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236 foreign exchange
loss due to an adverse movement of the schilling
against the pound, but would also forgo the
possibility of a gain if the movement were in the
opposite direction. Refraining from hedging is
known as maintaining an open position.
In long-run equilibrium, exchange rates are
affected by purchasing power parity and by interest
rate parity, which are linked by the International
Fisher Effect. The first states that if there is a
discrepancy in the purchasing powers of the
currencies of two countries, such that the prices
of goods and services in Country A are higher than
those in Country B when compared using the
exchange rate between the two currencies, then the
inhabitants of Country A will tend to purchase
goods and services as far as possible in Country B.
This will affect A's balance of payments
negatively, and B's positively. Consequently, the
spot exchange rate between the two countries'
currencies will tend to shift so as to remove the
discrepancy in their purchasing powers. This
tendency will be reflected in the forward exchange
rates.
The two parity models are similar, but in the
case of interest rate parity it is the price of money
�that is, interest rates) and investment flows that
are involved. Differences in interest rates between
countries would, other things being equal, induce
investors to shift their funds from the country with
the lower interest rates to that with the higher ones.
One reason why this may not happen is the
International Fisher Effect; in other words, the
country with the higher nominal interest rates
typically also has a higher expected inflation rate,
so that after correcting for expected inflation, the
real interest rates do not differ. Continuing the
previous example, a fall in the exchange rate of
Country A's currency would increase the prices of
A's imports and decrease the prices of its exports.
This, in turn, might lead to inflation in Country A.
Investors in interest-bearing assets in Country A
would expect a higher nominal interest rate so as to
be compensated for the inflation �so as to receive
the same real rate).
Hence, there is a relationship between the spot
and forward exchange rates of the two currencies
on the one hand, and the difference between the
interest rates applicable to the two currencies on
the other hand. This relationship �interest rate
parity) is such that the financial outcome of an
inhabitant of Country A hedging an amount
payable in Country B's currency in �for instance)
six months should be much the same as using the
money markets to borrow the amount required at
A's six-month interest rate, converting it into
Country B's currency in the spot market and
placing it on deposit at B's six-month interest rate
until required to make the payment. If the financial
outcomes of using the money market and using the
forward exchange market were significantly different,
then market operators known as arbitrageurs
could make riskless profits by exploiting the
discrepancy; and by doing so they would cause
interest rates and forward exchange rates to move
towards the levels required to produce interest rate
parity.
These relationships assume that the currencies
involved are fully convertible and not subject to
exchange and other currency controls. Because of
the potentially disruptive effects of exchange rate
variations in international trade, forcing businesses
to choose between the costs of hedging and the
risks of exchange losses, various attempts have been
made to stabilise exchange rates. One such attempt
was the Bretton Woods Agreement of 1944, setting
up a worldwide system of fixed exchange rates in
which the US dollar served as a standard to which
all other convertible currencies were pegged. In
turn, the US dollar was convertible into gold at a
rate guaranteed by the US Federal Reserve Bank.
To this extent, the Bretton Woods system resembled
a revival of the old gold standard, which
had prevailed until it was abandoned in the 1920s.
Adjustments to the exchange rates of individual
currencies �normally devaluations) were possible on
an exceptional basis. For example, in 1948 the
pound was devalued from $4 to $2.8, a devaluation
of 30 per cent.
Apart from such major adjustments, exchange
rates of currencies into the US dollar were
expected to vary within a relatively narrow band.
In the 1970s, the United States ceased to be able to
guarantee the convertibility of its dollar into gold,
and in connection with this the system of fixed
exchange rates was abandoned. An era of floating
rates ensued. Subsequently, rather than a worldwide
system of fixed exchange rates, the idea of
currency unions has gained some acceptance,