors[edit]
The flight from domestic money depends on a country's institutional factors. The first factor is the
level of development of the domestic financial market. An economy with a well-developed financial
market can offer a set of alternative financial instruments denominated in domestic currency,
reducing the role of foreign currency as an inflation hedge. The pattern of the currency substitution
process also varies across countries with different foreign exchange and capital controls. In a
country with strict foreign exchange regulations, the demand for foreign currency will be satisfied in
the holding of foreign currency assets abroad and outside the domestic banking system. This
demand often puts pressure on the parallel market of foreign currency and on the country's
international reserves.[30] Evidence for this pattern is given in the absence of currency substitution
during the pre-reform period in most transition economies, because of constricted controls on foreign
exchange and the banking system.[31]: 13 In contrast, by increasing foreign currency reserves, a
country might mitigate the shift of assets abroad and strengthen its external reserves in exchange for
a currency substitution process. However, the effect of this regulation on the pattern of currency
substitution depends on the public's expectations of macroeconomic stability and the sustainability of
the foreign exchange regime.[30]

Anchor currencies[edit]
Australian dollar[edit]
Main article: Australian dollar

 Kiribati (since 1943. Also uses its own coins)[33]: 17

 Nauru (since 1914; also issues non-circulating Nauran collector coins pegged to the
Australian dollar.)[33]: 17 [34]
 Tuvalu (since 1892. Also uses its own coins.)[33]: 17
Euro[edit]
Main articles: Euro and International status and usage of the euro

 Andorra (formerly French franc and Spanish peseta; issued non-circulating Andorran
diner coins; issues its own euro coins). Has used French and Spanish currency since 1278.[33]: 17
 Cyprus (used in the Sovereign Base Areas of Akrotiri and Dhekelia; formerly used
the Cypriot pound.)
 France (used in the Overseas country and territories of the French Southern and Antarctic
Lands, Saint Barthélemy and Saint Pierre and Miquelon. Euro is used in the French overseas
and department region of Guadeloupe.)
 Kosovo (formerly German mark and Yugoslav dinar.)
 Luxembourg (used the Luxembourgish franc from 1839-2001 and the Belgian franc at par;
issues its own euro coins.)
 Monaco (formerly French franc from 1865-2002 and Monégasque franc;[33]: 17 issues its own
euro coins.)
 Montenegro (formerly German mark and Yugoslav dinar.)
 North Korea (along with the Renminbi, United States dollar, and North Korean won)[35]
 San Marino (formerly Italian lira and Sammarinese lira; issues its own euro coins.)
 Vatican City (formerly Italian lira and Vatican lira; issues its own euro coins.)
 Zimbabwe (Alongside United States dollar, South African rand, Botswana pula, Japanese
yen, several other currencies and US dollar-denominated bond coins and bond notes of the Real
Time Gross Settlement (RTGS) dollar.)
Monetary policy is the policy adopted by the monetary authority of a nation to control either
the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet
their short-term needs) or the money supply, often as an attempt to reduce inflation or the interest
rate, to ensure price stability and general trust of the value and stability of the nation's currency.[1][2][3]

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Monetary policy is a modification of the supply of money, i.e. "printing" more money, or decreasing
the money supply by changing interest rates or removing excess reserves. This is in contrast
to fiscal policy, which relies on taxation, government spending, and government borrowing[4] as
methods for a government to manage business cycle phenomena such as recessions.
Further purposes of a monetary policy are usually to contribute to the stability of gross domestic
product, to achieve and maintain low unemployment, and to maintain predictable exchange
rates with other currencies.
Monetary economics can provide insight into crafting optimal monetary policy. In developed
countries, monetary policy is generally formed separately from fiscal policy.
Monetary policy is referred to as being either expansionary or contractionary.
Expansionary policy occurs when a monetary authority uses its procedures to stimulate the
economy. An expansionary policy maintains short-term interest rates at a lower than usual rate or
increases the total supply of money in the economy more rapidly than usual. It is traditionally used to
try to reduce unemployment during a recession by decreasing interest rates in the hope that less
expensive credit will entice businesses into borrowing more money and thereby expanding. This
would increase aggregate demand (the overall demand for all goods and services in an economy),
which would increase short-term growth as measured by increase of gross domestic product (GDP).
Expansionary monetary policy, by increasing the amount of currency in circulation, usually
diminishes the value of the currency relative to other currencies (the exchange rate), in which case
foreign purchasers will be able to purchase more with their currency in the country with the devalued
currency.[5]
Contractionary policy maintains short-term interest rates greater than usual, slows the rate of
growth of the money supply, or even decreases it to slow short-term economic growth and
lessen inflation. Contractionary policy can result in increased unemployment and depressed
borrowing and spending by consumers and businesses, which can eventually result in an economic
recession if implemented too vigorously.[6]
Monetary policy instruments[edit]
The main monetary policy instruments available to central banks are open market operation,
bank reserve requirement, interest rate policy, re-lending and re-discount (including using the term
repurchase market), and credit policy (often coordinated with trade policy). While capital adequacy is
important, it is defined and regulated by the Bank for International Settlements, and central banks in
practice generally do not apply stricter rules.

Conventional instrument[edit]
The central bank influences interest rates by expanding or contracting the monetary base, which
consists of currency in circulation and banks' reserves on deposit at the central bank. Central banks
have three main methods of monetary policy: open market operations, the discount rate and
the reserve requirements.
Key Interest rates & refinancing operations[edit]
By far the most visible and obvious power of many modern central banks is to influence market
interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. Although the
mechanism differs from country to country, most use a similar mechanism based on a central bank's
ability to create as much fiat money as required.
The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is
generally to lend money or borrow money in theoretically unlimited quantities until the targeted
market rate is sufficiently close to the target. Central banks may do so by lending money to and
borrowing money from (taking deposits from) a limited number of qualified banks, or by purchasing
and selling bonds. As an example of how this functions, the Bank of Canada sets a target overnight
rate, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band,
but never above or below, because the central bank will always lend to them at the top of the band,
and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the
extremes of the band are unlimited.[16] Other central banks use similar mechanisms.

Yield curve becomes inverted when short-term rates exceed long-term rates.

The target rates are generally short-term rates. The actual rate that borrowers and lenders receive
on the market will depend on (perceived) credit risk, maturity and other factors. For example, a
central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-
year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, even below the short-term
rate. Many central banks have one primary "headline" rate that is quoted as the "central bank rate".
In practice, they will have other tools and rates that are used, but only one that is rigorously targeted
and enforced.

2016 meeting of the Federal Open Market Committee at the Eccles Building, Washington, D.C.

"The rate at which the central bank lends money can indeed be chosen at will by the central bank;
this is the rate that makes the financial headlines."[17] Henry C.K. Liu explains further that "the U.S.
central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed funds
rate, which its Open Market Committee tries to match by lending or borrowing in the money
market ... a fiat money system set by command of the central bank. The Fed is the head of the
central-bank because the U.S. dollar is the key reserve currency for international trade. The global
money market is a USA dollar market. All other currencies markets revolve around the U.S. dollar
market." Accordingly, the U.S. situation is not typical of central banks in general.
Typically a central bank controls certain types of short-term interest rates. These influence
the stock- and bond markets as well as mortgage and other interest rates. The European Central
Bank, for example, announces its interest rate at the meeting of its Governing Council; in the case of
the U.S. Federal Reserve, the Federal Reserve Board of Governors. Both the Federal Reserve and
the ECB are composed of one or more central bodies that are responsible for the main decisions
about interest rates and the size and type of open market operations, and several branches to
execute its policies. In the case of the Federal Reserve, they are the local Federal Reserve Banks;
for the ECB they are the national central banks.
A typical central bank has several interest rates or monetary policy tools it can set to influence
markets.

 Marginal lending rate – a fixed rate for institutions to borrow money from the central bank. (In the
USA this is called the discount rate).
 Main refinancing rate – the publicly visible interest rate the central bank announces. It is also
known as minimum bid rate and serves as a bidding floor for refinancing loans. (In the USA this
is called the federal funds rate).
 Deposit rate, generally consisting of interest on reserves and sometimes also interest on excess
reserves – the rates parties receive for deposits at the central bank.
These rates directly affect the rates in the money market, the market for short-term loans.
Some central banks (e.g. in Denmark, Sweden and the Eurozone) are currently applying negative
interest rates.
Open market operations[edit]

Mechanics of open market operations: Demand-Supply model for reserves market

Through open market operations, a central bank influences the money supply in an economy. Each
time it buys securities (such as a government bond or treasury bill), it in effect creates money. The
central bank exchanges money for the security, increasing the money supply while lowering the
supply of the specific security. Conversely, selling of securities by the central bank reduces the
money supply.

1979 $10,000 United States Treasury bond

Open market operations usually take the form of:

 Buying or selling securities ("direct operations") to achieve an interest rate target in the interbank
market .
 Temporary lending of money for collateral securities ("Reverse Operations" or "repurchase
operations", otherwise known as the "repo" market). These operations are carried out on a
regular basis, where fixed maturity loans (of one week and one month for the ECB) are
auctioned off.
 Foreign exchange operations such as foreign exchange swaps.
These interventions can also influence the foreign exchange market and thus the exchange rate. For
example, the People's Bank of China and the Bank of Japan have on occasion bought several
hundred billions of U.S. Treasuries, presumably in order to stop the decline of the U.S. dollar versus
the renminbi and the yen.
Reserve requirements[edit]

A run on a Bank of East Asia branch in Hong Kong, caused by "malicious rumours" in 2008.

Historically, bank reserves have formed only a small fraction of deposits, a system called fractional-
reserve banking. Banks would hold only a small percentage of their assets in the form of
cash reserves as insurance against bank runs. Over time this process has been regulated and
insured by central banks. Such legal reserve requirements were introduced in the 19th century as an
attempt to reduce the risk of banks overextending themselves and suffering from bank runs, as this
could lead to knock-on effects on other overextended banks. See also money multiplier.

Gold certificates were used as paper currency in the United States from 1882 to 1933. These certificates were
freely convertible into gold coins.

As the early 20th century gold standard was undermined by inflation and the late 20th-century
fiat dollar hegemony evolved, and as banks proliferated and engaged in more complex transactions
and were able to profit from dealings globally on a moment's notice, these practices became
mandatory, if only to ensure that there was some limit on the ballooning of money supply. [citation needed]
A number of central banks have since abolished their reserve requirements over the last few
decades, beginning with the Reserve Bank of New Zealand in 1985 and continuing with the Federal
Reserve in 2020. For the respective banking systems, bank capital requirements provide a check on
the growth of the money supply.
The People's Bank of China retains (and uses) more powers over reserves because the yuan that it
manages is a non-convertible currency.[citation needed]
Loan activity by banks plays a fundamental role in determining the money supply. The central-bank
money after aggregate settlement – "final money" – can take only one of two forms:

 physical cash, which is rarely used in wholesale financial markets,

 central-bank money which is rarely used by the people
The currency component of the money supply is far smaller than the deposit component. Currency,
bank reserves and institutional loan agreements together make up the monetary base, called M1,
M2 and M3. The Federal Reserve Bank stopped publishing M3 and counting it as part of the money
supply in 2006.[18]
Credit guidance[edit]
Main article: Window guidance
Central banks can directly or indirectly influence the allocation of bank lending in certain sectors of
the economy by applying quotas, limits or differentiated interest rates. [19][20] This allows the central
bank to control both the quantity of lending and its allocation towards certain strategic sectors of the
economy, for example to support the national industrial policy, or to environmental investment such
as housing renovation.[21][22]

The Bank of Japan, in Tokyo, established in 1882.

The Bank of Japan used to apply such policy ("window guidance") between 1962 and 1991.[23]
[24]
The Banque de France also widely used credit guidance during the post-war period of 1948 until
1973 .[25]
The European Central Bank's ongoing TLTROs operations can also be described as form of credit
guidance insofar as the level of interest rate ultimately paid by banks is differentiated according to
the volume of lending made by commercial banks at the end of the maintenance period. If
commercial banks achieve a certain lending performance threshold, they get a discount interest rate,
that is lower than the standard key interest rate. For this reason, some economists have described
the TLTROs as a "dual interest rates" policy.[26][27] China is also applying a form of dual rate policy.[28][29]
Exchange requirements[edit]
To influence the money supply, some central banks may require that some or all foreign exchange
receipts (generally from exports) be exchanged for the local currency. The rate that is used to
purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally
used in countries with non-convertible currencies or partially convertible currencies. The recipient of
the local currency may be allowed to freely dispose of the funds, required to hold the funds with the
central bank for some period of time, or allowed to use the funds subject to certain restrictions. In
other cases, the ability to hold or use the foreign exchange may be otherwise limited.
In this method, money supply is increased by the central bank when it purchases the foreign
currency by issuing (selling) the local currency. The central bank may subsequently reduce the
money supply by various means, including selling bonds or foreign exchange interventions.
Collateral policy[edit]
In some countries, central banks may have other tools that work indirectly to limit lending practices
and otherwise restrict or regulate capital markets. For example, a central bank may regulate margin
lending, whereby individuals or companies may borrow against pledged securities. The margin
requirement establishes a minimum ratio of the value of the securities to the amount borrowed.
Central banks often have requirements for the quality of assets that may be held by financial
institutions; these requirements may act as a limit on the amount of risk and leverage created by the
financial system. These requirements may be direct, such as requiring certain assets to bear certain
minimum credit ratings, or indirect, by the central bank lending to counter-parties only when security
of a certain quality is pledged as collateral.
Forward guidance[edit]
Main article: Forward guidance

Forward guidance is a communication practice whereby the central bank announces its forecasts
and future intentions to increase market expectations of future levels of interest rates.

Unconventional monetary policy at the zero bound[edit]

Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are
concerns about deflation or deflation is occurring, are referred to as unconventional monetary
policy. These include credit easing, quantitative easing, forward guidance, and signalling.[30] In credit
easing, a central bank purchases private sector assets to improve liquidity and improve access to
credit. Signaling can be used to lower market expectations for lower interest rates in the future. For
example, during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for
an "extended period", and the Bank of Canada made a "conditional commitment" to keep rates at the
lower bound of 25 basis points (0.25%) until the end of the second quarter of 2010.
Helicopter money[edit]
Main article: Helicopter money

Further heterodox monetary policy proposals include the idea of helicopter money whereby central
banks would create money without assets as counterpart in their balance sheet. The money created
could be distributed directly to the population as a citizen's dividend. Virtues of such money shock
include the decrease of household risk aversion and the increase in demand, boosting both inflation
and the output gap. This option has been increasingly discussed since March 2016 after the ECB's
president Mario Draghi said he found the concept "very interesting".[31] The idea was also promoted
by prominent former central bankers Stanley Fischer and Philipp Hildebrand in a paper published
by BlackRock,[32] and in France by economists Philippe Martin and Xavier Ragot from the French
Council for Economic Analysis, a think tank attached to the Prime minister's office. [33]
Some have envisaged the use of what Milton Friedman once called "helicopter money" whereby the
central bank would make direct transfers to citizens[34] in order to lift inflation up to the central bank's
intended target. Such policy option could be particularly effective at the zero lower bound. [35]

Nominal anchors[edit]
A nominal anchor for monetary policy is a single variable or device which the central bank uses to
pin down expectations of private agents about the nominal price level or its path or about what the
central bank might do with respect to achieving that path. Monetary regimes combine long-run
nominal anchoring with flexibility in the short run. Nominal variables used as anchors primarily
include exchange rate targets, money supply targets, and inflation targets with interest rate policy. [36]

Types[edit]
In practice, to implement any type of monetary policy the main tool used is modifying the amount
of base money in circulation. The monetary authority does this by buying or selling financial assets
(usually government obligations). These open market operations change either the amount of money
or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional
reserve banking amplifies the effects of these actions on the money supply, which includes bank
deposits as well as base money.
Constant market transactions by the monetary authority modify the supply of currency and this
impacts other market variables such as short-term interest rates and the exchange rate.
The distinction between the various types of monetary policy lies primarily with the set of instruments
and target variables that are used by the monetary authority to achieve their goals.
 Monetary Policy Target Market Variable Long Term Objective

Interest rate on overnight

Inflation Targeting A given rate of change in the CPI
debt

Interest rate on overnight

Price Level Targeting A specific CPI number
debt

Monetary
The growth in money supply A given rate of change in the CPI
Aggregates

Fixed Exchange
The spot price of the currency The spot price of the currency
Rate

Gold Standard The spot price of gold Low inflation as measured by the gold price

Mixed Policy Usually interest rates Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange-rate
regimes. A fixed exchange rate is also an exchange-rate regime; The gold standard results in a
relatively fixed regime towards the currency of other countries on the gold standard and a floating
regime towards those that are not. Targeting inflation, the price level or other monetary aggregates
implies floating the exchange rate unless the management of the relevant foreign currencies is
tracking exactly the same variables (such as a harmonized consumer price index).
Inflation targeting[edit]
Main article: Inflation targeting

Under this policy approach, the target is to keep inflation, under a particular definition such as
the Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the central bank interest rate target.
The interest rate used is generally the overnight rate at which banks lend to each other overnight for
cash flow purposes. Depending on the country this particular interest rate might be called the cash
rate or something similar.
As the Fisher effect model explains, the equation linking inflation with interest rates is the following:
π=i–r
where π is the inflation rate, i is the home nominal interest rate set by the central bank, and r is
the real interest rate. Using i as an anchor, central banks can influence π. Central banks can
choose to maintain a fixed interest rate at all times, or just temporarily. The duration of this policy
varies, because of the simplicity associated with changing the nominal interest rate.
The interest rate target is maintained for a specific duration using open market operations.
Typically the duration that the interest rate target is kept constant will vary between months and
years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy
committee.[36]
Changes to the interest rate target are made in response to various market indicators in an
attempt to forecast economic trends and in so doing keep the market on track towards achieving
the defined inflation target. For example, one simple method of inflation targeting called
the Taylor rule adjusts the interest rate in response to changes in the inflation rate and
the output gap. The rule was proposed by John B. Taylor of Stanford University.[37]
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It
has been used in Australia, Brazil, Canada, Chile, Colombia, the Czech Republic, Hungary, New
Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and
the United Kingdom. Since 1990, an increasing number of countries have switched to inflation
targeting as its monetary policy framework.[38] However, critics contend that there are unintended
consequences to this approach such as fueling the increase in housing prices and contributing
to wealth inequalities by supporting higher equity values.[39]
Price level targeting[edit]
Price level targeting is a monetary policy that is similar to inflation targeting except that CPI
growth in one year over or under the long term price level target is offset in subsequent years
such that a targeted price-level trend is reached over time, e.g. five years, giving more certainty
about future price increases to consumers. Under inflation targeting what happened in the
immediate past years is not taken into account or adjusted for in the current and future years.
Uncertainty in price levels can create uncertainty around price and wage setting activity for firms
and workers, and undermines any information that can be gained from relative prices, as it is
more difficult for firms to determine if a change in the price of a good or service is because
of inflation or other factors, such as an increase in the efficiency of factors of production,
if inflation is high and volatile. An increase in inflation also leads to a decrease in the demand for
money, as it reduces the incentive to hold money and increases transaction costs and shoe
leather costs.
Monetary aggregates/money supply targeting[edit]
In the 1980s, several countries used an approach based on a constant growth in the money
supply. This approach was refined to include different classes of money and credit (M0, M1
etc.). In the US this approach to monetary policy was discontinued with the selection of Alan
Greenspan as Fed Chairman.
This approach is also sometimes called monetarism.
Central banks might choose to set a money supply growth target as a nominal anchor to keep
prices stable in the long term. The quantity theory is a long run model, which links price levels to
money supply and demand. Using this equation, we can rearrange to see the following:
π = μ − g,
where π is the inflation rate, μ is the money supply growth rate and g is the real output
growth rate. This equation suggests that controlling the money supply's growth rate can
ultimately lead to price stability in the long run. To use this nominal anchor, a central bank
would need to set μ equal to a constant and commit to maintaining this target.
However, targeting the money supply growth rate is considered a weak policy, because it is
not stably related to the real output growth, As a result, a higher output growth rate will result
in a too low level of inflation. A low output growth rate will result in inflation that would be
higher than the desired level.[36]
While monetary policy typically focuses on a price signal of one form or another, this
approach is focused on monetary quantities. As these quantities could have a role in the
economy and business cycles depending on the households' risk aversion level, money is
sometimes explicitly added in the central bank's reaction function.[40] After the 1980s,
however, central banks have shifted away from policies that focus on money supply
targeting, because of the uncertainty that real output growth introduces. Some central
banks, like the ECB, have chosen to combine a money supply anchor with other targets.
Nominal income/NGDP targeting[edit]
Main article: Nominal income target

Related to money targeting, nominal income targeting (also called Nominal GDP or NGDP
targeting), originally proposed by James Meade (1978) and James Tobin (1980), was
advocated by Scott Sumner and reinforced by the market monetarist school of thought.[41]
Central banks do not implement this monetary policy explicitly. However, numerous studies
shown that such a monetary policy targeting better matches central bank losses[42] and
welfare optimizing monetary policy[43] compared to more standard monetary policy targeting.
Fixed exchange rate targeting[edit]
This policy is based on maintaining a fixed exchange rate with a foreign currency. There are
varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the
fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a
fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead,
the rate is enforced by non-convertibility measures (e.g. capital controls, import/export
licenses, etc.). In this case there is a black market exchange rate where the currency trades
at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank or
monetary authority on a daily basis to achieve the target exchange rate. This target rate may
be a fixed level or a fixed band within which the exchange rate may fluctuate until the
monetary authority intervenes to buy or sell as necessary to maintain the exchange rate
within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a
special case of the fixed exchange rate with bands where the bands are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of local
currency must be backed by a unit of foreign currency (correcting for the exchange rate).
This ensures that the local monetary base does not inflate without being backed by hard
currency and eliminates any worries about a run on the local currency by those wishing to
convert the local currency to the hard (anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is
used freely as the medium of exchange either exclusively or in parallel with local currency.
This outcome can come about because the local population has lost all faith in the local
currency, or it may also be a policy of the government (usually to rein in inflation and import
credible monetary policy).
Theoretically, using relative purchasing power parity (PPP), the rate of depreciation of the
home country's currency must equal the inflation differential:
rate of depreciation = home inflation rate – foreign inflation rate,
which implies that
home inflation rate = foreign inflation rate + rate of depreciation.
The anchor variable is the rate of depreciation. Therefore, the rate of inflation at
home must equal the rate of inflation in the foreign country plus the rate of
depreciation of the exchange rate of the home country currency, relative to the
other.
With a strict fixed exchange rate or a peg, the rate of depreciation of the exchange
rate is set equal to zero. In the case of a crawling peg, the rate of depreciation is set
equal to a constant. With a limited flexible band, the rate of depreciation is allowed
to fluctuate within a given range.
By fixing the rate of depreciation, PPP theory concludes that the home country's
inflation rate must depend on the foreign country's.
Countries may decide to use a fixed exchange rate monetary regime in order to take
advantage of price stability and control inflation. In practice, more than half of
nations’ monetary regimes use fixed exchange rate anchoring.[36]
These policies often abdicate monetary policy to the foreign monetary authority or
government as monetary policy in the pegging nation must align with monetary
policy in the anchor nation to maintain the exchange rate. The degree to which local
monetary policy becomes dependent on the anchor nation depends on factors such
as capital mobility, openness, credit channels and other economic factors.
Currency intervention, also known as foreign exchange market intervention or currency
manipulation, is a monetary policy operation. It occurs when a government or central bank buys or
sells foreign currency in exchange for its own domestic currency, generally with the intention of
influencing the exchange rate and trade policy.
Policymakers may intervene in foreign exchange markets in order to advance a variety of economic
objectives: controlling inflation, maintaining competitiveness, or maintaining financial stability. The
precise objectives are likely to depend on the stage of a country's development, the degree of
financial market development and international integration, and the country's overall vulnerability to
shocks, among other factors.[1]
The most complete type of currency intervention is the imposition of a fixed exchange rate with
respect to some other currency or to a weighted average of some other currencies.

Purposes[edit]
There are many reasons a country's monetary and/or fiscal authority may want to intervene in
the foreign exchange market. Central banks generally agree that the primary objective of foreign
exchange market intervention is to manage the volatility and/or influence the level of the exchange
rate. Governments prefer to stabilize the exchange rate because excessive short-
term volatility erodes market confidence and affects both the financial market and the real goods
market.
When there is inordinate instability, exchange rate uncertainty generates extra costs and
reduces profits for firms. As a result, investors are unwilling to make investment in foreign financial
assets. Firms are reluctant to engage in international trade. Moreover, the exchange rate fluctuation
would spill over into the other financial markets. If the exchange rate volatility increases the risk of
holding domestic assets, then prices of these assets would also become more volatile. The
increased volatility of financial markets would threaten the stability of the financial system and make
monetary policy goals more difficult to attain. Therefore, authorities conduct currency intervention.
In addition, when economic conditions change or when the market misinterprets economic signals,
authorities use foreign exchange intervention to correct exchange rates, in order to
avoid overshooting of either direction. Anna Schwartz contended that the central bank can cause the
sudden collapse of speculative excess, and that it can limit growth by constricting the money supply.
[2]

Today, forex market intervention is largely used by the central banks of developing countries, and
less so by developed countries. There are a few reasons most developed countries no longer
actively intervene:

 Research and experience suggest that the instrument is only effective (at least beyond the very
short term) if seen as foreshadowing interest rate or other policy adjustments. Without a durable
and independent impact on the nominal exchange rate, intervention is seen as having no lasting
power to influence the real exchange rate and thus competitive conditions for the tradable
sector.
 Large-scale intervention can undermine the stance of monetary policy.
Developing countries, on the other hand, do sometimes intervene, presumably because they believe
the instrument to be an effective tool in the circumstances and for the situations they face.
Objectives include: to control inflation, to achieve external balance or enhance competitiveness to
boost growth, or to prevent currency crises, such as large depreciation/appreciation swings.[3]
In a Bank for International Settlements (BIS) paper published in 2015, the authors describe the
common reasons central banks intervene. Based on a BIS survey, in foreign exchange markets
"emerging market central banks" use the strategy of "leaning against the wind" "to limit exchange
rate volatility and smooth the trend path of the exchange rate".[4]: 5, 6 In their 2005 meeting on foreign
exchange market intervention, central bank governors had noted that, "Many central banks would
argue that their main aim is to limit exchange rate volatility rather than to meet a specific target for
the level of the exchange rate". Other reasons cited (that do not target the exchange rate) were to
"slow the rate of change of the exchange rate", "dampen exchange rate volatility", "supply liquidity to
the forex market", or "influence the level of foreign reserves".[5]: 1

Direct intervention[edit]
Direct currency intervention is generally defined as foreign exchange transactions that are
conducted by the monetary authority and aimed at influencing the exchange rate. Depending on
whether it changes the monetary base or not, currency intervention can be distinguished between
non-sterilized intervention and sterilized intervention, respectively.

Sterilized intervention[edit]
Sterilized intervention is a policy that attempts to influence the exchange rate without changing the
monetary base. The procedure is a combination of two transactions. First, the central bank conducts
a non-sterilized intervention by buying (selling) foreign currency bonds using domestic currency that
it issues. Then the central bank "sterilizes" the effects on the monetary base by selling (buying) a
corresponding quantity of domestic-currency-denominated bonds to soak up the initial increase
(decrease) of the domestic currency. The net effect of the two operations is the same as a swap of
domestic-currency bonds for foreign-currency bonds with no change in the money supply.[8] With
sterilization, any purchase of foreign exchange is accompanied by an equal-valued sale of domestic
bonds.
For example, desiring to decrease the exchange rate, expressed as the price of domestic currency,
without changing the monetary base, the monetary authority purchases foreign-currency bonds, the
same action as in the last section. After this action, in order to keep the monetary base unchanged,
the monetary authority conducts a new transaction, selling an equal amount of domestic-currency
bonds, so that the total money supply is back to the original level.

Non-sterilized intervention[edit]
Non-sterilized intervention is a policy that alters the monetary base. Specifically, authorities affect
the exchange rate through purchasing or selling foreign money or bonds with domestic currency.
For example, aiming at decreasing the exchange rate/price of the domestic currency, authorities
could purchase foreign currency bonds. During this transaction, extra supply of domestic currency
will drag down domestic currency price, and extra demand of foreign currency will push up foreign
currency price. As a result, the exchange rate drops.

Indirect intervention[edit]
Indirect currency intervention is a policy that influences the exchange rate indirectly. Some examples
are capital controls (taxes or restrictions on international transactions in assets), and exchange
controls (the restriction of trade in currencies).[9] Those policies may lead to inefficiencies or reduce
market confidence, or in the case of exchange controls may lead to the creation of a black market,
but can be used as an emergency damage control.
Effectiveness[edit]

Imports and exports from Argentina 1992 to 2004

The largest empirical study on effectiveness shows success around 80% when it comes to
managing volatility of a currency.[10] A meta-analysis based on 300 different estimations on the
effectiveness of the practice show that, on average, a $1 billion dollar purchase depreciates
domestic currency in 1%.[11]

Non-sterilization intervention[edit]
In general, there is a consensus in the profession that non-sterilized intervention is effective.
Similarly to the monetary policy, nonsterilized intervention influences the exchange rate by inducing
changes in the stock of the monetary base, which, in turn, induces changes in broader monetary
aggregates, interest rates, market expectations and ultimately the exchange rate. [12] As we have
shown in the previous example, the purchase of foreign-currency bonds leads to the increase of
home-currency money supply and thus a decrease of the exchange rate.

Sterilization intervention[edit]
On the other hand, the effectiveness of sterilized intervention is more controversial and ambiguous.
By definition, the sterilized intervention has little or no effect on domestic interest rates, since the
level of the money supply has remained constant. However, according to some literature, sterilized
intervention can influence the exchange rate through two channels: the portfolio balance channel
and the expectations or signaling channel.[13]
The portfolio balance channel
In the portfolio balance approach, domestic and foreign bonds are not perfect substitutes.
Agents balance their portfolios among domestic money and bonds, and foreign currency and
bonds. Whenever aggregate economic conditions change, agents adjust their portfolios to a
new equilibrium, based on a variety of considerations, i.e., wealth, tastes, expectation, etc..
Thus, these actions to balance portfolios will influence exchange rates.
The expectations or signaling channel
Even if domestic and foreign assets are perfectly substitutable with each other, sterilized
intervention is still effective. According to the signaling channel theory, agents may view
exchange rate intervention as a signal about the future stance of policy. Then the change of
expectation will affect the current level of the exchange rate.

Modern examples[edit]
According to the Peterson Institute, there are four groups that stand out as frequent
currency manipulators: longstanding advanced and developed economies, such as Japan
and Switzerland, newly industrialized economies such as Singapore, developing Asian
economies such as China, and oil exporters, such as Russia.[14] China's currency
intervention and foreign exchange holdings are unprecedented.[15] It is common for countries
to manage their exchange rate via central bank to make their exports cheap. That method is
being used extensively by the emerging markets of Southeast Asia, in particular.
The American dollar is generally the primary target for these currency managers. The dollar
is the global trading system's premier reserve currency, meaning dollars are freely traded
and confidently accepted by international investors.[16] System Open Market Account is
a monetary tool of the Federal Reserve system that may intervene to counter disorderly
market conditions.[17] In 2014, a number of large investment banks,
including UBS, JPMorgan Chase, Citigroup, HSBC and the Royal Bank of Scotland were
fined for currency manipulations.[18]

Swiss franc[edit]
As the financial crisis of 2007–08 hit Switzerland, the Swiss franc appreciated "owing to a
flight to safety and to the repayment of Swiss franc liabilities funding carry trades in high
yielding currencies." On March 12, 2009, the Swiss National Bank (SNB) announced that it
intended to buy foreign exchange to prevent the Swiss franc from further appreciation.
Affected by the SNB purchase of euros and US dollars, the Swiss franc weakened from 1.48
against the euro to 1.52 in a single day. At the end of 2009, the currency risk seemed to be
solved; the SNB changed its attitude to preventing substantial appreciation. Unfortunately,
the Swiss franc began to appreciate again. Thus, the SNB stepped in one more time and
intervened at a rate of more than CHF 30 billion per month. By the end of June 17, 2010,
when the SNB announced the end of its intervention, it had purchased an equivalent of $179
billion of Euros and U.S. dollars, amounting to 33% of Swiss GDP.[19] Furthermore, in
September 2011, the SNB influenced the foreign exchange market again, and set a
minimum exchange rate target of SFr 1.2 to the Euro.
On January 15, 2015, the SNB suddenly announced that it would no longer hold the Swiss
Franc at the fixed exchange rate with the euro it had set in 2011. The franc soared in
response; the euro fell roughly 40 percent in value in relation to the franc, falling as low as
0.85 francs (from the original 1.2 francs).[20]
As investors flocked to the franc during the financial crisis, they dramatically pushed up its
value. An expensive franc may have large adverse effects on the Swiss economy; the Swiss
economy is heavily reliant on selling things abroad. Exports of goods and services are worth
over 70% of Swiss GDP. To maintain price stability and lower the franc's value, the SNB
created new francs and used them to buy euros. Increasing the supply of francs relative to
euros on foreign-exchange markets caused the franc's value to fall (ensuring the euro was
worth 1.2 francs). This policy resulted in the SNB amassing roughly $480 billion-worth of
foreign currency, a sum equal to about 70% of Swiss GDP.
The Economist[citation needed] asserts that the SNB dropped the cap for the following reasons: first,
rising criticisms among Swiss citizens regarding the large build-up of foreign reserves. Fears
of runaway inflation underlie these criticisms, despite inflation of the franc being too low,
according to the SNB. Second, in response to the European Central Bank's decision to
initiate a quantitative easing program to combat euro deflation. The consequent devaluation
of the euro would require the SNB to further devalue the franc had they decided to maintain
the fixed exchange rate. Third, due to recent euro depreciation in 2014, the franc lost
roughly 12% of its value against the USD and 10% against the rupee (exported goods and
services to the U.S. and India account for roughly 20% Swiss exports).
Following the SNB's announcement, the Swiss stock market sharply declined; due to a
stronger franc, Swiss companies would have had a more difficult time selling goods and
services to neighboring European citizens.[21]
In June 2016, when the results of the Brexit referendum were announced, the SNB gave a
rare confirmation that it had increased foreign currency purchases again, as evidenced by a
rise of commercial deposits to the national bank. Negative interest rates coupled with
targeted foreign currency purchases have helped to limit the strength of the Swiss Franc in a
time when the demand for safe haven currencies is increasing. Such interventions assure
the price competitiveness of Swiss products in the European Union and global markets.[22]
In late 2022, when the 2022 inflation surge trigged significant inflation in Switzerland, the
SNB experienced a turn-around in monetary policies. Rather than buying foreign currencies
to lower the value of the Swiss franc, the national bank reduced assets in foreign money to
curb imported inflation. After massive over-evaluations in 2019 and 2020, the Swiss franc
was "no longer over-valued" in relation to other currencies, which allowed the bank to
intervene less.[23]

Japanese yen[edit]
From 1989 to 2003, Japan was suffering from a long deflationary period. After experiencing
economic boom, the Japanese economy slowly declined in the early 1990s and entered a
deflationary spiral in 1998. Within this period, Japanese output was stagnating; the deflation
(negative inflation rate) was continuing, and the unemployment rate was increasing.
Simultaneously, confidence in the financial sector waned, and several banks failed. During
the period, the Bank of Japan, having become legally independent in March 1998, aimed at
stimulating the economy by ending deflation and stabilizing the financial system. [24] The
"availability and effectiveness of traditional policy instruments was severely constrained as
the policy interest rate was already virtually at zero, and the nominal interest rate could not
become negative (the zero bound problem)."[25]
In response of deflationary pressures, the Bank of Japan, in coordination with the Ministry of
Finance, launched a reserve targeting program. The BOJ increased the commercial bank
current account balance to ¥35 trillion. Subsequently, the MoF used those funds to purchase
$320 billion in U.S. treasury bonds and agency debt.[26]
By 2014, critics of Japanese currency intervention asserted that the central bank of Japan
was artificially and intentionally devaluing the yen. Some state that the 2014 US-Japan trade
deficit — $261.7 billion — was increased unemployment in the United States. [citation needed] Bank
of Korea Governor Kim Choong Soo has urged Asian countries to work together to defend
themselves against the side-effects of Japanese Prime Minister Shinzo Abe's reflation
campaign. Some have (who?) stated this campaign is in response to Japan's stagnant
economy and potential deflationary spiral.[citation needed]
In 2013, Japanese Finance Minister Taro Aso stated Japan planned to use its foreign
exchange reserves to buy bonds issued by the European Stability Mechanism and euro-
area sovereigns, in order to weaken the yen.[citation needed] The U.S. criticized Japan for
undertaking unilateral sales of the yen in 2011, after Group of Seven economies jointly
intervened to weaken the currency in the aftermath of the record earthquake and tsunami
that year.[citation needed]
By 2013, Japan held $1.27 trillion in foreign reserves according to finance ministry data. [27] In
2022, in the context of a dollar appreciation, Japan intervened again on foreign exchange
markets.[28]

Qatari riyal[edit]
On August 27, 2019, the Qatar Financial Centre Regulatory Authority, also known as
QFCRA, fined the First Abu Dhabi Bank (FAB) for $55 million, over its failure to cooperate in
a probe into possible manipulation of the Qatari riyal. The action followed a significant
amount of volatility in the exchange rates of the Qatari riyal during the first eight months of
the Qatar diplomatic crisis.[29]
In December 2020, Bloomberg News reviewed a large number of emails, legal filings and
documents, along with interviews conducted with the former officials and insiders of Banque
Havilland. The observation-based findings showed the extent of services that
financier David Rowland and his private banking service went, in order to serve one of its
customers, the Crown Prince of Abu Dhabi, Mohammed bin Zayed. The findings showed
that the ruler used the bank for financial advice as well as for manipulating the value of the
Qatari riyal in a coordinated attack aimed at deleting the country’s foreign exchange
reserves. One of the five mission statements reviewed by Bloomberg read, “Control the yield
curve, decide the future.” The statement belonged to a presentation made by one of the ex-
Banque Havilland analysts that called for the attack in 2017.[30]

Chinese yuan[edit]

Graph of the price of a US dollar in Chinese yuan since 1990

In the 1990s and 2000s, there was a marked increase in American imports of Chinese
goods. China's central bank allegedly devalued yuan by buying large amounts of US dollars
with yuan, thus increasing the supply of the yuan in the foreign exchange market, while
increasing the demand for US dollars, thus increasing the price of USD.[citation needed] According to
an article published in KurzyCZ by Vladimir Urbanek, by December 2012, China's foreign
exchange reserve held roughly $3.3 trillion, making it the highest foreign exchange reserve
in the world. Roughly 60% of this reserve was composed of US government bonds and
debentures.[31]
There has been much disagreement on how the United States should respond to Chinese
devaluation of the yuan. This is partly due to disagreement over the actual effects of the
undervalued yuan on capital markets, trade deficits, and the US domestic economy. [citation needed]
Paul Krugman argued in 2010, that China intentionally devalued its currency to boost its
exports to the United States and as a result, widening its trade deficit with the US. Krugman
suggested at that time, that the United States should impose tariffs on Chinese goods.
Krugman stated:[32]
The more depreciated China’s exchange rate — the higher the price of the dollar in yuan —
the more dollars China earns from exports, and the fewer dollars it spends on imports.
(Capital flows complicate the story a bit, but don’t change it in any fundamental way). By
keeping its current artificially weak — a higher price of dollars in terms of yuan — China
generates a dollar surplus; this means the Chinese government has to buy up the excess
dollars.

— Paul Krugman 2010 The New York Times

Greg Mankiw, on the other hand, asserted in 2010 the U.S. protectionism via tariffs will hurt
the U.S. economy far more than Chinese devaluation. Similarly, others [who?] have stated that
the undervalued yuan has actually hurt China more in the long run insofar that the
undervalued yuan does not subsidize the Chinese exporter, but subsidizes the American
importer. Thus, importers within China have been substantially hurt due to the Chinese
government's intention to continue to grow exports.[33]
The view that China manipulates its currency for its own benefit in trade has been criticized
by Cato Institute trade policy studies fellow Daniel Pearson,[34] National Taxpayers
Union Policy and Government Affairs Manager Clark Packard,[35] entrepreneur and Forbes
contributor Louis Woodhill,[36] Henry Kaufman Professor of Financial Institutions at Columbia
University Charles W. Calomiris,[37] economist Ed Dolan,[38] William L. Clayton Professor of
International Economic Affairs at the Fletcher School, Tufts University Michael W. Klein,
[39]
Harvard University Kennedy School of Government Professor Jeffrey Frankel,
[40]
Bloomberg columnist William Pesek,[41] Quartz reporter Gwynn Guilford,[42][43] The Wall
Street Journal Digital Network Editor-In-Chief Randall W. Forsyth,[44] United Courier Services,
[45]
and China Learning Curve.[46]

Russian ruble[edit]
On November 10, 2014, the Central Bank of Russia decided to fully float the ruble in
response to its biggest weekly drop in 11 years (roughly 6 percent drop in value against
USD).[47] In doing so, the central bank abolished the dual-currency trading band within which
the ruble had previously traded. The central bank also ended regular interventions that had
previously limited sudden movements in the currency's value. Earlier steps to raise interest
rates by 150 basis points to 9.5 percent failed to stop the ruble's decline. The central bank
sharply adjusted its macroeconomic forecasts. It stated that Russia's foreign exchange
reserves, then the fourth largest in the world at roughly US$480 billion, were expected to
decrease to US$422 billion by the end of 2014, US$415 billion in 2015, and under US$400
billion in 2016, in an effort to prop up the ruble.[48]
On December 11, the Russian central bank raised the key rate by 100 basis points, from 9.5
percent to 10.5 percent.[49]
Declining oil prices and economic sanctions imposed by the West in response to the
Russian annexation of Crimea led to worsening Russian recession. On December 15, 2014,
the ruble dropped as much as 19 percent, the worst single-day drop for the ruble in 16
years.[50][51]
The Russian central bank response was twofold: first, continue using Russia's large foreign
currency reserve to buy rubles on the forex market in order to maintain its value through
artificial demand on a larger scale. The same week of the December 15 drop, the Russian
central bank sold an additional US$700 million in foreign currency reserves, in addition to
the nearly US$30 billion spent over previous months to stave off decline. Russia's reserves
then sat at US$420 billion, down from US$510 billion in January 2014.
Second, increase interest rates dramatically. The central bank increased the key interest
rate 650 basis points from 10.5 percent to 17 percent, the world's largest increase since
1998, when Russian rates soared past 100 percent and the government defaulted on its
debt. The central bank hoped the higher rates would provide incentives to the forex market
to maintain rubles.[52][53]
From February 12 to 19, 2015, the Russian central bank spent an additional US$6.4
billion in reserves. Russian foreign reserves at this point stood at $368.3 billion, greatly
below the central bank's initial forecast for 2015. Since the collapse in global oil prices in
June 2014, Russian reserves have fallen by over US$100 billion.[54]
As oil prices began to stabilize in February–March 2015, the ruble likewise stabilized. The
Russian central bank has decreased the key rate from its high of 17 percent to its current 15
percent as of February 2015. Russian foreign reserves currently sit at US$360 billion.[55][56]
In March and April 2015, with the stabilization of oil prices, the ruble has made a surge,
which Russian authorities have deemed a "miracle". Over three months, the ruble gained 20
percent against the US dollar, and 35 percent against the euro. The ruble was the best
performing currency of 2015 in the forex market. Despite being far from its pre-recession
levels (in January 2014, US$1 equaled roughly 33 Russian rubles), it is currently trading at
roughly 52 rubles to US$1 (an increase in value from 80 rubles to US$1 in December 2014).
[57]

Current Russian foreign reserves sit at $360 billion. In response to the ruble's surge, the
Russian central bank lowered its key interest rate further to 14 percent in March 2015. The
ruble's recent gains have been largely accredited to oil price stabilization and the calming of
conflict in Ukraine.[58][59]
Exchange Rate Risk: Economic Exposure
By
ELVIS PICARDO

Updated October 25, 2021

Reviewed by
SOMER ANDERSON

Fact checked by
SUZANNE KVILHAUG

In the present era of increasing globalization and heightened currency volatility,

changes in exchange rates have a substantial influence on companies’
operations and profitability. Exchange rate volatility affects not
just multinationals, large corporations, and businesses that trade in
international markets, but also small and medium-sized enterprises, including
those who only operate in their home country. While understanding and
managing exchange rate risk is a subject of obvious importance to business
owners, investors should also be familiar with it because of the huge impact it
can have on their holdings.

KEY TAKEAWAYS

 Exchange rate risk refers to the risk that a company’s operations and
profitability may be affected by changes in the exchange rates between
currencies.
 Companies are exposed to three types of risk caused by currency
volatility: transaction exposure, translation exposure, and economic or
operating exposure.
 The risks of operating or economic exposure can be alleviated through
operational strategies and currency risk mitigation strategies.
  In the current globalized market, exchange rate risk affects not only
multinationals and businesses that trade in international markets, but
also small and medium-sized enterprises.

0 seconds of 1 minute, 46 secondsVolume 75%

1:45
Minimize Exchange Rate Risk With Currency ETFs

What Is Economic Exposure?

Companies are exposed to three types of risk caused by currency volatility:

 Transaction exposure arises from the effect that exchange rate fluctuations
have on a company’s obligations to make or receive payments
denominated in foreign currency. This type of exposure is short-term to
medium-term in nature.
 Translation exposure arises from the effect of currency fluctuations on a
company’s consolidated financial statements, particularly when it has
foreign subsidiaries. This type of exposure is medium-term to long-term.
 Economic (or operating) exposure is lesser-known than the previous two but
is a significant risk nevertheless. It is caused by the effect of
unexpected currency fluctuations on a company’s future cash
flows and market value and is long-term in nature. The impact can be
substantial, as unanticipated exchange rate changes can greatly affect
a company’s competitive position, even if it does not operate or sell
overseas. For example, a U.S. furniture manufacturer who only sells
locally still has to contend with imports from Asia and Europe, which
may get cheaper and thus more competitive if the dollar strengthens
markedly.1

Note that economic exposure deals with unexpected changes in exchange

rates—which by definition are impossible to predict—since a company’s
management bases their budgets and forecasts on certain assumptions,
which represents their expected change in currency rates. In addition, while
transaction and translation exposure can be accurately estimated and
therefore hedged, economic exposure is difficult to quantify precisely and as a
result, is challenging to hedge.
Economic Exposure Example
Here’s a hypothetical example of economic exposure. Consider a large U.S.
pharmaceutical with subsidiaries and operations in a number of countries
around the world. The company’s largest export markets are Europe and
Japan, which together account for 40% of its annual revenues. Management
had factored in an average decline of 3% for the dollar versus the euro and
Japanese yen for the current year and the next two years.

Their bearish view on the dollar was based on issues such as the recurring
U.S. budget deadlock, as well as the nation’s growing fiscal and current
account deficits, which they expected would weigh on the greenback going
forward.

However, a rapidly improving U.S. economy has triggered speculation that

the Federal Reserve may be poised to tighten monetary policy much sooner
than expected. The dollar has been rallying, as a result, and over the past
few months has gained about 5% against the euro and yen. The outlook for
the next two years suggests further gains in store for the dollar, as monetary
policy in Japan remains very stimulative and the European economy is just
emerging out of recession.

The U.S. pharmaceutical company is faced not just with transaction exposure
(because of its large export sales) and translation exposure (as it has
subsidiaries worldwide), but also with economic exposure. Recall that
management had expected the dollar to decline about 3% annually against
the euro and yen over a three-year period, but the greenback has already
gained 5% versus these currencies, a variance of eight percentage points and
growing. This will obviously have a negative effect on the company’s sales
and cash flows. Savvy investors have already cottoned on to the challenges
facing the company due to these currency fluctuations and the stock has
declined 7% in recent months.
. Introduction

Poverty is a multidimensional problem that goes beyond economics to include, among

other things, social, political, and cultural issues (see Box 1). Therefore, solutions to
poverty cannot be based exclusively on economic policies, but require a
comprehensive set of well-coordinated measures. Indeed, this is the foundation for the
rationale underlying comprehensive poverty reduction strategies.1 So why focus on
macroeconomic issues? Because economic growth is the single most important factor
influencing poverty, and macroeconomic stability is essential for high and sustainable
rates of growth.2 Hence, macroeconomic stability should be a key component of any
poverty reduction strategy.

Macroeconomic stability by itself, however, does not ensure high rates of economic
growth. In most cases, sustained high rates of growth also depend upon key structural
measures, such as regulatory reform, privatization, civil service reform, improved
governance, trade liberalization, and banking sector reform, many of which are
discussed at length in the Poverty Reduction Strategy Sourcebook, published by the
World Bank.3 Moreover, growth alone is not sufficient for poverty reduction. Growth
associated with progressive distributional changes will have a greater impact on
poverty than growth that leaves distribution unchanged. Hence, policies that improve
the distribution of income and assets within a society, such as land tenure reform, pro-
poor public expenditure, and measures to increase the poor’s access to financial
markets, will also form essential elements of a country’s poverty reduction strategy.4

Box 1. Definition and Measurement of Poverty

The World Bank’s 2000 World Development Report defines poverty as an

unacceptable deprivation in human well-being that can comprise both
physiological and social deprivation. Physiological deprivation involves the
non-fulfillment of basic material or biological needs, including inadequate
nutrition, health, education, and shelter. A person can be considered poor if
he or she is unable to secure the goods and services to meet these basic
material needs. The concept of physiological deprivation is thus closely
related to, but can extend beyond, low monetary income and consumption
levels. Social deprivation widens the concept of deprivation to include risk,
vulnerability, lack of autonomy, powerlessness, and lack of self-respect.
Given that countries’ definitions of deprivation often go beyond
physiological deprivation and sometimes give greater weight to social
deprivation, local populations (including poor communities) should be
engaged in the dialogue that leads to the most appropriate definition of
poverty in a country.
To safeguard macroeconomic stability, the government budget, including the
country’s poverty reduction strategies, must be financed in a sustainable,
noninflationary manner. The formulation and integration of a country’s
macroeconomic policy and poverty reduction strategy are iterative processes. Poverty
reduction strategies need first to be articulated (i.e., objectives and policies specified),
then costed, and finally financed within the overall budget in a noninflationary
manner. The amount of finance, much of which will be on concessional terms, is,
however, not necessarily fixed during this process: if credible poverty reduction
strategies cannot be financed from available resources, World Bank and IMF staff
should and will actively assist countries in their efforts to raise additional financial
support from the donor community. Nonetheless, in situations where financing gaps
remain, a country would have to revisit the intermediate objectives of their strategy
and reexamine their priorities. Except in cases where macroeconomic imbalances are
severe, there will usually be some scope for flexibility in setting short-term
macroeconomic targets. However, the objective of macroeconomic stability should
not be compromised.

2. The Links Between Macroeconomic Policy and Poverty Reduction: Growth

Matters

Economic growth is the single most important factor influencing poverty. Numerous
statistical studies have found a strong association between national per capita income
and national poverty indicators, using both income and nonincome measures of
poverty.5 One recent study consisting of 80 countries covering four decades found
that, on average, the income of the bottom one-fifth of the population rose one-for-one
with the overall growth of the economy as defined by per capita GDP (Dollar and
Kraay, 2000). Moreover, the study found that the effect of growth on the income of
the poor was on average no different in poor countries than in rich countries, that the
poverty–growth relationship had not changed in recent years, and that policy-induced
growth was as good for the poor as it was for the overall population. Another study
that looked at 143 growth episodes also found that the “growth effect” dominated,
with the “distribution effect” being important in only a minority of cases (White and
Anderson, forthcoming). These studies, however, establish association, but not
causation. In fact, the causality could well go the other way. In such cases, poverty
reduction could in fact be necessary to implement stable macroeconomic policies or to
achieve higher growth.

Studies show that capital accumulation by the private sector drives

growth.6 Therefore, a key objective of a country’s poverty reduction strategy should
be to establish conditions that facilitate private sector investment. No magic bullet can
guarantee increased rates of private sector investment. Instead, in addition to a
sustainable and stable set of macroeconomic policies, a country’s poverty reduction
policy agenda should, in most cases, extend across a variety of policy areas, including
privatization, trade liberalization, banking and financial sector reforms, labor markets,
the regulatory environment, and the judicial system. The agenda will certainly include
increased and more efficient public investment in a country’s health, education, and
other priority social service sectors.7

Macroeconomic Stability Is Necessary for Growth

Macroeconomic stability is the cornerstone of any successful effort to increase private

sector development and economic growth (see Box 2). Cross-country regressions
using a large sample of countries suggest that growth, investment, and productivity
are positively correlated with macroeconomic stability (Easterly and Kraay, 1999).
Although it is difficult to prove the direction of causation, these results confirm
that macroeconomic instability has generally been associated with poor growth
performance. Without macroeconomic stability, domestic and foreign investors will
stay away and resources will be diverted elsewhere. In fact, econometric evidence of
investment behavior indicates that in addition to conventional factors (i.e., past growth
of economic activity, real interest rates, and private sector credit), private investment
is significantly and negatively influenced by uncertainty and macroeconomic
instability (see, for example, Ramey and Ramey, 1995).

Box 2. Macroeconomic Stability

Macroeconomic stability exists when key economic relationships are in

balance—for example, between domestic demand and output, the balance of
payments, fiscal revenues and expenditure, and savings and investment.
These relationships, however, need not necessarily be in exact balance.
Imbalances such as fiscal and current account deficits or surpluses are
perfectly compatible with economic stability provided that they can be
financed in a sustainable manner.

There is no unique set of thresholds for each macroeconomic variable

between stability and instability. Rather, there is a continuum of various
combinations of levels of key macroeconomic variables (e.g., growth,
inflation, fiscal deficit, current account deficit, international reserves) that
could indicate macroeconomic instability. While it may be relatively easy to
identify a country in a state of macroeconomic instability (e.g., large current
account deficits financed by short-term borrowing, high and rising levels of
public debt, double-digit inflation rates, and stagnant or declining GDP) or
stability (e.g., current account and fiscal balances consistent with low and
declining debt levels, inflation in the low single digits, and rising per capita
 GDP), there is a substantial “gray area” in between where countries enjoy a
degree of stability, but where macroeconomic performance could clearly be
improved.

Finally, macroeconomic stability depends not only on the macroeconomic

management of an economy, but also on the structure of key markets and
sectors. To enhance macroeconomic stability, countries need to support
macroeconomic policy with structural reforms that strengthen and improve
the functioning of these markets and sectors.

Macroeconomic Instability Hurts the Poor

In addition to low (and sometimes even negative) growth rates, other aspects of
macroeconomic instability can place a heavy burden on the poor. Inflation, for
example, is a regressive and arbitrary tax, the burden of which is typically borne
disproportionately by those in lower income brackets. The reason is twofold. First, the
poor tend to hold most of their financial assets in the form of cash rather than in
interest-bearing assets. Second, they are generally less able than are the better off to
protect the real value of their incomes and assets from inflation. In consequence, price
jumps generally erode the real wages and assets of the poor more than those of the
non-poor. Moreover, beyond certain thresholds, inflation also curbs output growth, an
effect that will impact even those among the poor who infrequently use money for
economic transactions.8 In addition, low output growth that is typically associated
with instability can have a longer-term impact on poverty (a phenomenon known as
“hysteresis”). This phenomenon typically operates through shocks to the human
capital of the poor. In Africa, for instance, there is evidence that children from poor
families drop out of school during crises. Similarly, studies for Latin American
countries suggest that adverse terms-of-trade shocks explain part of the decline of
schooling attainment (see, for example, Behrman, Duryea, and Szeleky, 1999).

Policies to Insulate the Poor Against Shocks

Given that the poor are adversely affected by macroeconomic shocks, what should
governments do about it? The question can be divided into two parts: How should
economic policy be designed to cushion the impact of shocks on the poor, in
particular during times of crisis and/or adjustment? What specific policies can
governments undertake to insulate the poor from the consequences of shocks by
removing existing distortive policies?

Social Safety Nets

Sound macroeconomic policies will help a country to reduce its exposure to
macroeconomic shocks, but there is no cost-effective policy that will insure
against all possible shocks. It is therefore crucial to have social safety nets in place to
ensure that poor households are able to maintain minimum consumption levels and
access to basic social services during periods of crisis. Social safety net measures are
also necessary to protect the poor from shocks imposed on them during periods of
economic reform and adjustment.32 Safety nets include public work programs, limited
food subsidies, transfers to compensate for income loss, social funds, fee waivers, and
scholarships for essential services such as education and health. The specific mix of
measures will depend on the particular characteristics of the poor and their
vulnerability to shocks and should be well-targeted and designed in most cases to
provide temporary support.

Equally important, the resources allocated to social safety nets should be protected
during economic crises and/or adjustment, when fiscal tightening may be necessary.
Governments should have budgetary guidelines approved by their legislatures that
prioritize and protect poverty-related programs during periods of crisis and provide a
clear course of action that ensures access of the poor to basic social services during
periods of austerity (see Lustig, forthcoming). As will be discussed below,
countercyclical fiscal policies can also ensure the availability of funds for financing
safety nets during crises.

Another important factor to consider is that safety nets should already be operating
before economies get hit by shocks so that they can be effective in times of distress
(for a more detailed account, see World Bank, 2000). However, if a shock occurs
before appropriate safety nets have been developed, then “second-best” social
protection policies may be necessary. For instance, food subsidies have been found to
be inefficient and often benefiting the non-poor, and most reform programs call for
their reduction or even elimination. However, after a severe shock such as the 1997–
98 East Asian financial crisis, when countries like Indonesia lacked comprehensive
safety nets, existing food subsidies were probably the only means of preventing
widespread malnutrition and starvation. In the context of a country’s reform process,
however, these subsidies should be replaced with better targeted and less distorting
transfers to the poor.

Removing Market Distortions and Distortive Policies

In addition to pursuing favorable economic policies and putting in place appropriate

social safety nets, there are specific structural reforms that governments can undertake
to insulate the poor from the adverse consequences of shocks. Most of these have to
do with addressing the mechanisms through which macroeconomic shocks are
transmitted to the poor. (see Box 5).
To the extent that asset market distortions prevent the poor from saving and insulating
themselves against shocks, policies to remove these distortions can be valuable.33 For
instance, foreign exchange controls can force the poor to hold their assets in domestic
currency, whose value typically declines with adverse shocks. Relaxing these controls
in a well-managed fashion could give the poor access to safer assets, such as foreign
currency, that could protect them from devaluations, a typical outcome following
negative shocks.34 Similarly, severe financial repression, such as controlled interest
rates, can impede the poor’s ability to save.35 If properly managed, financial
liberalization policies can therefore have the additional benefit of increasing self-
insurance for the poor.

Box 5. How Shocks Harm the Poor: Transmission Channels

Credit markets, as well as safe asset markets for appropriate saving, are
major instruments for coping with income volatility. Distortions in these
markets curtail the ability of the poor to follow consumption smoothing
patterns. Government behavior in response to shocks is also a major
determinant of the effects of these shocks on the poor. Financial sector
behavior can also amplify the effects of shocks.

 Distortions in asset markets. To self-insure against shocks, agents need to

be able to save in assets whose value does not fall when they are needed
to compensate for a fall in income. Such saving instruments are typically
composed of foreign assets, domestic financial assets, and domestic real
assets. To the extent that governments impose controls on these asset
markets, it impedes the ability of the poor to use these savings
instruments, and channels their savings into less effective instruments.1
 Access to and structure of credit markets. Access to credit markets is
extremely limited for the poor to buffer the effects of shocks, in part as a
consequence of inadequate borrower information available to credit
institutions. The structure of credit markets can also affect the poor
indirectly: Firms may find that access to credit is typically collateralized.
Therefore, shocks that drastically reduce the value of collateral will also
reduce firms’ access to credit, amplifying the effect of shocks when firms
become credit constrained. Severe downturns may dramatically cut
employment of the poor and, hence, their welfare, especially since the
poor are usually employed by small firms that depend on collateralized
credit.
 Procyclical fiscal policy. During booms, some governments have
decreased export commodity taxes, reduced revenue collection effort, or
heavily increased expenditures, amplifying the effects of positive shocks.
These policies can make adjustment more severe during busts, since the
resulting expenditure cuts following a negative shock have sometimes
fallen on social programs and transfers to the poor—just when they are
needed the most. Examples of these policies can be traced back to the
 experience of Côte d’Ivoire in 1976–79, and Colombia in 1975–1980. It
has also been argued that synchronizing tax policies with shocks tends to
obscure the information content of prices on which agents make their
saving decisions, leading in many cases to lower saving rates than needed
to buffer future adverse shocks (Collier, Gunning, and associates 1999).
 Financial sector vulnerability and transmission to other sectors. Shocks
can also be amplified through the banking system. For example, a
negative terms of trade shock can adversely affect bank liquidity by
reducing demand for domestic deposits, forcing banks to curtail credit
roll-over, spreading the shock throughout the economy (IADB, 1995, and
Hausmann, 1999). Similarly, if a sudden stop in capital flows renders
many nontradable goods producers bankrupt because of big swings in
relative prices, this may in turn create financial turmoil as loans become
nonperforming, spreading the effect of the shock across the financial
system (Calvo, 1998). Bankruptcies in the nontradable sector may
translate into unemployment of the urban poor.

1
For example, in Ethiopia, livestock prices (often the poor’s only asset) fall during a
drought because all farmers are selling their cattle to compensate for the bad harvest.

Policies that increase borrower information and relax barriers to access to credit
markets can help the poor reduce consumption volatility, since credit availability
makes them less dependent on current income. Also, to the extent that collateralized
credit allocation amplifies the effects of negative shocks by reducing small- and
medium-sized firms’ access to credit when asset prices fall (Kiyotaki and Moore,
1977, and Izquierdo, 1999), policies promoting better financial-sector credit allocation
mechanisms based on project profitability and borrower information could reduce the
incidence of this particular transmission channel and its indirect effects on the poor
(i.e., lower employment opportunities).36

Finally, and most important, governments can do a lot to reduce the pro-cyclical
nature of their fiscal policies by saving rather than spending windfalls following
positive shocks and ideally using those savings as a buffer for expenditures against
negative shocks. A cautious approach would be for the government to “treat every
favorable shock as temporary and every adverse one as permanent,” although
judgment would also depend on, among other things, the availability of financing
(Little, and others, 1993). However, even this rule of thumb may not be enough.
Governments need to find ways of “tying their hands” to resist the pressure to spend
windfall revenues (Devarajan, 1999). For example, when the source of revenue is
publicly owned, such as oil or other natural resource, it may be appropriate to save the
windfall revenues abroad, with strict rules on how much of it can be repatriated.
Countries such as Colombia, Chile, and Botswana have tried variants of this strategy,
with benefits not just for overall macroeconomic management, but also for protecting
the poor during adverse shocks, since saved funds during good times can be applied to
financing of safety nets during crisis.
Currency Pegging: Overview and Pros and Cons
By AKHILESH GANTI

Updated August 24, 2021

Reviewed by
SOMER ANDERSON

What Is Pegging?
The term pegging refers to the practice of attaching or tying a currency's
exchange rate to another country's currency. Pegging often involves preset
ratios, which is why it's called a fixed rate. Pegs are often put in place to
provide stability to a nation's currency by linking it to an already stable
currency.

The U.S. dollar is often used as a currency peg by many nations, as it is the
world's reserve currency. Pegging can also refer to the practice of
manipulating the price of an underlying asset, such as a commodity, prior
to option expiry.

KEY TAKEAWAYS

 Pegging is a way of controlling a country's currency rate by tying it to

another country's currency.
 Many countries stabilize their currencies by pegging them to the U.S.
dollar, which is globally considered to be the most stable currency.
 Currencies that are pegged to the U.S. dollar include the Belize dollar,
the Hong Kong dollar, and the United Arab Emirates dirham.
 Pegging currencies can help expand trade and boost real incomes but
may also lead to chronic trade deficits.
 Pegging is also an illegal strategy deployed by some buyers and writers
(sellers) of call and put options to manipulate its price.
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1:31
What is Pegging?

Understanding Pegging
Wide currency fluctuations can be quite detrimental to international business
transactions, which is why many countries maintain a currency peg. Doing so
allows them to keep their currencies relatively stable against that of another
country.

Pegging to the U.S. dollar is common. As noted above, that's because the
dollar is the world's reserve currency. In Europe, the Swiss franc was pegged
to the euro for the better part of the four-year period between 2011 and 2015,
though this was done more so to curb the strength of the franc from a
persistent inflow of capital.1

Pegging is also a price manipulation strategy used sometimes

by options traders as expiration approaches. Writers (options shorts) are most
commonly associated with the practice of driving up or down the price of the
underlying security in an options contract as the expiry date approaches.
That's because they have a monetary incentive to ensure that the option
expires out of the money (OTM) so the buyer does not exercise the option
contract.

The currencies of over 66 countries are pegged to the U.S. dollar, according
to AvaTrade.2

Currency Pegging
Currency risk makes it difficult for companies to manage their finances. To
minimize currency risk, many countries peg an exchange rate to that of the
United States, which has a large and stable economy. But how does it work?

Countries often choose to peg their currencies to a stable one. This allows
them to keep their currencies stable while allowing their products and
services to remain competitive in the export market. Exchange rates between
pegged currencies are fixed. For instance, the fixed rate for a single U.S.
dollar is 3.67 United Arab Emirates dirham (AED).

A country's central bank goes into the open market to buy and sell its currency
in order to maintain the pegged ratio that has been deemed to provide
optimal stability. If a country’s currency value experiences large fluctuations,
it becomes even more difficult for foreign companies to operate and generate
a profit.

For example, if a U.S. company operates in Brazil, the firm has to convert
U.S. dollars into Brazilian reals (BRL) to fund the business. If the value of
Brazil’s currency changes dramatically compared to the dollar, the U.S.
company may incur a loss when it converts back into U.S. dollars.

Major currency peg breakdowns include the Argentine peso to the U.S. dollar
in 2002, the British pound to the German mark in 1992, and the U.S. dollar to
gold in 1971.
Advantages and Disadvantages of Pegging
There are some benefits and drawbacks when it comes to pegging. We've
highlighted some of the key pros and cons below.

Advantages

Pegged currencies can expand trade and boost real incomes, particularly
when currency fluctuations are relatively low and show no long-term changes.
Individuals, businesses, and nations are free to benefit fully from
specialization and exchange without any of the associated exchange rate risk
and tariffs. According to the theory of comparative advantage, everyone will be
able to spend more time doing what they do best.

Farmers can use pegged exchange rates to simply produce food as best they
can, rather than spending time and money hedging foreign exchange risk
with derivatives. Similarly, technology firms can focus on building better
computers.

Perhaps most importantly, retailers in both countries can source from the
most efficient producers. Pegged exchange rates make more long-term
investments possible in the other country. With a currency peg, fluctuating
exchange rates are not constantly disrupting supply chains and changing the
value of investments.

Central banks with a currency peg must monitor supply and demand and
manage cash flow to avoid spikes in demand or supply. These spikes can
cause a currency to stray from its pegged price. That means these authorities
need to hold large foreign exchange reserves to counter excessive buying or
selling of its currency. Currency pegs affect forex trading by artificially
stemming volatility.
Disadvantages

Countries experience a particular set of problems when a currency is pegged

at low exchange rates. Domestic consumers are deprived of the purchasing
power to buy foreign goods. Suppose the Chinese yuan is pegged too low
against the U.S. dollar. Chinese consumers will have to pay more
for imported food and oil, lowering their consumption and standard of living.
But U.S. farmers and Middle East oil producers who would sell them more
goods lose business. This situation naturally creates trade tensions between
the country with an undervalued currency and the rest of the world.

More problems emerge when a currency is pegged at an overly high rate. A

country may be unable to defend the peg over time. Since governments set
rates too high, domestic consumers will buy too many imports and consume
more than they can produce. These chronic trade deficits will create downward
pressure on the home currency, and the government will have to spend
foreign exchange reserves to defend the peg. The government's reserves will
eventually be exhausted, and the peg will collapse.

When a currency peg collapses, the country that set the peg too high will
suddenly find imports more expensive. That means inflation will rise, and the
nation may also have difficulty paying its debts. The other country will find
its exporters losing markets, and its investors losing money on foreign assets
that are no longer worth as much in domestic currency.

Pros

 Expands trade and boosts real income

 Producers focus on producing rather than hedging exchange risk

 Better chance to make long-term investments

Cons

 The power to purchase foreign goods drops

 Can lead to chronic trade deficits

 Higher priced imports and rising inflation

Why Peg to the Dollar?
When a country pegs its currency to the dollar, it fixes the exchange at a set,
predetermined rate. The value of the currency is maintained by the country's
central bank. Since the dollar's value is on a floating rate, it fluctuates. This
means that the pegged currency's value rises and drops with the dollar.

Countries that peg their currency to the dollar do so because the U.S. dollar
is the world's reserve currency and is relatively strong in the international
market. As such, transactions and any international trade that takes place often
happens in U.S. dollars. This helps keep a country's pegged currency stable.

Some countries peg to the dollar because it helps keep their currencies and,
therefore, their exports priced competitively. Others do so because they are
reliant on trade, such as Singapore and Malaysia.

Currencies Pegged to the Dollar

As noted above, the U.S. dollar is a popular currency that other countries use
to peg their own currencies. Countries that choose to do so often have
different reasons that are based on their own economies. Here are some of the
most notable countries whose currencies are pegged to the greenback along
with their rates:

 Belize dollar (BZ$): 2.00

 Cuba convertible peso (CUC): 1.000
 Hong Kong dollar (HKD): 7.76
 Panama balboa (PAB): 1.000
 Saudi Arabia riyal (SAR): 3.75
 United Arab Emirates dirham (AED): 3.673

Options Pegging
The buyer of a call option pays a premium to obtain the right to buy the stock
(underlying security) at a specified strike price. The writer of that call option,
meanwhile, receives the premium and is obligated to sell the stock, and
expose themselves to the resulting infinite risk potential, if the buyer chooses
to exercise the option contract.

For example, an investor buys a $50 call option, which gives them the right to
buy XYZ stock at the strike price of $50 by June 30. The writer has already
collected the premium from the buyer and would ideally like to see the option
expire worthless (stock price less than $50 at expiry).
The buyer wants the price of XYZ to rise above the strike price plus the
premium paid per share. Only at this level would it make sense for the buyer
to exercise the option. If the price is very close to the strike plus premium per
share level just before the option's expiry date then the buyer and especially
the writer of the call would have an incentive to be active in buying and selling
the underlying stock, respectively. This activity is known as pegging

The converse holds true as well. The buyer of a put option pays a premium to
obtain the right to sell the stock at the specified strike price, while the writer of
that put option receives the premium and is obligated to buy the stock, and
expose themselves to the resulting infinite risk potential, if the buyer chooses
to exercise the option contract.

A lesser-used definition of pegging occurs mainly in futures markets and

entails a commodity exchange linking daily trading limits to the previous
day's settlement price so as to control price fluctuations.

Example of Options Pegging

An investor buys a put option on XYZ stock with a strike price of $45 that
expires on July 31 and pays the required premium. The writer receives the
premium and the waiting game begins.

The writer wants the price of the underlying stock to remain above $45 minus
the premium paid per share, while the buyer wants to see it below that level.
Again, if the price of XYZ stock is very close to this level, then both would be
actively selling and buying to try to influence XYZ's price to where it would
benefit them.

While this concept of pegging could apply to both, it is used predominantly by

sellers as they have a bit more incentive to not see the option contract
exercised.

Is the Yuan Pegged to the Dollar?

The yuan has been pegged to a basket of international currencies, which
includes the U.S. dollar, since 2005. This allows the country's central bank to
maintain full control of the currency by setting a daily rate of parity against the
greenback. Any changes to the rate are restricted, meaning they can only fall
within 2% of that mark.
The yuan was pegged solely to the U.S. dollar before this. In 1994, the peg
was set at 8.28 yuan to a single U.S. dollar. Its major trading partners put
pressure on China's leaders to allow it to appreciate against the dollar in
2005.

Which Country Has No Currency of Its Own?

There are a number of different countries that don't have their own currency.
For instance, 19 member states of the European Union use the euro as their
currency. Some countries use the U.S. dollar exclusively for transactions,
including Zimbabwe, Ecuador, El Salvador, East Timor, and the Turks and
Caicos islands among others.

What Is a Soft Peg Versus a Hard Peg?

The foreign exchange market often controls the exchange rate for a specific
currency in a soft peg. In some cases, though, the government may choose
to act to strengthen or weaken the currency when the need arises. Hard pegs
occur when a government sets the exchange rate for its currency.
Pegged Exchange Rates: The Pros and Cons
By
RICHARD LEE

Full Bio

Richard Lee is a specialist in foreign exchange markets, contributing to a

number of online platforms, including Yahoo Finance and DailyReckoning.

Learn about our editorial policies

Updated December 31, 2021

Reviewed by CHARLES POTTERS

In June 2010, China's government decided to end a 23-month peg of
its currency to the U.S. dollar. The announcement, which followed months of
commentary and criticism from United States politicians, was lauded by
global economic leaders.

China's economic boom over the last decade has reshaped its own country
and the world. This pace of growth required a change in the monetary policy in
order to handle certain aspects of the economy effectively—in particular,
export trade and consumer price inflation. But none of the country's growth
rates could have been established without a fixed, or pegged, U.S. dollar
exchange rate.

Chinese currency pegging is the most obvious recent example, but they are
not the only one that has used this strategy. Economies big and small favor
this type of exchange rate for several reasons, despite some potential
drawbacks.

0 seconds of 1 minute, 34 secondsVolume 75%

1:34
The Pros And Cons Of A Pegged Exchange Rate

Pros of a Fixed/Pegged Rate

Countries prefer a fixed exchange rate regime for the purposes of export and
trade. By controlling its domestic currency a country can—and will more often
than not—keep its exchange rate low. This helps to support the
competitiveness of its goods as they are sold abroad. For example, let's
assume a euro (EUR)/Vietnamese dong (VND) exchange rate. Given that the
euro is much stronger than the Vietnamese currency, a T-shirt can cost a
company five times more to manufacture in a European Union country,
compared to Vietnam.

But the real advantage is seen in trade relationships between countries with
low costs of production (like Thailand and Vietnam) and economies with
stronger comparative currencies (the United States and the European Union).
When Chinese and Vietnamese manufacturers translate their earnings back to
their respective countries, there is an even greater amount of profit that is
made through the exchange rate. So, keeping the exchange rate low ensures
a domestic product's competitiveness abroad and profitability at home. (For
more insight, check out " Currency Exchange: Floating Versus Fixed.")

Currency Protection
The fixed exchange rate dynamic not only adds to a company's earnings
outlook, it also supports a rising standard of living and overall economic growth.
But that's not all. Governments that have sided with the idea of a fixed, or
pegged, exchange rate are looking to protect their domestic
economies. Foreign exchange swings have been known to adversely affect an
economy and its growth outlook. And, by shielding the domestic currency
from volatile swings, governments can reduce the likelihood of a currency
crisis.

After a short couple of years with a semi-floated currency, China decided

during the global financial crisis of 2008 to revert back to a fixed exchange rate
regime. The decision helped the Chinese economy to emerge two years later
relatively unscathed. Meanwhile, other global industrialized economies that
didn't have such a policy turned lower before rebounding.

KEY TAKEAWAYS

 By pegging its currency, a country can gain comparative trading

advantages while protecting its own economic interests.
 A pegged rate, or fixed exchange rate, can keep a country's exchange
rate low, helping with exports.
 Conversely, pegged rates can sometimes lead to higher long-term
inflation.
 Maintaining a pegged exchange rate usually requires a large amount of
capital reserves.
Cons of a Fixed/Pegged Rate
There are downsides to fixed currencies, as there is a price that governments
pay when implementing the pegged-currency policy in their countries. A
common element with all fixed or pegged foreign exchange regimes is the
need to maintain the fixed exchange rate. This requires large amounts of
reserves, as the country's government or central bank is constantly buying or
selling the domestic currency.

China is a perfect example. Before repealing the fixed-rate scheme in 2010,

Chinese foreign exchange reserves grew significantly each year in order to
maintain the U.S. dollar peg rate. The pace of growth in reserves was so
rapid it took China only a couple of years to overshadow Japan's foreign
exchange reserves. As of January 2011, it was announced that Beijing
owned $2.8 trillion in reserves—more than double that of Japan at the time.

The problem with huge currency reserves is that the massive amount of
funds or capital that is being created can create unwanted economic side
effects—namely higher inflation. The more currency reserves there are, the
bigger the monetary supply, which causes prices to rise. Rising prices can
cause havoc for countries that are looking to keep things stable.

Example Concerning the Thai Baht

These types of economic elements have caused many fixed exchange rate
regimes to fail. Although these economies are able to defend themselves
against adverse global situations, they tend to be exposed domestically.
Many times, indecision about adjusting the peg for an economy's currency
can be coupled with the inability to defend the underlying fixed rate. The Thai
baht was one such currency.
The baht was at one time pegged to the U.S. dollar. Once considered a
prized currency investment, the Thai baht came under attack following
adverse capital market events during 1996-1997. The currency depreciated and
the baht plunged rapidly, because the government was unwilling and unable
to defend the baht peg using limited reserves.

In July 1997, the Thai government was forced into floating the currency
before accepting an International Monetary Fund bailout. Even so, between July
of 1997 and October 1997, the baht fell by as much as 40%.
Advantages of Trade Deficits
The most obvious benefit of a trade deficit is that it allows a country to
consume more than it produces. In the short run, trade deficits can help
nations to avoid shortages of goods and other economic problems.

In some countries, trade deficits correct themselves over time. A trade deficit
creates downward pressure on a country's currency under a floating
exchange rate regime. With a cheaper domestic currency, imports become
more expensive in the country with the trade deficit. Consumers react by
reducing their consumption of imports and shifting toward domestically
produced alternatives. Domestic currency depreciation also makes the
country's exports less expensive and more competitive in foreign markets.

Trade deficits can also occur because a country is a highly desirable

destination for foreign investment. For example, the U.S. dollar's status as the
world's reserve currency creates a strong demand for U.S. dollars. Foreigners
must sell goods to Americans to obtain dollars. According to the U.S.
Treasury Department, foreign investors held over four trillion dollars in
Treasuries as of October 2019. Other nations had to run cumulative trade
surpluses with the U.S. totaling over four trillion dollars to buy those
Treasuries. The stability of developed countries generally attracts capital,
while less developed countries must worry about capital flight.

Disadvantages of Trade Deficits

Trade deficits can create substantial problems in the long run. The worst and
most obvious problem is that trade deficits can facilitate a sort of economic
colonization. If a country continually runs trade deficits, citizens of other
countries acquire funds to buy up capital in that nation. That can mean
making new investments that increase productivity and create jobs. However,
it may also involve merely buying up existing businesses, natural resources,
and other assets. If this buying continues, foreign investors will eventually
own nearly everything in the country.

Trade deficits are generally much more dangerous with fixed exchange rates.
Under a fixed exchange rate regime, devaluation of the currency is
impossible, trade deficits are more likely to continue, and unemployment may
increase significantly. According to the twin deficits hypothesis, there is also a
link between trade deficits and budget deficits. Some economists believe that
the European debt crisis was caused in part by some EU members running
persistent trade deficits with Germany. Exchange rates can no longer adjust
between countries in the Eurozone, making trade deficits a more serious
problem.

Pros of a Fixed/Pegged Rate

Countries prefer a fixed exchange rate regime for the purposes of export and
trade. By controlling its domestic currency a country can—and will more often
than not—keep its exchange rate low. This helps to support the
competitiveness of its goods as they are sold abroad. For example, let's
assume a euro (EUR)/Vietnamese dong (VND) exchange rate. Given that the
euro is much stronger than the Vietnamese currency, a T-shirt can cost a
company five times more to manufacture in a European Union country,
compared to Vietnam.

But the real advantage is seen in trade relationships between countries with
low costs of production (like Thailand and Vietnam) and economies with
stronger comparative currencies (the United States and the European Union).
When Chinese and Vietnamese manufacturers translate their earnings back
to their respective countries, there is an even greater amount of profit that is
made through the exchange rate. So, keeping the exchange rate low ensures
a domestic product's competitiveness abroad and profitability at home.