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CHAPTER 3 PAST AND PRESENT INTERNATIONAL MONETARY ARRANGEMENTS CHAPTER OUTLINE The Gold Standard: 1880–1914 The Interwar period: 1918–1939 The Gold Exchange Standard: 1944–1970 The Transition Years: 1971–1973 Floating Exchange Rates: 1973 to the Present The Choice of an Exchange Rate System Optimum Currency Areas The European Monetary System and The Euro Target Zones Currency Boards International Reserve Currencies Multiple Exchange Rates Summary Exercises References LECTURE HINTS 1. The pressures that led to the breakdown of the fixed exchange rate regime are usefully illustrated with a supply-and-demand diagram. With a fixed exchange rate supported by official intervention, private speculators start selling the weak currency in anticipation of a devaluation. The speculation leads to a greater deficit and more intervention which causes a more rapid depletion of reserves. 2. The Annual Report of the IMF appendixes is a convenient source of information to update tables 3.2 and 3.5. SUGGESTED ANSWERS TO CHAPTER 3 EXERCISES Exercise 1 Seigniorage is the difference between the cost of printing a currency and its purchasing power value. The seigniorage return to being the dominant reserve currency producer is small. One reason is that foreign holdings of actual currency are small relative to foreign holdings of dollardenominated interest-bearing securities and deposits. The United States earns no seigniorage return from interest-bearing bank deposits. Exercise 2 Gold is very costly to produce in the short run and thus its supply is quite limited. Under a gold standard, value of a currency depends upon the value of gold which is determined by the supply of gold, given the demand for gold. Since it is not easy to increase the supply of gold very fast, it is not possible for a country to achieve a high money supply growth and maintain the value of its currency in terms of gold. If it tries to repeatedly alter the gold value of its currency, then there is no longer a true gold standard. 6 Exercise 3 Suppose a country is running a balance-of-payments surplus. This would bring gold into the country, which would increase the domestic money supply and, in turn, prices. The rise in price would reduce net exports so that balance-of-payments equilibrium would be restored. Similarly, a country running a BOP deficit would find itself with net gold outflows, thus reducing its money supply and, in turn, its prices. The fall in price would bring about greater net exports so that BOP equilibrium is restored. Exercise 4 The euro began in January 1999. Countries and associated legacy currencies are: Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain schilling franc markka franc marc drachma pound lira franc guilder escudo peseta Exercise 5 Floaters large size closed economy divergent inflation rate diversified trade greater foreign tradable goods price fluctuations relative to domestic price disturbances Peggers small size open economy harmonious inflation rate concentrated trade greater domestic money shocks relative to foreign shocks Exercise 6 Under a “gold standard” each currency is defined in terms of its gold value and therefore all currencies are linked together in a system of “pegged” exchange rates. All currencies are convertible into gold. The Bretton Woods system, although essentially a pegged exchange rate system, allowed for changes in exchange rates when economic circumstances required such changes. Therefore, the system can be considered as an “adjustable peg.” The system may also be thought as a “gold exchange standard” since the key currency, the dollar, was convertible into gold for official holders of dollars, and other currencies were convertible into dollars. The Bretton Woods agreement required each country to fix a parity value of its currency in terms of gold. Countries were expected to maintain their exchange rates by buying and selling their own currencies. The IMF was created to aid countries with temporary BOP deficits. Countries were to change the pegged value of a currency only when BOP disequilibria were viewed as permanent. Individual country policies in the early 1970s demanded more flexibility in exchange rates than was permissible under Bretton Woods. This lack of flexibility led to the ultimate breakdown of the agreement. 7 Exercise 7 A target zone backed by credible government policies helps to stabilize an exchange rate relative to a floating exchange rate. This is due to the fact that as the exchange rate approaches the upper or lower bound of the zone the probability of government intervention increases. So private traders expect intervention to maintain the exchange rate within the bounds of the zone and act accordinly. Exercise 8 The ECB is in Frankfurt, Germany. The European System of Central Banks is like the Federal Reserve System in that the 12 national central banks deal with banking issues in each country in a similar manner to the way that the Federal Reserve district banks deal with banking issues in each of the 12 Federal Reserve districts. 8