In 1973, Nixon unilaterally decided to break off all references to gold and to float the dollar to escape the constraints of the international monetary system of Bretton Woods which was becoming increasingly burdensome on the U.S. economy. This ended the system of fixed exchange rates, which had been operational since 1944. This monetary system was officially replaced in 1976, with the Jamaica agreements (Kingston) which provide a more flexible monetary organization which gives the State a choice.
Today, 25% of member countries of F.M.I. have fixed exchange rate system, 45% have floating exchange system, and 35% are in an intermediate situation. In a fixed exchange rate system, monetary authorities should defend the official parity of the currency by intervening, through purchases or sales, on the foreign exchange market possibly through the conditional support of the IMF. The exchange rate is an administered price. However in a system of floating exchange, rates fluctuate according to supply and market demand.
The monetary authorities can influence but not control its fluctuations that are required to maintain the exchange rate at a pre defined value. It is through this system, that the current members of the G3 (U.S., EU, Japan) are related. The exchange rate is the price of one currency expressed in relation to a foreign currency. But since the establishment of the system, currency fluctuations are erratic. Then, it was the "yoyo dollar" during the 1970s. Many theories have been able to explain the origin of its short-term fluctuations and have predicted a return to long-run equilibrium.
Today, however, stability is far from being achieved, as evidenced by the imbalances between the Euro and the dollar. Why are exchange rates of the G3 so unstable? Are the theories of the 1970s obsolete? Can one find relevant explanations? The determinants of exchange rates should first be explores and then examine the synthesis of Dornbusch as well as analyze the criticism of this theory. Finally an analysis of the effects of volatile interest rates and solutions seems necessary.
The exchange rate is to link with the balance of payments. The balance of payments is an accounting document that records all financial and economic transactions between a country and the world. It records all cash flows associated with these relations. It is divided into two parts:an upper part on the fundamentals and a lower part on the monetary and financial aspect. Each part is a set of determinants of exchange rates.
If a country has a negative balance then it will have to find ways to finance this deficit. It will then provide its currency and demand more currencies, the currency is going to depreciate by the simple interaction of supply and demand.
Countries with a strong currency, that is to say, which tends to appreciate, would be the structural surplus countries. For example, Germany and Japan, that saw a large surplus in the years 1960-1980 have seen their currency, the Mark and the Yen appreciate. Conversely the weakness of the franc over the same period can be explained by the tendency of France to be in the deficit.
Tags: Foreign exchange rates; United States; Europes and Japan; unstable currency exchange value; effects of volatile interest rates; analysis
[...] In the short term this assessment corresponds to a depreciation greater than the long- term value of the currency since agents expect an exchange rate appreciation. In this theory, the instability of the exchange rate is due to the fact that the adjustment speeds are different on the financial markets and service markets. This refers to the third assumption of the model. It should be noted here that in the long term, the balanced path of the exchange rate corresponds to the Purchasing Power Parity (which refers to the inflation differentials between countries). Dornbusch therefore considers PPP as an anchor. [...]
[...] Thus the exchange rate decreases in parallel. Kenneth Rogoff showed thereafter that a random walk model allows us to make the best short-term forecasts in which economic approaches are normal. In the very short term the market is mainly influenced by Rogoff role of news and rumors that can be considered exogenous shocks permanently. Rogoff however points out one nuance: there are elements of predictability beyond two years, mainly with respect to purchasing power parity. The overshooting shows that even in the presence of rational expectations, monetary shocks can cause the appearance of persistent deviations of nominal exchange relative to their PPP equilibrium value. [...]
[...] According to them, the exchange rate gives Chinese exporters an unfair advantage and cause job losses in the United States. In conclusion, it is clear that changes in exchange rates greatly disrupt economies as a whole / Exchange instability can generate crises The main risk of currency instability is the risk of a systemic crisis. While such crises have not yet seriously affected the G3, erratic fluctuations of the dollar in particular have sparked major crises. According to Camdessus, the twenty-first century crises are crises because of the exchange rate. [...]
[...] This highlights the imperfection of the forex market B / How to prevent these adverse effects of instability in exchange rates 1 / monetarist theory disagrees with reality. The monetarist Milton Friedman believes that speculators earn market only if they buy when prices are low (therefore they raise prices and contribute to their stability) and sell when prices are at their highest (This lowers courses and plays a stabilizing role). Speculators can make mistakes and experience setbacks, but they can not do so, otherwise they would constantly be quickly ruined and driven out of the market. [...]
[...] Dornbusch opines that the high volatility of the nominal exchange rate since the end of Bretton Woods would come from an over-reaction (overshooting) to the exchange rate in monetary policy. 1/The assumptions of the model Dornbusch therefore includes monetary and financial behavior in a model of exchange rate determination. For this, it must appeal to three hypotheses: - The exchange rate expectations and foreign interest rate must be exogenous. - The Interest Rate Parity Not Covered (UIP) should be checked. [...]
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