Transcript 4. International Monetary System

• THE INTERNATIONAL
MONETARY SYSTEM
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• The International Monetary System
• Foreign exchange dealers, like those in the photograph, trade one
kind of currency for another. A better way to say it, is that these
dealers use one country's currency to buy the currency of another
country. The red digital numbers show the price, on June 18,
1998, of a dollar, reckoned in Japanese yen. If you wanted to buy
yen with your dollars, you could have gotten about 140 yen for
your dollar. A Japanese businessman would have had to pay 140
yen to buy your dollar. What determines how much a dollar (or the
yen) is worth? That depends on how many people, actually having
yen, would rather have dollars, and on how many people, actually
having dollars, wish they had yen. This is an example of the basic
economic concepts of SUPPLY and DEMAND .
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• The increased volatility of exchange rates
is one of the main economic
developments of the past 40 years.
• Policies for forecasting and reacting to
exchange rate fluctuations are still
evolving.
• Although volatile exchange rates
increase risk, they also create profit
opportunities for firms and investors.
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The International Monetary System
• The international monetary system is the
structure within which foreign exchange rates
are determined, international trade and capital
flows are accommodated, and the balance-ofpayments adjustments made.
• All of the instruments, institutions, and
agreements that link together the world’s
currency, money markets, securities, real
estate, and commodity markets are also
encompassed within that term.
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Currency Terminology
• Foreign Currency Exchange Rate – the
price of one country’s currency in units
of another currency of commodity.
– Can be fixed or floating
• Spot Exchange Rate – the quoted price
for foreign exchange to be delivered at
once, or in two days for interbank
transactions.
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Currency Terminology
• Forward Rate – the quoted price for foreign exchange
to be delivered at a specified date in the future.
– Can be guaranteed with a forward exchange
contract
• Forward Premium or Discount – the percentage
difference between the spot and forward exchange rate.
– Calculated as
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Spot – Forward x 360 x 100
Forward
n
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Currency Terminology
• Devaluation of a Currency – refers to a drop in
foreign exchange value of a currency that is
pegged to gold or another currency.
– The opposite is revaluation
• Weakening, deterioration, or depreciation of a
Currency – refers to a drop in the foreign
exchange value of a floating currency.
– The opposite is strengthening or appreciation
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Currency Terminology
• Soft or Weak – describes a currency that is
expected to devalue or depreciate relative to
major currencies.
– Also refers to currencies being artificially sustained
by their governments
• Hard or Strong – describes a currency that is
expected to revalue or appreciate relative to
major trading currencies.
• Eurocurrencies – are domestic currencies of
one country on deposit in a bank in a second
country.
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History of the International
Monetary System
• The Gold Standard (1876 – 1913)
– Gold has been a medium of exchange since 3000
BC
– “Rules of the game” were simple, each country set
the rate at which its currency unit could be
converted to a weight of gold
– Currency exchange rates were in effect “fixed”
– Expansionary monetary policy was limited to a
government’s supply of gold
– Was in effect until the outbreak of WWI as the free
movement of gold was interrupted
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History of the International
Monetary System
• The Inter-War Years & WWII (1914-1944)
– During this period, currencies were allowed to
fluctuate over a fairly wide range in terms of gold
and each other
– Increasing fluctuations in currency values became
realized as speculators sold short weak currencies
– The US adopted a modified gold standard in 1934
– During WWII and its chaotic aftermath the US
dollar was the only major trading currency that
continued to be convertible
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History of the International
Monetary System
• Bretton Woods and the International Monetary
Fund (IMF) (1944)
– As WWII drew to a close, the Allied Powers met at
Bretton Woods, New Hampshire to create a postwar international monetary system
– The Bretton Woods Agreement established a US
dollar based international monetary system and
created two new institutions the International
Monetary Fund (IMF) and the World Bank
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History of the International
Monetary System
– The International Monetary Fund is a key institution
in the new international monetary system and was
created to:
• Help countries defend their currencies against cyclical,
seasonal, or random occurrences
• Assist countries having structural trade problems if they
promise to take adequate steps to correct these problems
– The International Bank for Reconstruction and
Development (World Bank) helped fund post-war
reconstruction and has since then supported general
economic development
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History of the International
Monetary System
• Fixed Exchange Rates (1945-1973)
– The currency arrangement negotiated at Bretton Woods and
monitored by the IMF worked fairly well during the postWWII era of reconstruction and growth in world trade
– However, widely diverging monetary and fiscal policies,
differential rates of inflation and various currency shocks
resulted in the system’s demise
– The US dollar became the main reserve currency held by
central banks, resulting in a consistent and growing balance of
payments deficit which required a heavy capital outflow of
dollars to finance these deficits and meet the growing demand
for dollars from investors and businesses
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History of the International
Monetary System
– Eventually, the heavy overhang of dollars held by foreigners
resulted in a lack of confidence in the ability of the US to met
its commitment to convert dollars to gold
– The lack of confidence forced President Richard Nixon to
suspend official purchases or sales of gold by the US Treasury
on August 15, 1971
– This resulted in subsequent devaluations of the dollar
– Most currencies were allowed to float to levels determined by
market forces as of March, 1973
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History of the International
Monetary System
• An Eclectic Currency Arrangement
(1973 – Present)
– Since March 1973, exchange rates have
become much more volatile and less
predictable than they were during the
“fixed” period
– There have been numerous, significant
world currency events over the past 30 years
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The IMF’s Exchange Rate
Regime Classifications
• The International Monetary Fund
classifies all exchange rate regimes into
eight specific categories. There are eight
categories that span the spectrum of
exchange rate regimes from rigidly fixed
to independently floating.
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Fixed Versus Flexible
Exchange Rates
• A nation’s choice as to which currency regime
to follow reflects national priorities about all
facets of the economy, including inflation,
unemployment, interest rate levels, trade
balances, and economic growth.
• The choice between fixed and flexible rates
may change over time as priorities change.
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Fixed Versus Flexible
Exchange Rates
• Countries would prefer a fixed rate regime for
the following reasons:
– stability in international prices
– inherent anti-inflationary nature of fixed prices
• However, a fixed rate regime has the following
problems:
– Need for central banks to maintain large quantities
of hard currencies and gold to defend the fixed rate
– Fixed rates can be maintained at rates that are
inconsistent with economic fundamentals
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Attributes of the “Ideal” Currency
• Possesses three attributes, often referred
to as the Impossible Trinity:
– Exchange rate stability
– Full financial integration
– Monetary independence
• The forces of economics to not allow the
simultaneous achievement of all three
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• The period of floating exchange rates-is
also referred to by Benjamin Cohen as
the era of the “Unholy Trinity”
• Countries want…
• The ability to respond to domestic
political forces- “monetary autonomy”
• International capital mobility (necessary
for efficient international finance)
• Stable exchange rates
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• The problem is that these three goals are
mutually inconsistent-you cannot have all
three…
• For example…if a nation wishes to stimulate
demand in its economy…it may decide to
assist this by cutting interest rates.(monetary
autonomy)
• BUT this will reduce the attractiveness of the
currency on the FX markets a fall in the
value of the currency (reducing exchange rate stability)
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• In the Bretton Woods system…capital controls
eliminated international capital mobility.
• This allowed states, for a time at least, to
respond to domestic political forces without
causing exchange rate instability.
• “Hot Money” could not rush in or out of the
nation in response to domestic policies, so it
could not disturb international exchange rate
stability.
• In the floating exchange rate era, capital
controls have proved impossible to enforce…
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• There are now too many ways to use technology and
ingenuity to transfer funds from one country to another.
• This means that states MUST CHOOSE between stable
exchange rates and the ability to set their own domestic
economic agenda.
• For Ireland the Euro confers exchange rate stability, but
we still trade heavily with Britain and the
USA…(Britain although in the EU is not in the Euro).
• However the economic needs of France and Germany
whose economies have been in the doldrums has
resulted in the ECB reducing interest rates…Just at a
time when the Irish economy was in danger of
overheating (2001-2002) a policy was implemented
which added further demand to the Irish economy
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• The recent increase in the value of the Euro
makes it more difficult for Irish exporters to
penetrate non-euro zone markets..particularly
the important British and US markets..since it
makes Irish goods more expensive in terms of
the pound sterling and the American $.
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Emerging Markets
and Regime Choices
• A currency board exists when a country’s central bank
commits to back its monetary base – its money supply
– entirely with foreign reserves at all times.
• This means that a unit of domestic currency cannot be
introduced into the economy without an additional unit
of foreign exchange reserves being obtained first.
– Argentina moved from a managed exchange rate to
a currency board in 1991
– In 2002, the country ended the currency board as a
result of substantial economic and political turmoil
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Emerging Markets
and Regime Choices
• Dollarization is the use of the US dollar as the
official currency of the country.
• One attraction of dollarization is that sound
monetary and exchange-rate policies no longer
depend on the intelligence and discipline of
domestic policymakers.
– Panama has used the dollar as its official currency
since 1907
– Ecuador replaced its domestic currency with the US
dollar in September, 2000
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The Euro:
Birth of a European Currency
• In December 1991, the members of the
European Union met at Maastricht, the
Netherlands to finalize a treaty that
changed Europe’s currency future.
• This treaty set out a timetable and a plan
to replace all individual ECU currencies
with a single currency called the euro.
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The Euro:
Birth of a European Currency
• To prepare for the EMU, a convergence criteria
was laid out whereby each member country
was responsible for managing the following to
a specific level:
–
–
–
–
Nominal inflation rates
Long-term interest rates
Fiscal deficits
Government debt
• In addition, a strong central bank, called the
European Central Bank (ECB), was established
in Frankfurt, Germany.
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Effects of the Euro
• The euro affects markets in three ways:
– Cheaper transactions costs in the Euro Zone
– Currency risks and costs related to
uncertainty are reduced
– All consumers and businesses both inside
and outside the Euro Zone enjoy price
transparency and increased price-based
competition
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Achieving Monetary Unification
• If the euro is to be successful, it must have a
solid economic foundation.
• The primary driver of a currency’s value is its
ability to maintain its purchasing power.
• The single largest threat to maintaining
purchasing power is inflation, so the job of the
EU has been to prevent inflationary forces
from undermining the euro.
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Exchange Rate Regimes:
The Future
• All exchange rate regimes must deal with the tradeoff
between rules and discretion (vertical), as well as between
cooperation and independence (horizontal).
• The pre WWI Gold Standard required adherence to rules
and allowed independence.
• The Bretton Woods agreement (and to a certain extent the
EMS) also required adherence to rules in addition to
cooperation.
• The present system is characterized by no rules, with
varying degrees of cooperation.
• Many believe that a new international monetary system
could succeed only if it combined cooperation among
nations with individual discretion to pursue domestic social,
economic, and financial goals.
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