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International Financial Management

Notes

Notes The disadvantage of this system is that it requires countries to have ample reserves
for the prolonged process of adjustment. Also, the minor adjustments may not correct the
currency’s overvaluation or undervaluation.

Wide Band: The purpose of the wide band is to compensate for the rigidity of the fixed rate
systems. Similar to and yet different from the adjustable peg system, the wide band allows
the currency value to fluctuate by say 5 per cent on each side of the par. Not primarily
dedicated to exchange rate changes, this system uses the more flexible movement to warn
speculators of the more adverse consequence when their guess about the direction of the
exchange rate proves to be wrong.
Under the wide band scheme, a country pursuing more inflationary policies will find the
prices of its international goods going up, necessitating a depreciation programme to
correct the country’s balance of payments in order to slow growth and curb inflation,
while eventually risking recession. The country’s exchange rate would then sink towards
the floor under its par value. Once the fixed limit is reached (i.e., after hitting either the
floor or the ceiling), the country is back to the rigidity of the fixed rate all over again.
Moreover, if a wide band is desirable because of the increase in flexibility, a country may
be better off with no limit for movement at all.
Flexible (Floating) System: Under the fixed systems, excessive demand for gold developed
and the United States was forced to suspend the sale of gold in 1968, except to official
parties. But taking this action did not help and by the late 1960s, the dollar came under
increasing pressure because of the prolonged and steep deterioration of the balance of
payments. A crisis of confidence developed and foreigners’ reluctance to hold dollars
resulted in a change in the dollar’s historic value. On August 15, 1971, the United States
suspended the convertibility of the dollar into gold and other reserve assets altogether
and it floated the dollar to force a change in the parity as well as a review of the IMF. The
subsequent Smithsonian Agreement resulted in a revaluation of other currencies and the
devaluation of the dollar by 10.35 per cent. In February of 1973, following a great deal of
speculation against the dollar, the crisis renewed, and a second 10 per cent devaluation
followed. The crisis forced the official foreign exchange markets to close in Europe and
Japan for about two-and-a-half weeks. When these markets reopened, all major currencies
were allowed to float.
After an initial period of remarkable stability, the dollar sank rapidly for seven weeks
because of balance of payments deficits, Watergate revelations, renewed inflation in the
United States and a tightening of money abroad. Had the fixed systems been in effect, a
traditional crisis would have resulted; foreign exchange markets would have been closed
and large-scale adjustment of parities would have been necessary. With the dollar free to
float, however, the beneficial effect was that speculative pressures were reflected in a
sharp drop in the exchange value of the dollar without a closing of the market. The
resultant devaluation, in turn, helped the United States to improve its trade performance.

In October, 1978, another crisis came along for the US dollar. Concerns over inflation in
the United States prompted a panic selling of the dollar and the stock market plunged. In
spite of the risk of recession, the Carter administration was forced to take drastic measures
because of several reasons: (1) The dollar decline reduced American consumers’ purchasing
power (2) Soaring prices hurt the anti-inflation programme (3) OPEC members’ declining
value of their dollar reserves encouraged them to boost oil prices and (4) Stock values lost
more than $110 billion, resulting in a large-scale retrenchment of business investment
plans. Among the measures taken were an increase in the Federal Reserve’s discount rate,

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