Transcript Chapter 3

Chapter 4
International Monetary System
Definition of the International Monetary
System

International monetary system is a set of
conventions, rules, procedures and
institutions that govern the conduct of
financial relations between nations.

International monetary system is based on
the exchange rate system adopted by
individual nations. The exchange rate system
is a set of rules governing the value of a
currency relative to other currencies.

The centerpiece of the system is to select an
international currency as a medium of
exchange in international settlements.

Commodity money such as gold or silver were
widely used in history. Gold or silver were
inconvenient to carry and impractical in
settlement.

Commodity-backed money refers to the bank
notes which are backed by gold or silver. The
bank notes can be freely converted into gold
or silver.

Fiat money is inconvertible money that is
made legal tender by government decree. The
only thing gives the money value is the faith
placed in it by the people that use it.

An international monetary system needs to
solve the following problems:
An international currency;
The determination of the exchange rate;
A mechanism of balance-of-payments
adjustment.
The Classical Gold Standard (1876 – 1914)

The gold standard was a commitment by
participating nations to fix the price of
their domestic currencies in terms of a
specified amount of gold.

The government announces the gold par value
which is the amount of its currency needed
to buy one ounce of gold. Therefore, the gold
was the international currency under the
gold standard.
Gold Standard and Exchange Values


Pegging the value
of each currency to
gold established an
exchange rate
system.
The gold par value
determined the
exchange rate
between two
currencies known
as “mint par of
exchange”

Since each country has the gold par value,
the exchange rate was then determined by
the gold par value of each currency.

The exchange rate was pretty stable because
of the gold import and export point. The gold
standard was regarded as “fixed exchange
rate” system.

The BOP disequilibrium was corrected by
“Price-specie-flow mechanism”.
Example of gold export and import

If the gold par value in New Zealand was
NZ$125/ounce and A$100/ounce in Australia, so
mint par of exchange: 100/125 = A$0.80/NZ$
Costs of gold transportation: A$0.008/NZ$
The exchange rate would fluctuate between
(0.80 + 0.008) = 0.8008 and (0.80 – 0.008) = 0.792

0.8008 and 0.792 are called gold export and
import points.
Price-specie-flow mechanism
Rapid growth rate
(tech innovation)
Outputs increase
Prices fall
Exports rise
Imports shrink
BOP surpluses
Gold inflows
BOP deficits
Gold outflows
Exports decline
Imports increase
Money supply up
Prices up
Performance of the gold standard

Long-term price stability (lower inflation
rate) 0.1% (1880 – 1914), 4.2% (1946 – 1990)

No central bank needed

Vulnerable to real and monetary shocks
Inflation in one country would influence
prices, money supply and real income of
another country.

Higher unemployment rate
6.8% (1879 – 1913), 5.6% (1946 – 1990)

Higher cost to maintain the system, in 1990
the cost would be $137 billion.

Limited supply of the gold can hamper the
rapid growth of international trade and
investment.
The International Monetary System from
1914 to 1944

World War I interrupted trade and the free
movement of gold.

Main countries suspended convertibility of
gold. They also imposed embargoes on gold
exports.

Exchange rate were fluctuated over fairly
wide ranges because of the predatory
devaluation of the domestic currency.

Gold exchange system were adopted. Other
countries held gold, U.S. dollars or British
pounds as reserves. U.S. and U.K. held gold.
U.S. and U.K. traded gold only with foreign
central banks, not private citizens.

From 1934 to the end of the War, countries
adopted paper standard, the gold standard
was virtually abandoned.

The international trade and investment
declined to a historical low level with the
protectionist policies adopted by many
countries.
Bretton Woods System (1944 – 1971)

Bretton Woods Agreement was to design a new
international monetary system.

International monetary fund (IMF)
to lend to member countries experiencing a
shortage of foreign exchange reserves

The International Bank for Reconstruction
and Development (IBRD) (World bank)
to finance postwar reconstruction

GATT (WTO)
to promote the reduction of trade barriers
and settle trade disputes

Pegged exchange rate system
US dollar was the international currency.
Each country pegged the value of their
currencies to the US dollar.
US dollar was pegged to the gold. ($35/ounce)
Parity band was within 1% on either side.
The pegged value was adjustable.
The Bretton Woods System
•The value of the dollar was
pegged to gold and the dollar
was convertible to gold at the
mint parity rate.
•A pegged exchange rate
system in which a country pegs
the value of its currency to the
currency of another nation.
•In practice a dollar-exchangerate system as nations pegged to
the dollar and freely exchanged
the domestic currency for the
dollar at the parity rate.

Triffin dilemma
The U.S. would neither run BOP surplus of
deficits. If U.S. keeps BOP surplus, there
would not be enough international currency
for world trade and international investment.
If U.S. has long term BOP deficit, people will
lose the confidence to the dollar.

Decline of Bretton Woods system
European and Japanese economy grew fast.
US dollars were being spent overseas, in the
form of foreign aid, defense spending, trade,
investment and tourism.

U.S. ran BOP deficits in 1960s. (capital
account)

Dollar crises (1965, 1968)
Worsening situation in Vietnam
Rumors the US intend to eliminate the gold
reserve requirement against deposits, notes
French verbal attacks on the US dollar
drastic increase in purchases of gold (1968)

Gold pool closed in 1968.
U.S. Balance of Payments
1959 – 1973 ($ billions)

The breakdown of the Bretton Woods system
U.S. suspended the convertibility of the
dollar into gold in 1971.
An emergency 10% tariff on all US imports
Price and wage controls to stabilize
inflation
Those measures officially broke off the link
between the U.S. dollar and the gold. The
Bretton Woods system was callapsed.

Smithsonian agreement (Dec. 1971)
G-10 met in Smithsonian Institute in
December 1971 to reach the agreement.
Devalue dollar against gold ($35 to $38)
Revalue other currencies against dollar (8%)
Parity band widened (±1% to ±2.25%)
U.S. remove 10% tariff

After the Smithsonian agreement, major
currencies were allowed to fluctuate.

The oil crisis and its aftermath
In 1973, OPEC quadrupled the oil price which
had a huge impact on the world economy and
effectively ended any hopes of restoring a
fixed exchange rate system.

LDCs were hard hit both by high oil prices
and recession in the industrialized countries.

Oil importing countries such as Japan and UK
suffered greatly from the shock.
The real price of OPEC crude oil
Global current account balances
1973-80 ($ billions)
Floating Exchange Rate System
(1976 – Now)

Jamaica accord (1976)
Jamaica accord in 1976 amended the IMF
constitution and signified the start of the
floating exchange rate era.
Floating rates were declared acceptable.
Gold was abandoned as a reserve asset.
Total annual IMF quotas were increased to
$41 billion. (in 2008, $311 billion)

Plaza agreement (1985)
G-5 jointly intervened the foreign exchange
market to pull the value of the dollar down.

Louvre accord (1987)
G-7 declared to cease to drive down the
value of the dollar since they felt that the
dollar had depreciated far enough.

The two events showed the floating exchange
rate system was more like a managed (dirty)
floating rate instead of a freely (clean)
floating rate system.
The nominal and real effective exchange
rate of the dollar, 1980 – 2005
The creation of the Euro

The 1991 Treaty of Maastricht
The timetable for the introduction of the
euro:
January 1, 1999. The euro replaced the ECU.
January 1, 2002. The euro began public
circulation alongside national currencies.
July 1, 2002. The euro formally replaced the
currencies of participating countries.
Convergence criteria

Countries that were qualified to adopt euro
should meet convergence criteria:

Inflation rates should be within 1.5% of the
three members of the EU with the lowest
inflation rates during the previous year.

Long-term interest rates should be within
2% of the three members of the EU with the
lowest interest rates.

Budget deficits should be no higher than 3%
of gross domestic product.

Government debt should be less than 60% of
gross domestic product.

Only 11 member countries of the EU met the
criteria when the euro was introduced. Now
there are 16 countries.

The performance of the euro (against the
dollar).
The Dollar/Euro Spot Exchange Rate,
1990 – 2007 (Monthly Average)
Currency Crises post - 1990

The Mexican peso crisis of 1995
The peso lost 40% of its value against the
dollar. Stock market fell 50% of its value.

The Asian financial storm of 1997
Thailand: baht lost 50% of its value.
Indonesia: rupiah lost 75% of its value.
South Korea: won lost 44% of its value.

The fall of the Russian ruble in 1998
Russia defaulted on more than $40 billion of
debt and was forced to abandon pegged rate.

2002 Argentina peso crisis
Argentina was forced to devalue the peso and
allowed the peso to float.
Exchange Rate Arrangements Today
•A nation’s
policymakers may
choose any type of
exchange rate system.
•Hence, there is a
wide range of
arrangements in place
at this time.
Exchange Rate Systems in Practice

Crawling peg is an exchange rate system in
which a country pegs its currency to another
currency, but allows the parity value to
change at regular time intervals. It can help
eliminate some sudden currency attacks.

Mexico, Nicaragua and others used to adopt
the crawling peg system.
Nicaragua
Nicaragua’s crawling-peg
exchange-rate arrangement
allows for a 1 percent
monthly rate of crawl of
depreciation of the cordoba
relative to the U.S. dollar.

Currency baskets refer to peg a currency to
a weighted average of a number of foreign
currencies. The weighted average of a basket
of currencies is likely to be less variable
than the exchange rate of a single currency.

Currency board is an exchange rate system in
which the monetary authority issues notes
and coins convertible into a foreign anchor
currency at a truly fixed rate and on demand.

The currency board supplies currency on the
basis of 100% foreign reserves.

For example, if the monetary authority in
Hong Kong issues one Hong Kong dollar, it
must have the equivalent U.S. dollar. Suppose
the exchange rate is HK$7.50/$, it implies
that for each Hong Kong dollar issued, the
monetary authority must keep $0.13 (1/7.5).

Currency board eliminates the possibility of
a nation’s money supply growing too rapidly
and causing inflation.

Dollarization (Euroization) means that a
country use the currency of another nation
to serve as legal tender. For some countries
it is an effective way to reduce risk and
protect against inflation and devaluation.

Advantages of the dollarization
(1) Avoid speculative attacks on the local
money
(2) Reduce country risk, create positive
investor sentiment and more stable capital
market.
(3) Improve the global economy by allowing
for easier integration of economies into the
world’s market.

Disadvantage of dollarization
(1) The central bank loses the ability to
administer monetary polices.
(2) The central bank loses its ability to
collect “seigniorage”, the profit gained from
issuing money.
(3) The central bank loses the role as “the
last resort”.
(4) Dollarization damages a nation’s sense of
pride.
Arguments for Fixed vs. Floating
Exchange Rates

The case for floating exchange rates
(1)Monetary policy autonomy
Removal of the obligation to maintain
exchange rate parity would restore monetary
control to a government.
(2)Trade balance adjustments
Floating rates respond quickly to changing
supply and demand conditions, clearing the
market of shortages or surpluses of a given
currency.
(3)Economic stability
Floating exchange rate are more conducive to
economic stability.

The case for fixed exchange rates
(1)Monetary discipline
Fixed rates ensures that governments do not
expand their money supplies at inflationary
rates.
(2)Speculation
Speculation accentuates the fluctuations in
exchange rates’ long term value. It can
damage a country’s economy by distorting
export and import prices.
(3)Uncertainty
Floating rates have made business planning
difficult, and add risk to exporting,
importing, and foreign investments.
(4)Competitiveness in foreign trade
By keeping exchange rate low helps to
support the competitiveness of a country’s
exports.