Download Industrial countries other than the United States

International Finance
FINA 5331
Lecture 2: Historical and current
monetary arrangements:
Please Read Chapter 2
Aaron Smallwood Ph.D.
Exchange Rate Markets: Brief Introduction
• A spot contract is a binding commitment for an
exchange of funds, with normal settlement and
delivery of bank balances following in two
business days (one day in the case of North
American currencies).
• A forward contract, or outright forward, is an
agreement made today for an obligatory
exchange of funds at some specified time in the
future (typically 1,2,3,6,12 months).
Foreign Exchange Market
Example
• On November 16, 2011: The yuan price of the dollar
(known as a “direct quotation” from China’s perspective)
was: RMB 6.34
– 6.34 units of Chinese currency were needed to buy one
dollar
• At the same time, the dollar price of the RMB was
(known as an indirect quotation from China’s
perspective):
– 1/6.34 = $0.1576 (roughly 16 cents needed to buy one
yuan).
More recently
• The RMB price of the dollar has been falling (a decline in
the direct quotation is known as an appreciation).
Through 2011, the yuan appreciated by 4.7% against the
dollar.
– Policy intended to keep inflation in check and
potentially increase standards of living.
• According to the Wall Street Journal, on January 5, “The
PBOC on Thursday set the dollar-yuan central parity at
RMB 6.3115, significantly above Wednesday's 6.3001,
which was an all-time low.”
Cross currency exchange rate
• On Thursday, the yen price of the dollar
fell to 76.73.
• The RMB price of the yen:
– S(RMB/$)/S(Yen/$) = 6.3115/76.73 =
RMB 0.08226.
International Monetary Arrangements
• International Monetary Arrangements
in Theory and Practice
– The International Gold Standard, 1879-1913
– Bretton Woods Agreement, 1945-1971
– Smithsonian Agreement, 1971-1973
– The Floating-Rate Dollar Standard, 19731984
– The Plaza-Louvre Intervention Accords and
the Floating-Rate Dollar Standard, 1985-1999
Additionally
• What exchange rate systems exist today?
– The choice between a fixed system and a flexible
system.
• How does another country’s exchange rate
system affect you? How does China’s changing
exchange rate system affect you?
• What are currency crises and how can they
impact your business?
• What is the euro? Will the euro-zone expand?
How does expansion of the euro-zone affect
you?
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.
The International Gold Standard, 1879-1913
For example, during the gold standard,
the dollar is pegged to gold at :
U.S.$20.67 = 1 ounce of gold
The British pound is pegged at :
£4.2474 = 1 ounce of gold.
The exchange rate is determined by the
relative gold contents: $20.67 = £4.2474
$4.866 = £1
The International Gold Standard, 1879-1913
• 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 pricespecie-flow mechanism.
Price-Specie-Flow Mechanism
• Suppose Great Britain exported more to
France than France imported 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.
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.
The International Gold Standard, 1879-1913
• 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.
The Relationship Between Money and Growth
• Money is needed to facilitate economic transactions.
• MV=PY →The equation of exchange.
• Assuming velocity (V) is relatively stable, the
quantity of money (M) determines the level of
spending (PY) in the economy.
• If sufficient money is not available, say because gold
supplies are fixed, it may restrain the level of
economic transactions.
• If income (Y) grows but money (M) is constant, either
velocity (V) must increase or prices (P) must fall. If
the latter occurs it creates a deflationary trap.
• Deflationary episodes were common in the U.S.
during the Gold Standard.
Interwar Period: 1918-1941
• 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.
• Smoot-Hawley tariffs
• Great Depression
Economic Performance and Degree of Exchange Rate
Depreciation During the Great Depression
Bretton Woods System: 1945-1971
• 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.
Bretton Woods System: 1945-1971
• Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.
• Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par value
by buying or selling foreign reserves as necessary.
• The U.S. was only responsible for maintaining the
gold parity.
• Under Bretton Woods, the IMF was created.
• The Bretton Woods is also known as an adjustable
peg system. When facing serious balance of
payments problems, countries could re-value their
exchange rate. The US and Japan are the only
countries to never re-value.
The Fixed-Rate Dollar Standard, 1945-1971
• In practice, the Bretton Woods system
evolved into a fixed-rate dollar standard.
Industrial countries other than the United States :
Fix an official par value for domestic currency in terms
of the US$, and keep the exchange rate within 1% of
this par value indefinitely.
United States : Remain passive in the foreign change
market; practice free trade without a balance of
payments or exchange rate target.
Bretton Woods System: 1945-1971
British
pound
German
mark
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
Purpose of the IMF
The IMF was created to facilitate the
orderly adjustment of Balance of
Payments among member countries by:
• encouraging stability of exchange rates,
• avoidance of competitive devaluations,
and
• providing short-term liquidity through loan
facilities to member countries
Composition of SDR
(Special Drawing Right)
Collapse of Bretton Woods
• Triffin paradox – world demand for $ requires U.S. to
run persistent balance-of-payments deficits that
ultimately leads to loss of confidence in the $.
• SDR was created to relieve the $ shortage.
• Throughout the 1960s countries with large $ reserves
began buying gold from the U.S. in increasing
quantities threatening the gold reserves of the U.S.
• Large U.S. budget deficits and high money growth
created exchange rate imbalances that could not be
sustained, i.e. the $ was overvalued and the DM and
£ were undervalued.
• Several attempts were made at re-alignment but
eventually the run on U.S. gold supplies prompted
the suspension of convertibility in September 1971.
• Smithsonian Agreement – December 1971
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.
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.
The Plaza-Louvre Intervention Accords and
the Floating-Rate Dollar Standard, 1985-1999
• Plaza Accord (1985):
– Allow the dollar to depreciate following
massive appreciation…announced that
intervention may be used.
• Louvre Accord (1987) and “Managed
Floating”
– G-7 countries will cooperate to achieve
exchange rate stability.
– G-7 countries agree to meet and closely
monitor macroeconomic policies.
Value of $ since 1965
IMF Classification of Exchange Rate
Regimes
•
•
•
•
•
Independent floating
Managed floating
Exchange rate systems with crawling bands
Crawling peg systems
Pegged exchange rate systems within horizontal
bands
• Conventional pegs
• Currency board
• Exchange rate systems with no separate legal tender
Independent Floating
• Exchange rate determined by market
forces, with intervention aimed at
minimizing volatility:
• Example: United States
Managed Floating
• There is no pre-announced path for the
exchange rate, although intervention is
common. Policy makers will try to
influence the “level” of the exchange rate:
example: India
Crawling Band
• The currency is maintained within bands
around a central target for the domestic
currency against another currency (or
group of currencies). The bands
themselves are periodically adjusted,
sometimes in response to changes in
economic indicators.
• Example: Costa Rica, Mexico in 1994.
Example: Belarus through Feb 2008
Crawling pegs
• The domestic currency is pegged to
another currency or basket of currencies
at an established target rate. The target
rate is periodically adjusted, perhaps in
response to changing economic indicators.
• Example: Bolivia, China
• China allows for a daily revaluation of the
RMB against a basket of currencies.
Birr/$ between Apr 10 and Apr 11
Exchange rates within horizontal bands
• The domestic currency is pegged to
another currency or group of currencies.
The exchange rate is maintained within
bands that are wider than 1% of the
established target:
• Example: Any ERM II country, including
Denmark
Conventional pegs
• The country pegs its currency at a fixed
rate to another currency (or group of
currencies). The currency cannot fluctuate
by more than 1% relative to the
established target:
• Example: Saudi Arabia, formerly China
Currency boards
• Currency board countries are sometimes called
“hard peggers”. Example: Hong Kong….
• The currency board is a separate government
institution whose only responsibility is to buy and
sell foreign currency at an established price. The
country will typically maintain foreign currency
reserves equivalent to 100% of the total amount
of outstanding domestic money and credit.
Hong Kong
• Jim Rogers a famed currency trader has
noted: “If I were the Hong Kong
government, I would abolish the Hong
Kong dollar. There's no reason for the
Hong Kong dollar. It's a historical anomaly
and I don't know why it exists anymore….
You have a gigantic neighbor who is
becoming the most incredible economy in
the world.”
No separate legal tender
• The country uses another country’s (or
group of countries’) currency as its own:
• Example: Ecuador (US dollar)