5 Int Monetary System.ppt 1l6i61

International Monetary System  

    

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 Fixed versus Flexible Exchange Rate Regimes

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What is an international monetary system? 



Narrowly speaking, it refers to international exchange rate system. There are three international exchange rate systems in history: the gold standard, the Bretton Woods, and the floating exchange rate system. 2-1

International Monetary System  The

international monetary system can be defined as the institutional framework within which international payments are made, movements of capital are accommodated, and exchange rate among currencies are determined. 2-2

Features of a good international monetary system 





Adjustment : a good system must be able to adjust imbalances in balance of payments quickly and at a relatively lower cost; Stability and Confidence: the system must be able to keep exchange rates relatively fixed and people must have confidence in the stability of the system; Liquidity: the system must be able to provide enough reserve assets for a nation to correct its balance of payments deficits without making the nation run into deflation or inflation. 2-3

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

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Bimetallism: Before 1875 





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, some on both. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents.

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Bimetallism: Before 1875



Britain- until 1816 (Neapoleonic war) US – until 1873 (dropped silver dollar) – until 1878 China, India, – Silver standard



No systematic IMS until 1870

  

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Classical Gold Standard: 1875-1914 The gold standard had its origin in the use of gold coins as a medium of exchange, unit of , and store of value. 

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. 2-7

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 = £6

$5 = £1 2-8

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-specie-flow mechanism which is attributed to David Hume, Scottish philosopher 2-9

price-specie-flow mechanism 

If any country has 





Net Exports > Gold inflow > Increase in Money supply > Increase in price level > Slower the exports Net Imports > Gold outflow > decrease in Money supply > decrease in price level > encourage exports

This mechanism was intended to restore equilibrium automatically

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Rules of the game 

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Fix an official gold price or “mint parity” and allow free convertibility between domestic money and gold at that price. Impose no restrictions on the import or export of gold by private citizens, or on the use of gold for international transactions. Issue national currency and coins only with gold backing, and link the growth in national bank deposits to the availability of national gold reserves. If Rule I is ever temporarily suspended, restore convertibility at the original mint parity as soon as possible. 2-11

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 if govt. finds it politically necessary to pursue national objectives that are inconsistent with gold standards.

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The Interwar Years,1915-1944 1918-1939 Interwar Period: 

With the eruption of WW-I in 1914, the gold standard was suspended. 



The interwar years were marked by severe economic instability and hyperinflation in Europe.

The German Hyperinflation 

’s price index rose from a level of 262 in January 1919 to a level of 126,160,000,000,000 in December 1923 (a factor of 481.5 billion). 2-13

The Interwar Years,1915-1944 1918-1939 Interwar Period: 

After war, Return to Gold Standard



1919 



U.S. returned to gold

1922 

A group of countries (Britain, , Italy, and Japan) agreed on a program calling for a general return to the gold standard and cooperation among central banks in attaining external and internal objectives. 2-14

The Interwar Years,1915-1944 1918-1939 The Interwar Years, Interwar Period: 

1925 Britain



returned to the gold standard

1929 The

Great Depression was followed by bank failures throughout the world.



1931 Britain

was forced off gold when foreign holders of pounds lost confidence in Britain’s commitment to maintain its currency’s value. 2-15

The Interwar Years, 1918-1939v Interwar Period: 1915-1944 The Interwar Years, 1918-1939 

International Economic Disintegration Many countries suffered during the Great Depression.  Major economic harm was done by restrictions on international trade and payments.  These beggar-thy-neighbor policies provoked foreign retaliation and led to the disintegration of the world economy. Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. 



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Interwar Period: 1915-1944 Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game” and Great Depression in 1929 and the accompanying financial crisis were the main reasons 

All countries’ situations could have been bettered through international cooperation  Bretton

Woods agreement

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Bretton Woods System: 1945-1972 

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

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Named for meeting of 44 nations at Bretton Woods, New Hampshire in July 1944. 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. 2-18

Bretton Woods System: 1945-1972 

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

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 Bretton Woods system was a dollar-based gold exchange standard.

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Bretton Woods System: 1945-1972 British pound

German mark

French franc

Par Value

U.S. dollar Pegged at $35/oz.

Gold

Bretton Woods System: 1945-1972 

Triffin Paradox 

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  

To satisfy the growing need for reserve, the US had to run balance of payment deficit continuously which may eventually impair the public confidence in the dollar

1960 – US gold stock fell short of foreign dollar holdings created concern about viability of system Creation of artificial reserve called SDR in 1970 SDR is basket currency allotted to IMF Weighted avg. of 16 currencies – more than 1 % share in world export, 1981 only 5 currencies 2-21

Bretton Woods System: 1945-1972 

Smithsonian Agreement 

  

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To save the bretton woods system G-10 met at Smithsonian institution in Washington. the price of gold was raised to 38$ Each country revalued its currency by 10% The band of 1% expanded to 2.25%

February 1973, further devaluation by 42$ By March 1973, Japan and European currecies were allowed to float and end of Bretton woods 2-22

Collapse of the Bretton Woods System: Process of dollar devaluation

Dollar value per ounce of gold

35

38 42.22 1944 2-23

1971

1973

The Flexible Exchange Rate Regime: 1973-Present.  

Jamaica Agreement in January 1976 Flexible exchange rates were declared acceptable to the IMF . 



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Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities.

Gold was abandoned as an international reserve Non-oil-exporting countries and less-developed countries were given greater access to IMF funds. 2-24

Current Exchange Rate Arrangements 

Free Float 

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Managed Float 

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About 25 countries combine government intervention with market forces to set exchange rates.

Pegged to another currency 

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The largest number of countries, about 48, allow market forces to determine their currency’s value.

Such as the U.S. dollar or euro (through franc or mark).

No national currency 

Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador has recently dollarized. 2-25

IMF Classification The current exchange rate system is a hybrid of many different arrangements. The International Monetary Fund classifies these exchange rate regimes into eight specific categories. The eight categories span the spectrum of exchange rate regimes from rigidly fixed to independently floating: 



Exchange Arrangements with No Separate Legal Tender: The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union in which the same legal tender is shared by the of the union. Currency Board Arrangements: A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. 2-26

IMF Classification 

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Other Conventional Fixed Peg Arrangements: The country pegs its currency at a fixed rate to a major currency or a basket of currencies , where the exchange rate fluctuates within a narrow margin or at most ±1% around a central rate. Pegged Exchange Rates within Horizontal Bands: The value of the currency is maintained within margins of fluctuation around a formal fixed peg that are wider than ±1% around a central rate. Crawling Pegs: The currency is adjusted periodically in small amounts at a fixed, pre-announced rate or in response to changes in selective quantitative indicators. Exchange Rates within Crawling Pegs: The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed pre-announced rate or in response to change in selective quantitative indicators. 2-27

IMF Classification 



Managed Floating with No Pre-Announced Path for the Exchange Rate: The monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying or pre-committing to a pre-announced path for the exchange rate. Independent Floating: The exchange rate is market determined, with central bank intervening only to moderate the speed of change and to prevent excessive fluctuations, but not attempting to maintain it at or drive it to any particular level.

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Arguments favoring floating rates Better adjustment Better confidence Better liquidity Gains from freer trade Increased independence of policy

1. 2. 3. 4. 5. 

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Easier external adjustments. National policy autonomy

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Arguments against floating rates: 1.

2. 3. 4. 5. 6.

Cause uncertainty and inhibit international trade and investment Cause destabilizing and speculation No safeguards to prevent crises Are inflationary Are unstable because of small trade elasticity Cause structural unemployment

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Fixed versus Flexible Exchange Rate Regimes  

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Suppose the exchange rate is $1.40/£ today. In the next slide, we see that demand for British pounds far exceed supply at this exchange rate. The U.S. experiences trade deficits.

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Dollar price per £ (exchange rate)

Fixed versus Flexible Exchange Rate Regimes Supply (S)

Demand (D)

$1.40

Trade deficit

S 2-32

D

Q of £

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.

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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*)

D=S 2-34

Q of £

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. 2-35

Dollar price per £ (exchange rate)

Fixed versus Flexible Exchange Rate Regimes Supply (S)

Contractionary policies

(fixed regime)

Demand (D)

$1.40

Demand (D*)

D* = S 2-36

Q of £

European Monetary System 



Eleven European countries maintain exchange rates among their currencies within narrow bands, and tly float against outside currencies. Objectives:  

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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. 2-37

The Mexican Peso Crisis 

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 

On 20 December, 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. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent. 2-38

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: 

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It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. An influx of foreign capital can lead to an overvaluation in the first place. 2-39

The Asian Currency Crisis 

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The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession. 2-40

Currency Crisis Explanations 

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In theory, a currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies in the long run. In the short run, currency trader’s expectations play a much more important role. In today’s environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to “get to the exits first”. Thus, fears of depreciation become self-fulfilling prophecies. 2-41

Quiz Time 1.

2. 3. 4.

5.

6.

7.

Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard. Discuss the advantages and disadvantages of the gold standard. What were the main objectives of the Bretton Woods system? Explain how the special drawing rights (SDR) is constructed. Also, discuss the circumstances under which the SDR was created. List the advantages of the flexible exchange rate regime. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed exchange rate regime. Discuss the criteria for a ‘good’ international monetary system. 2-42