Download International Monetary System

International Monetary System
Alternative Exchange Rate Systems
• Free Float
Supply and demand determines the equilibrium exchange rate
• Managed (Dirty) Float
Smoothing out daily fluctuations
• Target-Zone Arrangements
European Monetary System
• Fixed-Rate System
Bretton Woods system, currency boards
A Brief History of the
International Monetary System
The Gold Standard
• Prices of all currencies were quoted in terms
of gold:
1 ounce of gold = $20.67
1 ounce of gold = £4.2474
• Exchange rates can then be determined as:
$20.67/ounce of gold
= $4.8665/£1
£4.2474/ounce of gold
• Prices of goods were stable for more than
100 years during the late 18th and throughout the 19th century
• Periodic episodes of inflation as large gold
discoveries were made
How the Gold Standard Works
in Theory
• Suppose initially there is an increase in US
exports over US imports
• This leads to two things:
There is an increased flow of foreign gold
into the US
This leads to an increase in US money
supply and an increase in US inflation
• As US prices rise, US exports fall as they
have become less competitive
• At the same time, foreign goods now appear
cheaper relative to US goods so US imports
will increase
• Gradually, this reverse trade flow will equilibrate the monetary system and prices to
their initial levels
How the Gold Standard Worked
in Practice
From 1821 until 1880 many countries joined the
gold standard
By the end of the 19th century almost every
country was on some form of gold standard
This led to a never before seen increase in the
volume of international trade
Prices and exchange rates were stable
However, there was a major world depression
during the 1890s
A serious economic contraction happened in 1907
as well
It is not clear whether a system of fiat money
and freely floating exchange rates would have
prevented these economic ups and downs
Breakdown of the Gold Standard
• During the first World War (WWI) the Gold
Standard was briefly suspended
• After WWI, the Gold Exchange Standard
was created under which countries could hold
both US dollars and British pounds as well
as gold as reserves
• However, the fixed rates of the US dollar
and the British pound were unrealistic and
Britain devalued the pound
• Many other countries followed Britain’s example and devalued their currencies; these
policies are referred to as “beggar-thy-neighbor”
devaluations
• The Gold Exchange Standard was abandoned
in 1931
• The last two events triggered the world depression of the 1930s
The Bretton Woods System:
1946–1971
• Fix the value of the US dollar in terms of
gold: 1 ounce of gold equals $35
• Fix all other currencies values against the
value of the US dollar: 1 Deutsche mark was
equal to 1/140 ounces of gold or $35/140=$0.25
• Exchange rates were allowed to fluctuate within
1% of their stated fixed rates against the US
dollar
Differences in inflation rates created economic
imbalances which lead to devaluation pressures
With increasing US inflation in the late 1960s
and 1970s a lot of countries devalued their currencies against the US dollar
This led to a large outflow of gold from the US
Finally, in 1971 President Nixon suspended the
convertibility of the US dollar in terms of gold;
the US dollar was devalued in 1973
Floating-Rate System:
1973–Present
Proponents of floating exchange rates expected
that:
• Floating rates would offset inflation differences across countries
• High inflation countries would experience currency devaluations
• Low inflation countries would experience currency appreciations
In reality, however, what happened was that:
• Currency exchange rate volatility increased
substantially
• Most of this volatility appears to be linked
to uncertainty about what economic policies
governments will adopt rather than just inflation differentials
Alternative Fixed-Rate Systems:
Monetary Unions
European Monetary System (EMS): March 1979
European Currency Unit (ECU): A basket of 12
currencies with fixed weights
• Each of the 12 currencies had a fixed rate
against the ECU
• These fixed rates against the ECU determined a fixed cross rates between all 12 currencies
• Each cross rate was allowed to fluctuate within
a band of 2.25% around the central rate
Lessons learnt from EMS:
• Differences in countries macroeconomic policies can put severe pressure on the central
rates
• Central banks spent large amounts of money
(mostly in vain) trying to defend the central
rates
The Euro: 1999–Present
Decrease the transaction costs of dealing with
12 different currencies:
• Philips estimates that the single European
currency will save it $300 million in transaction costs
There are still some unresolved issues as to the
monetary policy the European Central Bank
(ECB) will take and, in particular, how the 12
countries will decide on a common monetary
policy
Some recent signs of potential trouble:
• Germany and France have been running government deficits that may break the Maastricht barrier of 3% of GDP
• This may push up prices in Germany and
France
• Eventually this inflation will spread to the
other European countries
Another Alternative:
The Currency Boards
Most former British colonies have been running
a de facto currency board since they were liberated:
• Hong Kong has experienced no economic
problems as a result of its currency board
that fixes the Hong Kong dollar against the
US dollar
More recently, several Eastern European countries have established currency boards: Bulgaria
(first DM, now Euro), Estonia (first DM, now
Euro) and Lithuania (US dollar)
However, there is always the problem with credibility of the government that runs the currency
board:
• Earlier this year Argentina abandoned its
currency board after running large government deficits