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Chapter 19: International Monetary Regimes
1. The Trilemma or Impossible Trinity
any one time
The Trilemma
Discretionary
Monetary
Policy
Fixed
Exchange
Rate
International
Capital
Mobility
Only two may be achieved at
1. The Trilemma or Impossible Trinity
To achieve:
Fixed exchange rate
Trade-off:
• Discretionary monetary policy to create
elasticity of supply of currency
or
• International capital mobility to create
inelasticity of demand for currency
1. The Trilemma or Impossible Trinity
To achieve:
Discretionary monetary policy
Trade-off:
• Fixed exchange rate to allow for
inelasticity of supply of currency
or
• International capital mobility to create
inelasticity of demand for currency
1. The Trilemma or Impossible Trinity
To achieve:
International capital mobility
Trade-off:
• Fixed exchange rate to allow for
equilibrium price (floating exchange rate)
or
• Discretionary monetary policy to create
elasticity of supply for currency
1. The Trilemma or Impossible Trinity
International monetary regimes
Specie standard
• Fixed rate
• International
capital mobility
Managed fixed
exchange rate
• Fixed rate
• Discretionary
monetary policy
Free float
Managed float
• Discretionary
monetary policy
• International
capital mobility
• International
capital mobility
• Switch between
monetary policy
discretion and
fixed exchange
rate
2. Two Systems of Fixed Exchange Rates
Gold standard
• Domestic units of account were in terms of gold—
by weight and purity
• Allowed gold and bills of exchange to flow between
nations unfettered
U.S. 1 oz. gold = $20.00; Great Britain 1 oz. gold = £4
Exchange rates were dictated by the supply and
demand conditions in the sterling bills market
2. Two Systems of Fixed Exchange Rates
Gold standard system:
• Self-equilibrating
• Functioned without government intervention
• Had exchange rate stability
2. Two Systems of Fixed Exchange Rates
Bretton Woods System
• Adopted by the first world countries in the final
stages of World War II
• Designed to overcome the flaws of the GS while
maintaining the stability of fixed exchange rates
2. Two Systems of Fixed Exchange Rates
Bretton Woods System
• USD substituted gold as the free world's currency
• Ensured a more elastic supply of international reserves
• Allowed the U. S. to earn seigniorage to help offset the
costs it incurred from fighting wars
• U.S. was rendered the banker to more than half of the
world’s economy
2. Two Systems of Fixed Exchange Rates
Bretton Woods
Agreement, July 1944
730 delegates from all
44 Allied nations
gathered at the Mount
Washington Hotel in
Bretton Woods, NH
(USA) for the United
Nations Monetary and
Financial Conference
Established the International Bank for
Reconstruction and Development
(now the World Bank)
“…the absence of a high degree of
economic collaboration among the
leading nations will…inevitably result
in economic warfare that will be but
the prelude and instigator of military
warfare on an even vaster scale.”
-- Harry Dexter White, US
Department of the Treasury
2. Two Systems of Fixed Exchange Rates
Bretton Woods
Agreement, July 1944
730 delegates from all
44 Allied nations
gathered at the Mount
Washington Hotel in
Bretton Woods, NH
(USA) for the United
Nations Monetary and
Financial Conference
Established
the International Monetary Fund
“The nations should consult and
agree on international monetary
changes which affect each other.
They should outlaw practices which
are agreed to be harmful to world
prosperity, and they should assist
each other to overcome short-term
exchange difficulties.”
July 22, 1944
2. Two Systems of Fixed Exchange Rates
Bretton Woods
Agreement, July 1944
730 delegates from all
44 Allied nations
gathered at the Mount
Washington Hotel in
Bretton Woods, NH
(USA) for the United
Nations Monetary and
Financial Conference
Adopted the General Agreement on
Tariffs and Trade (GATT)
to regulate international trade.
Proposed establishment of
The International Trade Organization
to regulate GATT.
The ITO Charter was agreed to by the
U.N. in March 1948, but never
ratified by the U.S. Senate.
In 1995, the World Trade Organization
(WTO) was established.
3. The Managed or Dirty Float
To achieve:
• Discretionary monetary policy and
• International capital mobility
Trade-off:
• Fixed exchange rate
Use managed float: the central bank allows
market forces to determine second-to-second
(day-to-day) fluctuations in exchange rates but
intervenes if the currency grows too weak or
too strong.
3. The Managed or Dirty Float
Central bank intervention:
• Unsterilized foreign exchange intervention
Exchange:
• International reserves
• Assets denominated in foreign currencies
• Gold, and
• SDRs (Special Drawing Rights)for domestic
currency
3. The Managed or Dirty Float
Central bank intervention:
• Unsterilized foreign exchange intervention
Influence the FX rate via changes in MB:
• Selling international reserves for domestic
currency to appreciate the domestic currency.
• Shift the demand for domestic currency in FX
markets
3. The Managed or Dirty Float
Central bank intervention:
• Sterilized foreign exchange intervention
• No net change in MB, no long-term impact on
exchange rate
Uses:
• Short-term ruse
• Signal to market
3. The Managed or Dirty Float
Central bank intervention: Disadvantages
• Run out of international reserves in a fruitless
attempt to
– prevent depreciation or
– create appreciation
• Require increasing or decreasing the MB
counter to the needs of the domestic economy.
4. The Choice of International Policy Regime
Fixed rate or managed float: Costs
Run out of international reserves:
• Unable to use unsterilized foreign exchange
intervention
IMF lends, but:
 Not lender of last resort
 Requires fiscal austerity
 Creates moral hazard
4. The Choice of International Policy Regime
Fixed rate or managed float: Benefits
= monetary policy target similar to an inflation or money
supply target:
• Allows the developing nation’s central bank to figure
out whether to increase or decrease MB and by how
much
• Effectively ties the domestic inflation rate to that of the
anchor country
• Instills confidence in the developing country’s
macroeconomic performance
4. The Choice of International Policy Regime
Fixed rate or managed float: Benefits
Dollarization
= adopting an anchor currency
= (- seigniorage revenue) + outsource monetary policy
Hard peg
= pegged to an anchor currency
= outsource monetary policy
4. The Choice of International Policy Regime
Fixed rate or managed float: Benefits
 Dollarization
 Hard peg
Difficult to maintain because:
• Can create persistent imbalances between the
developing and the anchor currencies due to changes in
– Interest rates
– Trade
– Productivity