Download Chapter 2

International Financial Markets
Prices and Policies
Second Edition ©2001
Richard M. Levich
2

McGraw Hill / Irwin
An Overview of International Monetary
Systems and Recent Developments in
International Financial Markets
2-2
Overview
 International Monetary Arrangements in Theory
and Practice
The International Gold Standard, 1879-1913
 The Spirit of the Bretton Woods Agreement, 1945
 The Fixed-Rate Dollar Standard, 1950-1970
 The Floating-Rate Dollar Standard, 1973-1984
 The Plaza-Louvre Intervention Accords and the
Floating-Rate Dollar Standard, 1985-1999

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 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
2-3
Overview
 International Monetary Arrangements in Theory
and Practice …continued
The Spirit of the European Monetary System, 1979
 The European Monetary System as a “Greater DM”
Area, 1979-1998
 The Spirit of the European Economic and Monetary
Union, 1999

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2-4
Overview
 Recent Behavior of Prices in International
Financial Markets
Exchange Rate Developments
 Interest Rate Developments

 Policy Matters - Private Enterprises
The Conduct of Business under Pegged and
Floating Exchange Rates
 Greater Exchange Rate Variability under Floating
 Costs of Exchange Rate Variability

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2-5
Overview
 Policy Matters - Public Policymakers
Exchange Rate Policies in Emerging Markets
 Beyond Currency Boards to Full Dollarization
 Concerns About EMU

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International Monetary Arrangements
in Theory and Practice
2-6
 The international financial system can promote
the gains from international trade and the
economic integration of regions …
… but it may also be a conduit for the transfer
of macroeconomic shocks from one nation to
another.
 International financial systems based on rules
have evolved to balance these trade-offs.
… and the Rules of the Game are ...
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2-7
The International Gold Standard, 1879-1913
Fix an official gold price or “mint parity” and allow
free convertibility between domestic money and
gold at that price.
 Countries unilaterally elected to follow the
rules of the gold standard system, which lasted
until the outbreak of World War I in 1914,
when European governments ceased to
allow their currencies to be convertible
either into gold or other currencies.
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2-8
The International Gold Standard, 1879-1913
 With stable exchange rates and a common
monetary policy, prices of tradable commodities
were much equalized across countries.
 Real rates of interest also tended toward
equality across a broad range of countries.
 On the other hand, the workings of the internal
economy were subservient to balance in the
external economy.
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2-9
The Spirit of the Bretton Woods Agreement, 1945
Fix an official par value for domestic currency in
terms of gold or a currency tied to gold as a numeraire.
In the short run, keep the exchange rate pegged within
1% of its par value, but in the long-run leave open the
option to adjust the par value unilaterally if the IMF
concurs.
 In essence, the Agreement removed countries
from the tyranny of the gold standard and
permitted greater autonomy for national
monetary policies
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2 - 10
The Spirit of the Bretton Woods Agreement, 1945
D
Price of
Sterling
S
$2.82
a
$2.78
D
S
Quantity of sterling/Time
The Role of International Reserves in
Exchange Rate Determination
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2 - 11
The Spirit of the Bretton Woods Agreement, 1945
The Bank
must supply
cd £ each
period.
D
Price of
Sterling
D”
b
c
$2.82
d
a
D’
D”
S’
$2.78
The Bank of
England uses
its US$
reserves to
buy up fg £
each period.
S
g
f
e
S
D’
S’
j
The Bank
must buy
h
up ij £
each
D
period.
Quantity of sterling/Time
i
The Role of International Reserves in
Exchange Rate Determination
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2 - 12
The Fixed-Rate Dollar Standard, 1950-1970
 In practice, the Bretton Woods system evolved
into a fixed-rate dollar standard.
Industrial countries other than the United States :
Fix an official par value for domestic currency in terms
of the US$, and keep the exchange rate within 1% of
this par value indefinitely.
United States : Remain passive in the foreign exchange
market; practice free trade without a balance of
payments or exchange rate target.
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The Fixed-Rate Dollar Standard, 1950-1970
 Redundancy arises because the policies of N-1
countries are sufficient to determine the policies
of the Nth country in a world with N countries.
 So, the United States had to provide a stable
world price level and a monetary policy that met
the needs of the other N-1 countries.
 In 1971, the U.S. renounced any commitment to
exchange foreign dollar reserves for gold under
the strain of capital outflows and widening trade
deficits.
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2 - 14
The Floating-Rate Dollar Standard, 1973-1984
 Without an agreement on who would set the
common monetary policy and how it would be
set, a floating exchange rate system provided the
only alternative to the Bretton Woods system.
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2 - 15
The Floating-Rate Dollar Standard, 1973-1984
Industrial countries other than the United States :
Smooth short-term variability in the dollar exchange
rate, but do not commit to an official par value or to
long-term exchange rate stability.
United States : Remain passive in the foreign exchange
market; practice free trade without a balance of
payments or exchange rate target. No need for sizable
official foreign exchange reserves.
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2 - 16
The Floating-Rate Dollar Standard, 1973-1984
 Essentially, the foreign exchange rate was left
to play the role of a residual variable that did a
great deal of the adjusting to offset the
macroeconomic policy differences across
countries.
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The Plaza-Louvre Intervention Accords and
the Floating-Rate Dollar Standard, 1985-1999
2 - 17
Germany, Japan, and the United States (G-3) :
Set broad target zones for the $/DM and $/¥ exchange
rates. Do not announce the agreed-upon central rates,
and allow for flexible zonal boundaries. Allow the
implicit central rates to adjust when economic
fundamentals among the G-3 countries change
substantially.
Other industrial countries : Support or do not oppose
interventions by the G-3 to keep the dollar within its
target zone limits.
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The Plaza-Louvre Intervention Accords and
the Floating-Rate Dollar Standard, 1985-1999
2 - 18
 An episode started by an expansive U.S. fiscal
policy introduced in 1981 combined with tight
monetary control convinced policymakers that …
 exchange rates were too important to be left to
market forces

intervention was deemed appropriate
 exchange rates
were too important to be the
residual from uncoordinated economic policies

better policy coordination was required.
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2 - 19
The Spirit of the European Monetary System, 1979
 This is a pursuit by European nations to limit
exchange rate fluctuations against each other
and to establish coordinated macroeconomic
policies across Europe.
 The European Monetary System (EMS) was
built upon three building blocks:
the European Currency Unit (ECU),
 the Exchange Rate Mechanism (ERM), and
 the European Monetary Cooperation Fund (EMCF).

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2 - 20
The Spirit of the European Monetary System, 1979
All member countries :
Fix a par value for each exchange rate in terms of the
European Currency Unit, a basket weighted according
to country size.
Keep exchange rates stable in the short-run by
limiting movements in bilateral rates - the Exchange
Rate Mechanism.
Hold foreign exchange reserves primarily in ECUs
with the European Monetary Cooperation Fund, and
reduce US$ reserves.
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2 - 21
The Spirit of the European Monetary System, 1979
 The three building blocks of the EMS linked
together European exchange rates and monetary
policies until the chaotic events of 1992 and
1993.
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The European Monetary System as a
“Greater DM” Area, 1979-1998
2 - 22
 In practice, the DM was the centerpiece of the
ERM, and German monetary policy formed the
anchor for the EMS price level.
Member countries except Germany :
Intervene to stabilize currency values vis-à-vis the DM.
Germany : Remain passive in the foreign exchange
market with respect to other EMS countries.
Set German monetary policy independently to serve as
an anchor for the EMS price level.
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The European Monetary System as a
“Greater DM” Area, 1979-1998
2 - 23
 Some European leaders wanted to achieve an
even closer economic and social union.

In 1989, a plan for a European Economic and
Monetary Union (EMU) was presented .
 Under the EMU, a single central bank would set
monetary policy for a single European money.

The 1991 Maastricht Treaty spelled out the steps
needed to transfer the responsibilities for monetary
policy and national monies to a new EC institution.
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The European Monetary System as a
“Greater DM” Area, 1979-1998
2 - 24
 Doubts and debate about the economic
feasibility and advisability of EMU persisted
throughout the 1990s.
 In 1992, currency speculators sensed that the
treaty was in trouble and made attacks on
various European currencies. The tensions
persisted throughout 1993.
 In November 1992, the Maastricht Treaty was
adopted and the European Union (EU) was born.
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The Spirit of the European Economic and
Monetary Union, 1999
2 - 25
 The EMU was launched on January 1, 1999
with 11 member countries.
The European Central Bank (ECB) has sole
responsibility for monetary policy among EMU
countries.
National governments set other economic policies
such as taxation and expenditures within a set of
commonly agreed rules.
Old “legacy currencies” are exchanged for the
new surviving currency, the euro.
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The Spirit of the European Economic and
Monetary Union, 1999
2 - 26
 The large initial EMU was made possible by a
relaxed interpretation of the Maastricht criteria
and a dose of creative accounting.
 The selection of the ECB President was also
marred by disagreement and perhaps,
compromise of the Maastricht principles.
 In terms of operation, the transition to the euro
went smoothly. The last step is the replacement
of physical notes and coins, which is scheduled
to be completed by July 1, 2002.
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2 - 27
The Value of the Euro in Terms of
the Eleven Legacy Currencies of the EMU Countries
Irrevocable Conversion Rates Set on January 1, 1999
Country
Austria
Belgium
Finland
France
Germany
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
McGraw Hill / Irwin
Units Equal to One Euro ( € )
13.7603 schillings
40.3399 francs
5.94573 markkaab
6.55957 francs
1.95583 marks
0.787564 punt
1,936.27 lire
40.3399 francs
2.20371 guilders
200.482 escudos
166.386 pesetas
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Recent Behavior of Prices in
International Financial Markets
2 - 28
 Exchange Rate Developments
Nominal exchange rates against the US$, 1970-1999
 Nominal exchange rates in the ERM: the FFr/DM and
Guilder/DM rates.
 Nominal exchange rates for Asian currencies against
the US$, 1990-1999
 Volatility in spot exchange rates
 Real effective exchange rates for developed countries
 Real effective exchange rates for Asian currencies,
1990-1999

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Recent Behavior of Prices in
International Financial Markets
2 - 29
 Interest Rate Developments
Short-term nominal interest rate levels
 Nominal interest rate differentials
 Real interest rates

 Recent developments
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2 - 30
Policy Matters - Private Enterprises
 The government’s choice of monetary system
affects the decisions that firms face.
 There is greater exchange rate variability under
floating.
 Nominal exchange rate variability
raises the importance of the choice of currency of
denomination for cash flows and financial assets
 increases the demand for financial instruments that
can be used to hedge or offset currency risks.

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2 - 31
Policy Matters - Private Enterprises
 Real exchange rate variability
affects the competitiveness of an individual firm, as
well as the “financial health” of suppliers and
customers
 and thus affects the operating decisions of the firm.

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2 - 32
Policy Matters - Public Policymakers
 Some emerging markets adopt currency boards
as their exchange rate system.
A currency board fixes its exchange rate by making
a commitment to exchange domestic currency for
foreign currency at a pre-specified rate.
 A currency board gains credibility by its
commitment to forgo the devaluation option.

 Examples of countries with currency boards
include Argentina, Estonia, Hong Kong, and
Lithuania.
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2 - 33
Policy Matters - Public Policymakers
 A country with a currency board “pays” for its
option to abandon the board and devalue, by
being forced to pay higher interest on loans in
domestic currency.
 The high cost of the board to Argentina after
the 1995 Mexican peso crisis and the 1998
Russian ruble crisis prompted its president to
propose “dollarizing” its economy.

The major cost of dollarization would be the lost of
seigniorage from the printing of domestic pesos.
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2 - 34
Policy Matters - Public Policymakers
 At most, a country can only sustain two of the
following three policies:
pegged exchange rates
 free capital mobility
 scope for monetary policy independence

 Keeping exchange rates pegged and stable is
not a technological problem.

However, the technology can be too constraining on
the local monetary authorities, as in the Asian
currency and Russian ruble crises.
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2 - 35
Policy Matters - Public Policymakers
 Many were skeptical about EMU.

The European Union is not an ideal candidate for a
currency union because within the union, labor is
immobile, business cycles are weakly correlated,
and fiscal transfers are limited.
 Others focused on the advantages and dynamic
gains likely under EMU:

lower transaction costs and exchange rate risk, and
greater capital mobility and depth of financial
markets across Europe
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2 - 36
Policy Matters - Public Policymakers
Some Specific Concerns about the EMU
 The lack of national exchange rate policy under
EMU can be a source of tension if national
growth rates are not sufficiently correlated.

Ireland found it helpful to make a small adjustment
to the Irish punt’s central rate in 1998.
 The
euro can challenge the dominant role
played by the U.S. dollar over the last 50 years.

Liquidity in the US$ market may be affected.
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2 - 37
Policy Matters - Public Policymakers
 The
euro changes some basic aspects of
international financial management.

To obtain diversification benefits, the investor must
turn to other markets.
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 2001 by The McGraw-Hill Companies, Inc. All rights reserved.