Download Chapter 36 THE INTERNATIONAL MONETARY SYSTEM: ORDER OR

34
The International
Monetary System: Order
or Disorder?
Cecily, you will read your Political Economy in my
absence. The chapter on the Fall of the Rupee you
may omit. It is somewhat too sensational.
MISS PRISM IN OSCAR WILDE’S THE
IMPORTANCE OF BEING EARNEST
Contents
● What Are Exchange Rates?
● Exchange Rate Determination in a Free
Market
● Fixed Exchange Rates and the Balance of
Payments
● A Bit of History: The Gold Standard and
the Bretton Woods System
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Contents (continued)
● Adjustment Mechanism Under Fixed
Exchange Rates
● Why Try to Fix Exchange Rates?
● The Current “Nonsystem”
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What are Exchange Rates?
● Exchange rate = price, in terms of one
currency, at which another currency can be
bought
● A currency appreciates when it becomes
more expensive in terms of another; the
other currency depreciates.
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34-1 Exchange Rates with
the U.S. Dollar
TABLE
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What are Exchange Rates?
● Appreciation and depreciation refer to
exchange rate changes in free markets.
● In a system of fixed exchange rates, the
corresponding movements are called
revaluation and devaluation.
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Exchange Rate
Determination in Free Market
● The exchange rate of a currency is
determined by its supply and demand.
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34-1 Determination of
Exchange Rates in a Free Market
FIGURE
Price of a Euro
D
S
E
$0.90
S
D
Number of Euros
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Exchange Rate
Determination in Free Market
● Sources of demand:
♦ A country’s exports
♦ Foreign demand for its financial instruments
like stocks and bonds
♦ Capital inflow to acquire physical assets like
factories and machines
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Exchange Rate
Determination in Free Market
● Sources of supply:
♦ A country’s imports
♦ Capital outflows for both financial and physical
assets
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34-2 Stock Market Boom
on the Exchange Rate
FIGURE
D
S1
Price of a Euro
(in dollars)
S2
E
$0.90
A
0.80
D
S1
S2
Number of Euros
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Exchange Rate
Determination in Free Market
● Interest Rates and Exchange Rates: The
Short Run
♦ Massive amounts of liquid capital cross
national boundaries in search of interest rate
differentials.
♦ Thus, a country that increases its interest rates
will experience a capital inflow
■ demand for its bonds
■Appreciation of its currency
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Exchange Rate
Determination in Free Market
● The Medium-Run: Economic Activity and
Exchange Rates
♦ A country’s imports will rise quickly when its
economy booms, but rise only slowly when its
economy stagnates.
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Exchange Rate
Determination in Free Market
● The Medium-Run: Economic Activity and
Exchange Rates
♦ Thus, a country with a relatively high growth
rate will experience:
■ imports
■ demand for foreign currency
■Depreciation of its own currency
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Exchange Rate
Determination in Free Market
● The Purchasing-Power Parity Theory: The
Long Run
♦ Purchasing-power parity = exchange rates
adjust so that the same good costs the same,
whatever currency it is measured in
■Only applies over the long run
■Thus, the exchange rate should reflect differences
in price levels
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Deviations from Big Mac PPP,
December 2001
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34-3 The Effect of a Rise
in U.S. Interest Rates
FIGURE
D1
S1
Price of a Pound
D2
S2
E1
$1.60
E2
1.40
D1
S1
S2
D2
Number of Pounds
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Exchange Rate
Determination in Free Market
● Market Determination of Exchange Rates:
Summary
♦ Exchange rates will appreciate in countries
whose:
■Inflation rates are lower than other countries’
■Economic growth rates are slower
■Interest rates are higher
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Fixed Exchange Rates and
the Balance of Payments
● Countries can maintain fixed exchange rates
by buying or selling reserves.
♦ Compensates for shifts in the demand or supply
of their currencies
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Fixed Exchange Rates and
the Balance of Payments
● With a fixed exchange rate, the balance of
payments will likely be in either surplus or
deficit.
● A deficit cannot be maintained forever since
the country will run out of reserves.
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34-5 A Balance of
Payments Deficit
FIGURE
S
D
Price of a Peso
Balance of
payments deficit
1.00
A
B
E
0.50
D
S
4
8
Billions of Pesos per Year
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34-6 A Speculative Run
on the Peso
FIGURE
S1
D
Price of a Peso
S2
A
$1.00
B
C
S1
D
S2
4
8
12
Billions of Pesos per Year
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34-7 A Balance of
Payments Surplus
FIGURE
S
D
Price of a Mark
E
$0.50
A
B
0.33
Balance of
payments surplus
D
S
40
50
Billions of Marks per Year
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Fixed Exchange Rates and
the Balance of Payments
● Defining the Balance of Payments in
Practice
♦ The current account totes up exports and
imports of goods and services.
■The United States has been running large current
account deficits for years.
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Fixed Exchange Rates and
the Balance of Payments
● Defining the Balance of Payments in
Practice
♦ The capital account includes purchases and
sales of financial assets to and from citizens
and companies of other countries.
■In recent years, this part of our balance of
payments accounts has registered persistently large
surpluses, as foreigners have acquired U.S. assets.
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Fixed Exchange Rates and
the Balance of Payments
● Defining the Balance of Payments in
Practice
♦ In a system of floating exchange rates, the
exchange rates adjust in order to balance the
balance of payments.
♦ In a system of fixed exchange rates, the
balance of payments need not balance.
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The Gold Standard and the
Bretton Woods System
● The Bretton Woods System
♦ Readjustments in exchange rates were
permitted only in cases of “fundamental
disequilibrium.”
♦ Deficit nations were expected to follow
restrictive monetary and fiscal policies
voluntarily just as they would have done
automatically under the gold standard.
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The Gold Standard and the
Bretton Woods System
● The Bretton Woods System
♦ However, just as under the gold standard, this
medicine was often unpalatable.
♦ The Bretton Woods system collapsed in 1971
in the face of the U.S. chronic balance of
payments deficit.
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Adjustment Mechanisms
Under Fixed Exchange Rates
● Under a system of fixed exchange rates, a
country’s government loses some control
over its domestic economy.
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Adjustment Mechanisms
Under Fixed Exchange Rates
● There may be times when balance of
payments considerations force it to contract
its economy even though domestic needs
call for expansion
♦  AD
♦  demand for imports
♦  demand for foreign currency
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Adjustment Mechanisms
Under Fixed Exchange Rates
● Conversely, there may be times when the
domestic economy needs to be reined in, but
balance of payments considerations suggest
expansion.
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34-8 Adjusting to
Balance of Payments Deficits
FIGURE
D
S
D1
A
1.00
C
B
0.50
D2
D1
S
Price of a Peso in Dollars
Price of a Peso in Dollars
D2
S2
S1
A
1.00
C
B
0.50
S2
S1
D
Number of Pesos
Number of Pesos
(a)
(b)
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Why Try to Fix Exchange
Rates?
● Those in favor of fixed rates think that
floating rates are so unpredictable that they
reduce the amount of international trade.
● However, the experience with so-called
“fixed rates” was that they were
unpredictable and unstable.
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Why Try to Fix Exchange
Rates?
● Speculation in foreign exchange markets
smoothes out the highs and lows.
● Speculators can destabilize prices only if
they are systematically willing to lose
money.
● Consequently, floating rates are usually less
variable than feared.
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The Current “Nonsystem”
● Currently, some exchange rates are fixed
and some are floating.
● Few people think that rates can or should be
fixed for a long time.
● Even in the case of floating rates, central
banks often intervene.
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The Current “Nonsystem”
● Today, gold is a purely private commodity.
♦ Has virtually no role in international finance
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The Current “Nonsystem”
● The Role of the IMF
♦ The role of the International Monetary Fund
(IMF) in the current non-system is quite
different from what it was under the old
Bretton Woods system.
■No longer the policeman of fixed exchange rates
■IMF has evolved into a general-purpose
international fire-and-rescue squad
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The Current “Nonsystem”
● The Volatile Dollar
♦ The U.S. dollar depreciated in 1977 and 1978
♦ Appreciated sharply from 1980 through 1985
♦ Depreciated even more sharply from 1985 to
1988
♦ Fluctuated without much trend since then
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34-9 The Ups and Downs
of the Dollar
FIGURE
180
Exchange Rate
160
140
120
100
80
60
0
1974
1978
1982
1986
Years
1990
1994
1998
2001
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The Current “Nonsystem”
● The Birth of the Euro
♦ As part of the long-range goal of the European
Union (EU) to create a unified market like that
of the U.S., the EU perceived a need to
establish a single currency for all member
countries--a monetary union.
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The Current “Nonsystem”
● The Birth of the Euro
♦ Since January 1999, electronic and checking
transactions in eleven of the fifteen EU nations
have been denominated in euro rather than in
national currencies.
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The Current “Nonsystem”
● The Birth of the Euro
♦ Three member nations (the United Kingdom,
Sweden, and Denmark) have decided to opt out
of the common currency project for now.
♦ One country (Greece) has so far been unable to
qualify because its inflation rate and budget
deficit are too high.
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The Current “Nonsystem”
● The Birth of the Euro
♦ In the year 2002, euro coins and paper money
are scheduled to be introduced.
♦ Then French francs, German marks, Italian lira,
and at least eight other national currencies will
be withdrawn from circulation--and will
become relics of the past.
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The Current “Nonsystem”
● The Birth of the Euro
♦ The establishment of the euro marks a giant
step beyond fixed exchange rates.
■Abolishes exchange rates among the participating
nations
■Just as there has long been no exchange rate
between New York and New Jersey, there is now
no exchange rate between Germany and France.
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