Page 480 - Krugmans Economics for AP Text Book_Neat

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From Bretton Woods to the Euro
In 1944, while World War II was still raging, The accompanying figure Exchange
representatives of the Allied nations met in illustrates the history of rate
(francs
Bretton Woods, New Hampshire, to establish European exchange rate
per mark) Attempts to Exchange rate
a postwar international monetary system of arrangements. It shows the FF4.0 stabilize rates mechanism
fixed exchange rates among major currencies. exchange rate between the
The system was highly successful at first, but French franc and the Ger- 3.5
it broke down in 1971. After a confusing inter- man mark, measured as
3.0
val during which policy makers tried unsuc- francs per mark, since
cessfully to establish a new fixed exchange 1971. The exchange rate Exchange
2.5 rates locked
rate system, by 1973 most economically ad- fluctuated widely at first. before euro
vanced countries had moved to floating ex- The “plateaus” you can see 2.0
change rates. in the data—eras when the
In Europe, however, many policy makers exchange rate fluctuated 1.5
were unhappy with floating exchange rates, only modestly—are periods
which they believed created too much uncer- when attempts to restore
tainty for business. From the late 1970s on- fixed exchange rates were 1971 1975 1980 1985 1990 1995 2002
ward they tried several times to create a in process. The Exchange Year
system of more or less fixed exchange rates Rate Mechanism, after a
in Europe, culminating in an arrangement couple of false starts, became effective in 1987, The transition to the euro has not been with-
known as the Exchange Rate Mechanism. (The stabilizing the exchange rate at about 3.4 francs out costs. With most of Europe sharing the
Exchange Rate Mechanism was, strictly speak- per mark. (The wobbles in the early 1990s re- same currency, it must also share the same
ing, a “target zone” system—exchange rates flect two currency crises—episodes in which monetary policy. Yet economic conditions in the
were free to move within a narrow band, but widespread expectations of imminent devalua- different countries aren’t always the same.
not outside it.) And in 1991 they agreed to tions led to large but temporary capital flows.) Indeed, as this book went to press, there
move to the ultimate in fixed exchange rates: a In 1999 the exchange rate was “locked”—no were serious stresses within the eurozone be-
common European currency, the euro. To the further fluctuations were allowed as the coun- cause the world financial crisis was hitting
surprise of many analysts, they pulled it off: tries prepared to switch from francs and marks some countries, such as Greece, Portugal, Spain
today most of Europe has abandoned national to euros. At the end of 2001, the franc and the and Ireland, much more severely than it was
currencies for euros. mark ceased to exist. hitting others, notably Germany.

A reduction in the value of a currency that is set under a fixed exchange rate regime
A devaluation is a reduction in the value of
is called devaluation. As we’ve already learned, a depreciation is a downward move in a
a currency that is set under a fixed exchange
currency. A devaluation is a depreciation that is due to a revision in a fixed exchange
rate regime.
rate target. An increase in the value of a currency that is set under a fixed exchange rate
A revaluation is an increase in the value of
regime is called a revaluation.
a currency that is set under a fixed exchange
A devaluation, like any depreciation, makes domestic goods cheaper in terms
rate regime.
of foreign currency, which leads to higher exports. At the same time, it makes for-
eign goods more expensive in terms of domestic currency, which reduces imports.
The effect is to increase the balance of payments on the current account. Similarly, a
revaluation makes domestic goods more expensive in terms of foreign currency,
which reduces exports, and makes foreign goods cheaper in domestic currency,
which increases imports. So a revaluation reduces the balance of payments on the
current account.
Devaluations and revaluations serve two purposes under a fixed exchange rate
regime. First, they can be used to eliminate shortages or surpluses in the foreign ex-
change market. For example, in 2010, some economists were urging China to revalue

438 section 8 The Open Economy: Inter national Trade and Finance