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International Monetary System
Chapter Two
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Two Outline
 Evolution of the International Monetary
System
 Current Exchange Rate Arrangements
 European Monetary System
 Euro and the European Monetary Union
 The Mexican Peso Crisis
 The Asian Currency Crisis
 The Argentine Peso Crisis
 Fixed versus Flexible Exchange Rate
Regimes
2-2
Evolution of the
International Monetary System





Bimetallism: Before 1875
Classical Gold Standard: 1875-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime: 1973Present
2-3
Bimetallism: Before 1875
 Bimetallism was a “double standard” in
the sense that both gold and silver were
used as money.
 Some countries were on the gold
standard, some on the silver standard,
and some on both.
 Both gold and silver were used as an
international means of payment, and the
exchange rates among currencies were
determined by either their gold or silver
contents.
2-4
Gresham’s Law
 Gresham’s Law implies that the least valuable
metal is the one that tends to circulate.
“Bad(abundant) money drives our good
(scarce) money”
2-5
Classical Gold Standard: 1875-1914
 During this period in most major
countries:
– Gold alone was assured of unrestricted
coinage.
– There was two-way convertibility between
gold and national currencies at a stable ratio.
– Gold could be freely exported or imported.
 The exchange rate between two country’s
currencies would be determined by their
relative gold contents.
2-6
Classical Gold Standard: 1875-1914
For example, if the dollar is pegged to
gold at U.S. $30 = 1 ounce of gold, and the
British pound is pegged to gold at £6 = 1
ounce of gold, it must be the case that the
exchange rate is determined by the
relative gold contents:
$30 = 1 ounce of gold = £6
$30 = £6
$5 = £1
2-7
Classical Gold Standard: 1875-1914
 Highly stable exchange rates under the
classical gold standard provided an
environment that was conducive to
international trade and investment.
 Misalignment of exchange rates and
international imbalances of payment were
automatically corrected by the price-specieflow mechanism.
2-8
Price-Specie-Flow Mechanism
 Suppose Great Britain exports more to France than
France imports from Great Britain.
 This cannot persist under a gold standard.
– Net export of goods from Great Britain to France will
be accompanied by a net flow of gold from France to
Great Britain.
– This flow of gold will lead to a lower price level in
France and, at the same time, a higher price level in
Britain.
 The resultant change in relative price levels will
slow exports from Great Britain and encourage
exports from France.
2-9
Classical Gold Standard:
1875-1914
 There are shortcomings:
– The supply of newly minted gold is so
restricted that the growth of world trade and
investment can be hampered for the lack of
sufficient monetary reserves.
– Even if the world returned to a gold
standard, any national government could
abandon the standard.
2-10
2-10
Interwar Period: 1915-1944
 Exchange rates fluctuated as countries widely
used “predatory” depreciations of their
currencies as a means of gaining advantage in
the world export market.
 Attempts were made to restore the gold
standard, but participants lacked the political
will to “follow the rules of the game.”
 The result for international trade and
investment was profoundly detrimental.
2-11
Interwar Period: 1915-1944
 The interwar period was characterized by
economic nationalism, failure to restore the gold
standard, economic and political instabilities,
bank failures and panicky flights of capital
across borders.
 During this period, US dollar emerged as the
dominant world currency, gradually replacing
the British pound for the role.
2-12
Bretton Woods System: 1945-1972
 Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
 The purpose was to design a postwar
international monetary system.
 The goal was exchange rate stability
without the gold standard.
 The result was the creation of the IMF and
the World Bank.
2-13
Bretton Woods System: 1945-1972
British
pound
German
mark
French
franc
Par
Value
• The U.S. dollar was
pegged to gold at
$35 /ounce and other
currencies were pegged
to the U.S. dollar.
U.S. dollar
Pegged at $35/oz.
Gold
2-14
The Flexible Exchange Rate Regime:
1973-Present
 Flexible exchange rates were declared
acceptable to the IMF members.
– Central banks were allowed to intervene in
the exchange rate markets to iron out
unwarranted volatilities.
 Gold was abandoned as an international reserve
asset.
 Non-oil-exporting countries and less-developed
countries were given greater access to IMF
funds.
2-15
The Value of the U.S. Dollar since 1960
2-16
European Monetary System
 European countries maintain exchange rates among
their currencies within narrow bands, and jointly
float against outside currencies.
 European Monetary System (EMS) was launched in
1979.
 Objectives:
– To establish a zone of monetary stability in Europe.
– To coordinate exchange rate policies vis-à-vis nonEuropean currencies.
– To pave the way for the European Monetary Union.
2-17
2-17
European Monetary System
 There are two main instruments of the EMS are;
– European Currency Unit
– Exchange Rate Mechanism
 European Currency Unit (ECU) is a basket currency
constructed as a weighted average of the currencies
of member countries of the European Union.
 ECU serves as the accounting unit of the EMS and
plays an important role in the workings of the
exchange rate mechanism.
2-18
European Monetary System
 Exchange Rate Mechanism (ERM) refers to
the procedure by which EMS member
countries collectively manage their
exchange rates.
 ERM is the operational part of the EMS.
 Currencies within the ERM are expected
to remain within given limits of their
bilateral central rates compared to other
currencies in the ECU.
2-19
European Monetary System
 The band which the currency was allowed
to deviate from the parity with the other
currencies was widened.
 A turbulence existed in the EMS.
 EU countries signed Maastricht Treaty in
1991.
 The treaty requires that the EMS will
irrevocably fix exchange rates among the
countries and introduce a common
European currency, replacing individual
currencies.
2-20
European Monetary System
Maastricht Treaty;
 Keep government budget deficit/GDP
below 3 %
 Keep gross public debts below 60 % of
GDP
 Achieve a high degree of price stability
 Maintain its currency within the
prescribed exchange rate changes of the
ERM
2-21
What Is the Euro?
 With the launching the euro, the European
Monetary Union (EMU) was created in
1999.
 The EMU is an extension of EMS and
European Currency Unit was the
precursor of the euro.
2-22
What Is the Euro?
 The euro is the single currency of the
European Monetary Union which was
adopted by 11 Member States on 1
January 1999.
 These original member states were:
Belgium, Germany, Spain, France,
Ireland, Italy, Luxemburg, Finland,
Austria, Portugal and the Netherlands.
 4 members countries of EU(Denmark,
Greece, Sweden and UK) did not join the
first wave.
2-23
2-23
What Is the Euro?





Greece joined the euro club in 2001,
Slovenia adopted the euro in 2007,
Cyprus & Malta did so in 2008,
Slovakia in 2009
Estonia in 2011
2-24
The Long-Term Impact of the Euro
 As the euro proves successful, it will
advance the political integration of Europe
in a major way, eventually making a
“United States of Europe” feasible.
 It is possible that the U.S. dollar will lose
its place as the dominant world currency.
 The euro and the U.S. dollar will be the
two major currencies.
2-25
The benefits of Monetary Union
 Reduce transaction costs and the
elimination of exchange rate uncertainty.
 Enhance efficiency and competitiveness of
the European economy.
 Creates conditions conducive to the
development of the continental capital
markets with depth and liquidity.
 Promote political cooperation and peace
in Europe.
2-26
Costs of Monetary Union
 The main cost of monetary union is the
loss of national monetary and exchange
rate policy independence.
– The more trade-dependent and less
diversified a country’s economy is the more
prone to asymmetric shocks that country’s
economy would be.
2-27
2-27
Costs of Monetary Union
 As an example, if the economy of
Oklahoma was dependent on gas and oil,
and oil prices fall on the world market,
then Oklahoma might be better off if it
had its own currency rather than relying
on the U.S. dollar.
 This example shows that perhaps the
benefits of monetary union typically
outweigh the costs.
2-28
2-28
Macroeconomic Data for Major Economies
2-29
The Mexican Peso Crisis
 On December 20, 1994, the Mexican
government announced a plan to devalue
the peso against the dollar by 14 percent.
 This decision changed currency trader’s
expectations about the future value of the
peso, and they stampeded for the exits.
 In their rush to get out the peso fell by as
much as 40 percent.
2-30
The Mexican Peso Crisis
 The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of
portfolio capital.
 Two lessons emerge:
– It is essential to have a multinational safety
net in place to safeguard the world financial
system from such crises.
Disclosure requirements, transparency
– An influx of foreign capital can lead to an
overvaluation in the first place.
2-31
The Asian Currency Crisis
 The Asian currency crisis turned out to be
far more serious than the Mexican peso
crisis in terms of the extent of the
contagion and the severity of the resultant
economic and social costs.
 Many firms with foreign currency debts
were driven to extreme financial distress.
 The region experienced a deep,
widespread recession.
2-32
The Asian Currency Crisis
2-33
The Asian Currency Crisis
2-34
Origins of the Asian Currency
Crisis
 Several factors are responsible for the
onset of the Asian Currency Crisis:
- A weak domestic financial system
- Free international capital flows
- Contagion effects of changing market
sentiment
- Inconsistent economic policies
2-35
Lessons from the Asian Currency Crisis
 Countries first strengthen their domestic
financial system and then liberalize their
financial markets.
 The government should strengthen its
system of financial-sector regulation and
supervision.
 Banks should base their lending decisions
on economic merits rather than political
considerations.
 The reliable financial data should be
provided to the public in a timey fashion. 2-36
Lessons from the Asian Currency Crisis
 A country should encourage foreign direct
investments and equity and long-term
bond investment; should not encourage
short term investments.
 Countries should not restore the same
fixed exchange rate system unless they are
willing to impose capital controls.
 Economists are talking about the “socalled trilemma” and “incompatible
trinity”
2-37
The Argentinean Peso Crisis
 In 1991 the Argentine government passed
a convertibility law that linked the peso to
the U.S. dollar at parity.
 The initial economic effects were positive:
– Argentina’s chronic inflation was curtailed.
– Foreign investment poured in.
 As the U.S. dollar appreciated on the
world market the Argentine peso became
stronger as well.
2-38
The Argentinean Peso Crisis
 However, the strong peso hurt exports
from Argentina and caused a protracted
economic downturn that led to the
abandonment of peso–dollar parity in
January 2002.
– The unemployment rate rose above 20
percent.
– The inflation rate reached a monthly rate of 20
percent.
2-39
The Argentinean Peso Crisis
2-40
2-40
The Argentinean Peso Crisis
 There are at least three factors that are
related to the collapse of the currency
board arrangement and the ensuing
economic crisis:
– Lack of fiscal discipline
– Labor market inflexibility
– Contagion from the financial crises in Brazil
and Russia
2-41
2-41
Fixed versus Flexible
Exchange Rate Regimes
 Arguments in favor of flexible exchange
rates:
– Easier external adjustments.
– National policy autonomy.
 Arguments against flexible exchange
rates:
– Exchange rate uncertainty may hamper
international trade.
– No safeguards to prevent crises.
2-42
2-42
Fixed versus Flexible
Exchange Rate Regimes
Advantages
Disadvantages
FIXED RATE SYSTEM
FLOATING RATE SYSTEM
Strict control over money supply and
inflation
 No foreign exchange risk and uncertainty
 No speculative attacks on national
currency


No independence on monetary policy
(Inflation and interest rate pressures on
exc.rate)

Might lead to sharp devaluations and
financial crises
Eg: Turkey, Argentina,Asia


Independence on monetary
policy
Trade balance adjustments
from currency appreciation /
depreciation

More volatility and
uncertainty on exc.rates might
hamper international trade and
investment.

Possibility of speculative
attacks
2-43
Fixed versus Flexible
Exchange Rate Regimes
 Suppose the exchange rate is $1.40/€
today.
 In the next slide, we see that demand for
euro far exceeds supply at this exchange
rate.
 The U.S. experiences trade deficits.
2-44
2-44
Dollar price per €
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Demand
(D)
$1.40
Trade deficit
QS
2-45
QD
Q of €
2-45
Flexible
Exchange Rate Regimes
 Under a flexible exchange rate regime, the
dollar will simply depreciate to $1.60/€,
the price at which supply equals demand
and the trade deficit disappears.
2-46
2-46
Dollar price per €
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
$1.60
$1.40
Demand
(D)
Dollar depreciates
(flexible regime)
Demand (D*)
QD = QS
2-47
Q of €
2-47
Fixed versus Flexible
Exchange Rate Regimes
 Instead, suppose the exchange rate is
“fixed” at $1.40/€, and thus the imbalance
between supply and demand cannot be
eliminated by a price change.
 The government would have to shift the
demand curve from D to D*
– In this example this corresponds to
contractionary monetary and fiscal policies.
2-48
2-48
Dollar price per €
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Contractionary
policies
(fixed regime)
Demand
(D)
$1.40
Demand (D*)
QD* = QS
2-49
Q of €
2-49