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CHAPTER 3
PAST AND PRESENT INTERNATIONAL MONETARY
ARRANGEMENTS
CHAPTER OUTLINE
The Gold Standard: 1880–1914
The Interwar period: 1918–1939
The Gold Exchange Standard: 1944–1970
The Transition Years: 1971–1973
Floating Exchange Rates: 1973 to the Present
The Choice of an Exchange Rate System
Optimum Currency Areas
The European Monetary System and The Euro
Target Zones
Currency Boards
International Reserve Currencies
Multiple Exchange Rates
Summary
Exercises
References
LECTURE HINTS
1.
The pressures that led to the breakdown of the fixed exchange rate regime are usefully illustrated with
a supply-and-demand diagram. With a fixed exchange rate supported by official intervention, private
speculators start selling the weak currency in anticipation of a devaluation. The speculation leads to a
greater deficit and more intervention which causes a more rapid depletion of reserves.
2.
The Annual Report of the IMF appendixes is a convenient source of information to update tables 3.2
and 3.5.
SUGGESTED ANSWERS TO CHAPTER 3 EXERCISES
Exercise 1
Seigniorage is the difference between the cost of printing a currency and its purchasing power
value. The seigniorage return to being the dominant reserve currency producer is small. One reason
is that foreign holdings of actual currency are small relative to foreign holdings of dollardenominated interest-bearing securities and deposits. The United States earns no seigniorage return
from interest-bearing bank deposits.
Exercise 2
Gold is very costly to produce in the short run and thus its supply is quite limited. Under a gold
standard, value of a currency depends upon the value of gold which is determined by the supply of
gold, given the demand for gold. Since it is not easy to increase the supply of gold very fast, it is
not possible for a country to achieve a high money supply growth and maintain the value of its
currency in terms of gold. If it tries to repeatedly alter the gold value of its currency, then there is
no longer a true gold standard.
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Exercise 3
Suppose a country is running a balance-of-payments surplus. This would bring gold into the
country, which would increase the domestic money supply and, in turn, prices. The rise in price
would reduce net exports so that balance-of-payments equilibrium would be restored.
Similarly, a country running a BOP deficit would find itself with net gold outflows, thus reducing
its money supply and, in turn, its prices. The fall in price would bring about greater net exports so
that BOP equilibrium is restored.
Exercise 4
The euro began in January 1999. Countries and associated legacy currencies are:
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
schilling
franc
markka
franc
marc
drachma
pound
lira
franc
guilder
escudo
peseta
Exercise 5
Floaters





large size
closed economy
divergent inflation rate
diversified trade
greater foreign tradable goods price
fluctuations relative to domestic price
disturbances
Peggers





small size
open economy
harmonious inflation rate
concentrated trade
greater domestic money shocks relative to
foreign shocks
Exercise 6
Under a “gold standard” each currency is defined in terms of its gold value and therefore all
currencies are linked together in a system of “pegged” exchange rates. All currencies are
convertible into gold. The Bretton Woods system, although essentially a pegged exchange rate
system, allowed for changes in exchange rates when economic circumstances required such
changes. Therefore, the system can be considered as an “adjustable peg.” The system may also be
thought as a “gold exchange standard” since the key currency, the dollar, was convertible into gold
for official holders of dollars, and other currencies were convertible into dollars.
The Bretton Woods agreement required each country to fix a parity value of its currency in terms of
gold. Countries were expected to maintain their exchange rates by buying and selling their own
currencies. The IMF was created to aid countries with temporary BOP deficits. Countries were to
change the pegged value of a currency only when BOP disequilibria were viewed as permanent.
Individual country policies in the early 1970s demanded more flexibility in exchange rates than was
permissible under Bretton Woods. This lack of flexibility led to the ultimate breakdown of the
agreement.
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Exercise 7
A target zone backed by credible government policies helps to stabilize an exchange rate relative to a
floating exchange rate. This is due to the fact that as the exchange rate approaches the upper or lower
bound of the zone the probability of government intervention increases. So private traders expect
intervention to maintain the exchange rate within the bounds of the zone and act accordinly.
Exercise 8
The ECB is in Frankfurt, Germany.
The European System of Central Banks is like the Federal Reserve System in that the 12 national central
banks deal with banking issues in each country in a similar manner to the way that the Federal Reserve
district banks deal with banking issues in each of the 12 Federal Reserve districts.
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