Download Chapter 3 The International Monetary System

Chapter 3 The International Monetary System
A. Exchange Rate Systems
B. International Monetary System
C. European Monetary System and Monetary Union
D. Emerging Market Currency Crises
3.A Exchange Rate Systems

Free (“clean”) float
– Exchange rates are determined by currency supply and demand with no
government intervention.
– As economic parameters change, market participants adjust their
current and expected future currency needs.
– Shifts in currency needs in turn shift currency supply and demand
schedules, as seen in Chapter 2.

Managed (“dirty”) float
– Central banks intervene to reduce economic volatility.
– Three categories of intervention
1. Smoothing out daily fluctuations – central bank buys or sells currency to
smooth exchange rate adjustments.
2. Leaning against the wind – measures taken to moderate or prevent short- or
medium-term exchange rate fluctuations caused by random events.
3. Unofficial pegging – a country pegs the value of its currency to a foreign
currency to protect the value of its exports.
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3.A Exchange Rate Systems



Target zone arrangement
–
Countries agree to adopt economic policies that maintain their exchange
rates within a specific range.
–
Designed to minimize exchange rate volatility and enhance economic
stability in participating countries.
–
Requires coordination of economic policy objectives and practices.
Fixed-rate system
–
Governments maintain target exchange rates.
–
Central banks buy/sell currency to increase (“revalue”)/decrease
(“devalue”) exchange rates when exchange rates threaten to deviate
from their stated par values by more than an agreed-on percentage.
–
Monetary policy becomes subordinate to exchange rate policy.
Hybrid system – current international system consisting of free-float,
managed-float, and pegged currencies.
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3.B International Monetary System (1)

Gold Standard – participating countries fixed the prices of their
currencies in terms of a specified amount of gold.

Because the value of gold is fairly stable over time, the gold
standard ensured long-run price stability for both individual
countries and groups of countries, aka Self-balancing feature in
Econ303

Classical Gold Standard (1821-1914)
–
Characterized by price-specie-flow mechanism
•
Changes in the price level in one country were offset by an
automatic balance of payments (“BOP”) adjustment.
–
As U.S. exchange rate falls, exports rise, causing BOP surplus and
inflow of foreign gold.
–
U.S. prices rise, foreign prices fall
–
U.S. exports fall, foreign exports rise
–
BOP equilibrium achieved
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3.B International Monetary System (3)


Gold Exchange Standard (1925-1931)
–
The U.S. and England could hold only gold reserves
–
Other nations could hold both gold and dollars/pounds as reserves.
–
In 1931, England departed from gold given massive gold and capital
flows stemming from an unrealistic exchange rate, ending the Gold
Exchange Standard.
1931-1944
–
Beggar thy neighbor devaluations – countries devalued their currencies
to maintain trade competitiveness, leading to a trade war.
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3.B International Monetary System (4)

Bretton Woods System (1946-1971)
– Bretton Woods Conference, 1944
• New postwar monetary system
–
Allied nations pledged to maintain a fixed (pegged) exchange rate in
terms of the dollar or gold.
–
1 ounce of gold = $35
–
Exchange rates could fluctuate only within 1% of their stated par
values.
–
Fixed rates were maintained by central bank intervention in foreign
exchange markets.
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3.B International Monetary System (5)

Bretton Woods System (1946-1971), continued
–
Bretton Woods Conference, 1944, continued
•
Two new institutions created
–
International Monetary Fund (IMF) – created to promote monetary
stability
• Role has evolved over time
• Oversees exchange rate policies in 182 member countries
• Advises developing countries on economic policy
• Lender of last resort
• Moral hazard – expectation of IMF bailouts leads investors to
underestimate risks of lending to governments that pursue
irresponsible policies
–
International Bank for Reconstruction and Development (World Bank)
– created to lend money to countries to rebuild their war-damaged
infrastructures
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3.B International Monetary System (6)

Bretton Woods System (1946-1971), continued
– Collapse of Bretton Woods system
• Inflation in the U.S. stemming from the Johnson Administration printing
money instead of raising taxes to finance Viet Nam conflict.
• West Germany, Japan, and Switzerland would not accept the inflation that
a fixed exchange rate with the dollar would have imposed on them.
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3.B International Monetary System (7)

Post-Bretton Woods System (1971-Present)
– Smithsonian Agreement
• Dollar was devalued to 1/38 of an ounce of gold.
• Other currencies revalued by agreed-on amounts in terms of the dollar.
– Attempts to set new fixed rates unsuccessful.
– International floating exchange rate system instituted in 1973.
• System supposed to reduce economic volatility and facilitate free trade.
– Floating rates would offset international differences in inflation.
– Real exchange rates would stabilize given gradual changes in
underlying conditions affecting trade and productivity of capital.
– Nominal exchange rates would stabilize if countries coordinated their
monetary policies to achieve inflation rate convergence.
• However, currency volatility has increased due to non-monetary global
economic shocks (e.g., changing oil prices).
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3.C European Monetary System (1)

European Monetary System (EMS)
–
Began operating in March 1979.
–
Purpose: Foster monetary stability in the European Community (EC)
–
Members established the European Currency Unit (ECU), a composite
currency consisting of fixed amounts of the 12 EC member currencies.
–
The quantity of each currency reflected each country’s relative
economic strength within the ECU.
–
In 1992, the EC became the European Union (EU).
–
The EU currently has 27 member states.
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3.C European Monetary System (3)

European Monetary Union (EMU, or EU)
– Maastricht Treaty
• Formalized the EC’s moved toward a monetary union
• EC nations would establish the European Central Bank with sole power to
issue a single currency (euro).
– On January 1, 1999, the euro became a currency and conversion rates
for the euro were locked in for member countries.
– On January 1, 2002, member countries’ currencies were replaced by
euro bills and coins.
– To join the EU, countries were subjected to the Maastricht criteria
• Government debt ≤ 60% of GDP
• Budget deficit ≤ 3% of GDP
• Inflation ≤ 1.5 percentage points above the average rate of Europe’s three
lowest-inflation countries
• Long-term interest rates ≤ 2 percentage points above the average interest
rate in the three lowest-inflation countries
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3.C European Monetary System (4)

European Monetary Union (EMU, or EU), continued
–
Consequences of EU
•
Lower cross-border currency conversion costs
•
Eliminated risk of currency fluctuations
•
Facilitated cross-border price comparisons
•
Encouraged flow of trade and investments among member countries
•
Greater integration of Europe’s capital, labor, and commodity markets
•
Increased Europe’s competitiveness
•
Greater coordination of monetary policy
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3.D Emerging Market Currency Crises (1)


Currency crises spread from one country to another by two means.
–
Trade links – e.g., when Argentina is in crisis, it imports less from
Brazil, causing Brazil’s economy to contract and its currency to
weaken. Brazil’s contraction will in turn affect other trade partners.
–
The financial system – distress in one emerging market causes
investors to exit other countries with similar risk profiles.
Common denominator in promoting currency crises: Countries
issue too much short-term debt closely linked to the dollar. When
the dollar depreciates, the cost of repaying dollar-linked bonds
soars.
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3.D Emerging Market Currency Crises (2)

Circumventing emerging market crises
– Currency controls
• Abandoning free capital movement to insulate a country’s currency
from speculative attacks, e.g. China
• However:
– Open capital markets channel savings to where they are most
productive;
– Developing nations need foreign capital and know-how; and
– Currency controls have led to corruption.
– Freely floating currency – floating rates absorb the pressures created
in emerging countries that simultaneously peg their exchange rates
and pursue independent monetary policy.
– Permanently fix the exchange rate – through dollarization, use of a
currency board, or a monetary union, an economy can permanently fix
its exchange rate, e.g. Hong Kong
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