The idea of the exchange rate administration or regime can be described as the system employed by a country’s government so as to manage its currency in the perspective of other key world’s currencies. The Foreign Exchange Market (FOREX) is pretty significant in this situation as well. The history of the exchange rate of 19th century emphasizes the significance of gold standard; from the year 1876 to the year 1913 the system of exchange rate was reliant on an ounce of gold to convert a particular currency. The First World War led to suspension of the gold standard, and as a result the method of exchange rate determination was reassessed (Economywatch.com, 2010).
Suspension of gold standard in the year 1914 led to the collapse of the currency market and in early 1920s, a number of nations attempted to restore gold standard in order to obtain the old system of exchange back into operation. But the U.S. was hit by the Great Depression in the year 1929 (Economywatch.com, 2010). The overwhelming consequences of the depression were experienced by many other developed economies, as a consequence all the attempts to revive gold standard were discarded (Economywatch.com, 2010). This paper will investigate the U.S. and UK exchange rate administration from a historical perspective and based on their estimation of their Purchasing Power Parity (PPP).
Bretton Woods Agreement to the Present
Approximately thirty years ago, the U.S. managed its currency under two distinctive exchange rate administrations regimes; first, Bretton Woods System that operated the fixed exchange rates from the year 1958 to 1973 and the second, floating rate system started in the year 1973 which is still in practice today (Pauls, 2011).
The signing of the Bretton Woods Agreements took place when the Second World War was ending, and was enforced in the year 1945 but only became fully active in the year 1958. Since the consequences of the depression were fresh in policymakers’ minds, they sought to avoid all potentials of the same debacle. Bretton Woods Agreement established the fixed exchange rates system which pegged all nations’ currencies on U.S. dollar that was in turn based on gold standard. A fixed system is controlled by the central bank or government in that it intercedes in the FOREX market in order to fix the exchange rate for it to remain close to the targeted exchange rate (Economywatch.com, 2010).
The Agreement was in operation till the year 1971, by the year 1970 the system of the exchange rate in existence was previously under risk. The conversion of the U.S. dollar into gold was suspended by the Nixon-led government since the demand of U.S. dollar was less than the supply this led to the signing of the Smithsonian Agreement in the year 1971. This was a historical moment for the exchange rate since it was determined for the first time by market forces (demand and supply) rather than gold standard as has been the case. At first, the shift to the widespread floating system was broadly considered as a short-term mean of dealing with pressures from speculation, instead of a permanent aspect of the global monetary system (Pauls, 2011).
Smithsonian Agreement was not applied for a long time and by the year 1973 currencies which were widely traded were allowed to fluctuate. The system of floating currency allows the currency’s value to fluctuate in keeping pace with FOREX Market conditions (Economywatch.com, 2010). From the year 1944 to the year 1972, the UK operated a fixed system of currency exchange and in the year 1948 and 1967 there was irregular devaluations against the U.S. dollar.
While from 1972-87 the country administered it’s currency through managed floating, this changed after 1987-88 during the period when it used “Shadowing the DM” as an exchange system (Pauls, 2011).
The following three years or so, the UK restored the managed floating system and in last quarter of the year 1990, the UK joined European Exchange Rate Mechanism (ERM) and it fixed it’s currency to the rest of the European currency, a regime known as semi-fixed system. In 1992, the country left ERM at the period when its currency was under continued selling demands and the administrations could not validate the high rates of interests to sustain the value of the pound. In the same year (1992) the UK adopted the floating system, which is in use today (Tutor2u.net, 2010). The floating system is capable of adjusting itself, which is one of its major advantages. This system allows superior liquidity and control from the central bank, but it may be subjected to threats by the speculators or unexpected panic-driven actions by investors which can result to recessions and currency crisis (Economywatch.com, 2010).
Theories of Exchange Rate
The exchange rate can be determined using three theories namely; Purchasing Power Parity (PPP), International Fisher Effect (IFE) and Interest Rate Parity (IRP) (Oecd.org, 2010).
Interest Rate Parity
IRP theory states that “size of the forward premium or discount should be equal to the interest rate differential between the two economies of concern,” (Oecd.org, 2010) the U.S. and UK for instance. When IRP is in existence, the risk arising from the foreign exchange is eliminated that is the interest arbitrage covered is not possible, because advantage arising from the interest rate in the overseas nation is counterbalanced by the forward rate premium. Therefore, the action of covering interest arbitrage generates return not superior than that which would be earned by the domestic investment (Oecd.org, 2010). This covering results to the following equation;
(1 + rD) = F/S (1 + rF)
Where (1 + rD) is the amount earned by an investor after one period of investing in USD at an interest rate of rD in domestic market while if the investor invest in a foreign market at a rate of rF he/she earns F/S (1 + rF) this means that the USD investment yield similar return in both foreign and domestic market (Oecd.org, 2010).
While for the Uncovered IRP, the equation is as follows;
r + rD = S1/S (1 + rF)
Where S1 is equal to the anticipated spot rate in the future when earnings denominated in GBP (foreign currency) are converted to USD (domestic currency).
Therefore, we can say that interest arbitrage covered has a benefit because there is motivation to make an investment in superior-interest currency up to a point where that currency’s premium in forward market is not more than interest differentials. In case the premium of currency with superior rate of interest in forward market becomes higher than interest differentials, it becomes advantageous to make an investment in the currency with lower interest rate and benefit from the extreme forward discount on that currency (Oecd.org, 2010).
Purchasing Power Parity
PPP theory centres on the “exchange rate–inflation” relationship; PPP exists in two forms that is (1) absolute form that proposes that “prices of similar products of two different countries should be equal when measured by a common currency” (Oecd.org, 2010). (2) In case of existence of any inconsistency in the prices as gauged by a universal currency, the demand must shift for these prices to converge. (3) Relative form which accounts for probability of the market imperfections for instance, tariffs, transportation costs and quotas. As a result of these imperfections in the market, prices of same products from various nations will not essentially be similar when gauged using one common currency. But the theory in this case, states that “the rate of change in the prices of products should be somewhat similar when measured in a common currency, as long as the transportation costs and trade barriers are unchanged” (Oecd.org, 2010).
Absolute form equation is as follows;
S = α (PD/PF)
Where S (GBP/USD) is the spot rate, PD is US’s price level (domestic market), PF is UK’s price level (foreign market) and α is the price and shares constant of the sector (Povertytools.org, 2010). The equation shown above means that as the US’s price level increases, USD depreciates against GBP, because for every GBP an increased amount of pounds is to be disbursed (Povertytools.org, 2010).
Relative form equation is as shown below;
∆S = ∆PD – PF
The equation means that the proportion of change in the exchange rate equals the rate of interest differential. Therefore, PPP is greatly estimated in the long-term compared with the short-term as well as when interruptions are only monetary terms (Fuentes, 2011).
International Fisher Effect
IFE theory utilizes rate of interest instead of rate of inflation differentials to illustrate the reason for change in exchange rate after a while, but IFE is strongly related to PPP theory because rates of interest are normally strongly correlated with rates of inflation. IFE states that “nominal risk-free interest rates contain real rate of return and anticipated inflation” (Oecd.org, 2010). This implies that in case the investors from all nations need similar real return, rate of interest differentials between nations might be the product of the differences in the anticipated inflation (Oecd.org, 2010).
Theory of IFE proposes that overseas currencies with somewhat superior rate of interest will depreciate due to superior nominal rates of interest that reflect anticipated inflation. This nominal rate of interest would also include investment’s default risk (Oecd.org, 2010). The equation of IFE is as shown below;
rD – PD = rF – ∆PF
OR
PD – PF = ∆S = rD – rF
The equation above means that if barriers to the capital flows do not exist, investments will run in a way that real return rates on the investments will balance. The equation represents relations between monetary sector, FOREX market and real sector (The Institute of Chartered Accountants of India, 2010). If IFE holds, in that case the strategy of having a loan from US and investing these funds in UK should not on average offer constructive return. Reason being that the exchange rates must attune to offset on average the differences in the rate of interest. But the purchasing power cannot hold for particular time and since IFE is founded on PPP, IFE does not constantly hold too, due to other factors apart from inflation, exchange rate do not attune in conformity with inflation differential (The Institute of Chartered Accountants of India, 2010).
PPP, IFE and IRP theories compared
The theories differ but they all determine exchange rate, IRP centres on why forward rates vary from spot rate as well as the extent of the variation that must exist in relation to particular moment in time. On the contrary, IFE and PPP centre on how the spot rates of the currencies change after a while, PPP and IFE theories propose that spot rate changes in conformity with inflation and rate of interest differentials respectively. Nevertheless, PPP is linked to IFE in that the differences in inflation influences nominal rate of interest differentials between two nations (The Institute of Chartered Accountants of India, 2010).
Estimation of PPP
The following table shows hypothetical monthly data prices from the U.S. and UK for Coffee (Robusta) for 10 years period and relative PPP estimation. (See appendix )
References
Economywatch.com., 2010. Exchange rate history. Web.
Fuentes, G. 2011. How to calculate purchasing power parity. Web.
Oecd.org. 2010. Purchasing Power Parity. Web.
Pauls, D., 2011. U.S. exchange rate policy: Bretton Woods to the present- includes glossary. Web.
Povertytools.org. 2010. Calculating PPP conversion factors and “$1-a-day”poverty line. Web.
The Institute of Chartered Accountants of India, 2010. Foreign exchange exposure and risk management. Web.
Tutor2u.net. 2010. Fixed and floating exchange rates. Web.
Appendix
Table 1: Coffee (Robusta) prices
