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Why are foreign exchange rates of G3 (the United States, Japan, Europe) so unstable?

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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

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