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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