[MUSIC] Unlike the earlier uniform systems of first the Gold Standard, and then the Dollar Standard of Bretton Woods, today's global exchange rate system fits into no tidy mold. In fact, without anyone having planned it, the world has moved to a hybrid international financial environment, featuring both pure Fixed and Flexible exchange rate systems. As well as systems that feature a so called Managed Float and exotically named mechanisms, like a Gliding Peg or Crawling Peg. As a business executive or investor, trying to find your way through the ticket of exchange rate risk that you may encounter, it is important that you understand how each system works. And what that might mean when you conduct business or invest in the global economy. [MUSIC] As we have discuss with the Flexible of Floating Exchange Rate system, markets determine the currencies value, and there is very little intervention. In contrast, with a pure fixed exchange rate system, one country will peg the value of its currency to another currency or a basket of currencies. And maintain that peg through the buying and selling of its foreign reserves and own currency. These are the two ends of the international exchange rate systems poles. Here is what we have in between. [MUSIC] From a currency trader's perspective the Managed Float system, also called the Dirty Float is arguably the most risky. In such a system, the exchange rate of a country will fluctuate day to day. But there is always the very real risk that that country's central bank may intervene in the market by buying or selling its currency. For example, as a currency trader you may believe that the currency of a particular country is likely to depreciate in the face of what you see is a rapid rise in the inflation rate and you may speculate accordingly. However this trade may go against you if the central bank of that country decides to intervene in the market and buy it's currency to prevent such a devaluation. The broader key point here is that the existence of managed float systems make it more difficult for both business executives and investors to anticipate the movement of exchange rates. This in turn means the task of managing exchange rate risk is more difficult in a managed float environment. [MUSIC] It is useful to note at this point that many countries, particularly small ones, not only take their currencies to a major currency or do a basket of currencies. Sometimes the peg is allowed to glide smoothly upward or downward in a system known as a Gliding, or Crawling Peg. Since your Gliding or Crawling Peg system offers a combination of the stability of a fixed peg approach with the flexibility of a floating one. [MUSIC] Some countries may also join together in a currency bloc in order to stabilize exchange rates amongst themselves. These countries then allowed their single currency to flow relative to those of the rest of the world. The most important of this blocs is the European Union which in 1999 moved to a single currency the Euro. The story behind the birth of Euro as one of the world's major currencies is well worth telling as it illustrates both the difficulties of finding a stable exchange rate system and the advantages of coordinating policies across countries. [MUSIC] With the demise of the US dollar standard and in the late 1970s the nations of Europe established a fixed exchange rate system. It was pegged to the German Mark in the hopes of avoiding a repeat of the competitive devaluations and economic disruptions that had plagued Europe leading up to World War II. In fact, this European monetary system worked reasonably well for over a decade. However, in 1990, the reunification of Germany resulted in large budget deficits as West Germany subsidized East Germany industry. To cope with the resultant inflationary pressures, Germany's Central Bank, the Bundist Bank, significantly raised interest rates. And this in turn put significant upward pressure on the German Mark. Now in this case, German monetary policy was clearly uncoordinated with that of its neighbors. That is, Germany was unilaterally implementing a contractionary monetary policy by raising interest rates to cope with the domestic inflationary crisis. And doing so without adequate consultation with the other countries in the fixed exchange rates system. So, here's the question, knowing what you know about exchange rates and macro economics now. What do you think happened in Europe in the wake of Germany's actions? In particular, do you think the European economy grew faster or slower? Take a minute to think about this and jot out some ideas before moving on. [MUSIC] So what happened after Germany's central bank raised interest rates? Well, faced with rising German interest rates, the other European countries within the European monetary system had also raised their interest rates. These interest rate heights across Europe were necessary to prevent the other European currencies from depreciating against the German Mark and therefore moving outside the prescribed range of parries in the fixed peg system. In effect then, other countries in Europe in the system were forced by Germany to engage in contractuary monetary policy in response to the German rate hikes. But, these rate hikes collectively help push Europe into an ever deepening recession. And here's the quota to the story. Eventually the European monetary system was brought down by speculates who believe that the belligerent countries would not and could not continue to tolerate unrealistic exchange rates and high interest rates. One by one, currencies came under attack from these speculators. The Finnish Markka, the Swedish Crown, the Italian Lira, the British Pound, the Spanish Peseta, and so on, until the system collapsed. And here's the key point of this story. In today's global environment, a country cannot simultaneously have fixed exchange rates, open capital markets and an independent monetary policy. In seeking to resolve these contradictions, the major European countries adopted a common currency, the Euro in 1999. This was a step that strongly reinforces the importance of coordinating global macro policies. However, despite such coordination, the European Monetary Union remains prone to periodic instability and disruptions. Underscoring how difficult it is for the globe to maintain a stable monetary system. In our next and final module of this lesson, we will drill down just a bit further on the need for the coordination of fiscal and monetary policies among nations, in order to maintain stability in the international monetary system. So when you're ready, let's move on. [MUSIC]
