Download International Monetary System

The International
Monetary System
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Chapter Two
Chapter Objective:
 This chapter serves to introduce the student to the
institutional framework within which: (1) International
payments are made, (2) The movement of capital is
accommodated, (3) Exchange rates are determined.
Chapter Outline
 Evolution of the International Monetary System
 Current Exchange Rate Arrangements
 European Monetary System
 Euro and the European Monetary Union
 Fixed versus Flexible Exchange Rate Regimes
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Evolution of the
International Monetary System
 Definition: IMS is institutional framework within which
international payments are made, movements of capital are
accommodated, and exchange rates among currencies are
determined





Bimetallism: Before 1875
Classical Gold Standard: 1875-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime: 1973-Present
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Evolution of the International
Monetary System
Bimetallism (prior to 1875)


Gold and Silver used as international means of payment
and the exchange rate among currencies was determined
by either their gold or silver content.
Gresham’s law - exchange ratio between two metals
was officially fixed, therefore only more abundant metal
was used, driving the more scarce metal out of
circulation
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Evolution of the International
Monetary System (contd.)
Classic Gold Standard (1876 - 1913)

During this period in most major countries:
1.
gold alone is assured of unrestricted coinage
2.
two-way convertibility between gold and national currencies at a
stable ratio
3.
gold is freely exported or imported

The exchange rate between two country’s currencies would
be determined by their relative gold contents
Highly stable exchange rates under the classical gold
standard provided an environment that was conducive to
international trade and investment.
Price-specie-flow mechanism corrected misalignment of
exchange rates and international imbalances of payment
Might lead to deflationary pressures



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Evolution of the International
Monetary System (contd.)
Interwar period (1915 – 1944)
 characterized by:



Economic nationalism
Attempts and failure to restore gold standard
Economic and political instability
 These factors highlighted some of the shortcomings
of the gold standard

The result for international trade and investment was
profoundly detrimental.
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Evolution of the International
Monetary System (contd.)
Bretton Woods System (1944 – 1973)
 Creation of the International Monetary Fund (IMF) and the
World Bank
 Under the Bretton Woods system, the U.S. dollar was
pegged to gold at $35 per ounce and other currencies were
pegged to the U.S. dollar.
 Each country was responsible for maintaining its exchange
rate within ±1% of the adopted par value by buying or
selling foreign reserves as necessary.
 US dollar based gold exchange standard
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Evolution of the International
Monetary System (contd.)
 Bretton Woods System (1944 – 1973)
British
pound
German
mark
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
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Evolution of the International
Monetary System (contd.)
Bretton Woods System (1944 – 1973)
 Problem with the system is that U.S. constantly incurred
trade deficits as other countries wanted to maintain US$
reserves (Triffin Paradox)
 Special Drawing Rights (SDR) – new reserve asset,
(US$, FF, DM, BP, JY)
 Smithsonian Agreement (1971) – US$ devalued to
$38/oz.
 European, Japanese currencies allowed to float–Mar 1973
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Evolution of the International
Monetary System (contd.)
Flexible Exchange Rate Regime (1973–present)
 Jamaica Agreement (1976)
 Flexible exchange rates were declared acceptable to the IMF
members.

Central banks were allowed to intervene in the exchange rate
markets to iron out unwarranted volatilities.
 Gold was abandoned as an international reserve asset.
 Non-oil-exporting countries and less-developed countries
were given greater access to IMF funds.
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Contemporary Currency Regimes
 Free Float

The largest number of countries, about 36, allow market forces to
determine their currency’s value.
 Managed Float

About 50 countries combine government intervention with market
forces to set exchange rates.
 Pegged to (or horizontal band around) another currency

Such as the U.S. dollar or euro
 No national currency

About 40 countries do not bother printing their own, they just use the
U.S. dollar. For example, Ecuador, Panama, and El Salvador have
dollarized.
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Fixed vs. Flexible
Exchange Rate Regimes
 Arguments in favor of flexible exchange rates:


Easier external adjustments.
National policy autonomy.
 Arguments against flexible exchange rates:


Exchange rate uncertainty may hamper international trade.
No safeguards to prevent crises.
 Currencies depreciate (or appreciate) to reflect the
equilibrium value in flexible exchange rates
 Governments must adjust monetary or fiscal policies to return
exchange rates to equilibrium value in fixed exchange rate
regimes
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Fixed versus Flexible
Exchange Rate Regimes
 Suppose the exchange rate is $1.40/£ today.
 In the next slide, we see that demand for British
pounds far exceed supply at this exchange rate.
 The U.S. experiences trade deficits.
 Under a flexible ER regime, the dollar will
simply depreciate to $1.60/£, the price at which
supply equals demand and the trade deficit
disappears.
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Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Demand
(D)
$1.40
Trade deficit
S
D
Q of £
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Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
$1.60
$1.40
Demand
(D)
Dollar depreciates
(flexible regime)
Demand (D*)
D=S
Q of £
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Fixed versus Flexible
Exchange Rate Regimes
 Instead, suppose the exchange rate is “fixed” at $1.40/£,
and thus the imbalance between supply and demand
cannot be eliminated by a price change.
 The US Federal Reserve Bank may initially draw on its
foreign exchange reserve holdings to satisfy the excess
demand for British pounds.
 If the excess demand persists the government would
have to shift the demand curve from D to D*

In this example this corresponds to contractionary monetary
and fiscal policies.
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Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Contractionary
policies
(fixed regime)
Demand
(D)
$1.40
Demand (D*)
D* = S
Q of £
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European Monetary System (EMS)
 EMS was created in 1979 by EEC countries to maintain
exchange rates among their currencies within narrow bands,
and jointly float against outside currencies.
 Objectives:



Establish zone of monetary stability
Coordinate exchange rate policies vis-à-vis non-EMS countries
Develop plan for eventual European monetary union
 Exchange rate management instruments:

European Currency Unit (ECU)

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
Weighted average of participating currencies
Accounting unit of the EMS
Exchange Rate Mechanism (ERM)

Procedures by which countries collectively manage exchange rates
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What Is the Euro (€)?
 The euro is the single currency of the
EMU which was adopted by 11
Member States on 1 January 1999.
 These original member states were:
Belgium, Germany, Spain, France,
Ireland, Italy, Luxemburg, Finland,
Austria, Portugal and the Netherlands.
 Prominent countries initially missing
from Euro :
 Denmark, Greece, Sweden, UK
 Greece: did not meet convergence
criteria, was approved for
inclusion on June 19, 2000
(effective Jan. 2001)
Euro Conversion Rates
1 Euro is Equal to:
40.3399 BEF
Belgian franc
1.95583 DEM
German mark
166.386 ESP
Spanish peseta
6.55957 FRF
French franc
.787564 IEP
Irish punt
1936.27 ITL
Italian lira
40.3399 LUF
Luxembourg
franc
2.20371 NLG
Dutch guilder
13.7603 ATS
Austrian
schilling
200.482 PTE
Portuguese
escudo markka
5.94573 FIM
Finnish
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Benefits and Costs of the
Monetary Union
 Loss of national monetary
 Transaction costs reduced
and exchange rate policy
and FX risk eliminated
independence
 Creates a Eurozone – goods,
people and capital can move  Country-specific asymmetric
shocks can lead to extended
without restriction
recessions
 Compete with the U.S.

Approximately equal in terms
of population and GDP
 Price transparency and
competition
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The Long-Term Impact
of the Euro
 If the euro proves successful, it will advance the
political integration of Europe in a major way,
eventually making a “United States of Europe”
feasible.
 It is likely that the U.S. dollar will lose its place as
the dominant world currency.
 The euro and the U.S. dollar will be the two major
currencies.
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