1

The International Monetary System

Chapter Objective: This chapter serves to introduce the student to the

institutional framework within which: (1) International payments are made, (2) The movement of capital is accommodated, (3) Exchange rates are determined.

Chapter Outline Evolution of the International Monetary System Current Exchange Rate Arrangements European Monetary System Euro and the European Monetary Union Fixed versus Flexible Exchange Rate Regimes

2Chapter Two

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Evolution of the International Monetary System

Definition: IMS is institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined

Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973-Present

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Evolution of the International Monetary System

Bimetallism (prior to 1875) Gold and Silver used as international means of payment

and the exchange rate among currencies was determined by either their gold or silver content.

Gresham’s law - exchange ratio between two metals was officially fixed, therefore only more abundant metal was used, driving the more scarce metal out of circulation

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Evolution of the International Monetary System (contd.)

Classic Gold Standard (1876 - 1913) During this period in most major countries:

1. gold alone is assured of unrestricted coinage2. two-way convertibility between gold and national currencies at a

stable ratio3. gold is freely exported or imported

The exchange rate between two country’s currencies would be determined by their relative gold contents

Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment.

Price-specie-flow mechanism corrected misalignment of exchange rates and international imbalances of payment

Might lead to deflationary pressures

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Evolution of the International Monetary System (contd.)

Interwar period (1915 – 1944) characterized by:

Economic nationalism Attempts and failure to restore gold standard Economic and political instability

These factors highlighted some of the shortcomings of the gold standard

The result for international trade and investment was profoundly detrimental.

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Evolution of the International Monetary System (contd.)

Bretton Woods System (1944 – 1973) Creation of the International Monetary Fund (IMF) and the

World Bank 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.

US dollar based gold exchange standard

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Evolution of the International Monetary System (contd.)

Bretton Woods System (1944 – 1973)

British pound

French franc

U.S. dollar

Gold

Pegged at $35/oz.

Par Value

Par ValuePar

Value

German mark

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Evolution of the International Monetary System (contd.)

Bretton Woods System (1944 – 1973) Problem with the system is that U.S. constantly incurred

trade deficits as other countries wanted to maintain US$ reserves (Triffin Paradox)

Special Drawing Rights (SDR) – new reserve asset, (US$, FF, DM, BP, JY)

Smithsonian Agreement (1971) – US$ devalued to $38/oz.

European, Japanese currencies allowed to float–Mar 1973

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Evolution of the International Monetary System (contd.)

Flexible Exchange Rate Regime (1973–present) Jamaica Agreement (1976) Flexible exchange rates were declared acceptable to the

IMF members. Central banks were allowed to intervene in the exchange rate

markets to iron out unwarranted volatilities.

Gold was abandoned as an international reserve asset. Non-oil-exporting countries and less-developed countries

were given greater access to IMF funds.

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Contemporary Currency Regimes

Free Float The largest number of countries, about 36, allow market forces to

determine their currency’s value.

Managed Float About 50 countries combine government intervention with market

forces to set exchange rates.

Pegged to (or horizontal band around) another currency Such as the U.S. dollar or euro

No national currency About 40 countries do not bother printing their own, they just use the

U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

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Fixed vs. Flexible Exchange Rate Regimes

Arguments in favor of flexible exchange rates: Easier external adjustments. National policy autonomy.

Arguments against flexible exchange rates: Exchange rate uncertainty may hamper international trade. No safeguards to prevent crises.

Currencies depreciate (or appreciate) to reflect the equilibrium value in flexible exchange rates

Governments must adjust monetary or fiscal policies to return exchange rates to equilibrium value in fixed exchange rate regimes

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Fixed versus Flexible Exchange Rate Regimes

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. Under a flexible ER 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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Fixed versus Flexible Exchange Rate Regimes

S D Q of £

Dol

lar

pric

e pe

r £

(exc

hang

e ra

te)

$1.40

Trade deficit

Demand (D)

Supply (S)

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Fixed versus Flexible Exchange Rate Regimes

Supply (S)

Demand (D)

Demand (D*)

D = S

Dollar depreciates (flexible regime)

Q of £

Dol

lar

pric

e pe

r £

(exc

hang

e ra

te)

$1.60

$1.40

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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 US Federal Reserve Bank may initially draw on its foreign exchange reserve holdings to satisfy the excess demand for British pounds.

If the excess demand persists the government would have to shift the demand curve from D to D* In this example this corresponds to contractionary monetary and

fiscal policies.

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Fixed versus Flexible Exchange Rate Regimes

Supply (S)

Demand (D)

Demand (D*)

D* = S

Contractionary policies

(fixed regime)

Q of £

Dol

lar

pric

e pe

r £

(exc

hang

e ra

te)

$1.40

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European Monetary System (EMS)

EMS was created in 1979 by EEC countries to maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies.

Objectives: Establish zone of monetary stability Coordinate exchange rate policies vis-à-vis non-EMS countries Develop plan for eventual European monetary union

Exchange rate management instruments: European Currency Unit (ECU)

Weighted average of participating currencies Accounting unit of the EMS

Exchange Rate Mechanism (ERM) Procedures by which countries collectively manage exchange rates

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What Is the Euro (€)?

The euro is the single currency of the EMU which was adopted by 11 Member States on 1 January 1999.

These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

Prominent countries initially missing from Euro :

Denmark, Greece, Sweden, UK Greece: did not meet convergence

criteria, was approved for inclusion on June 19, 2000 (effective Jan. 2001)

1 Euro is Equal to:40.3399 BEF Belgian franc1.95583 DEM German mark166.386 ESP Spanish peseta6.55957 FRF French franc.787564 IEP Irish punt1936.27 ITL Italian lira40.3399 LUF Luxembourg

franc2.20371 NLG Dutch guilder13.7603 ATS Austrian

schilling200.482 PTE Portuguese escudo5.94573 FIM Finnish markka

Euro Conversion Rates

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Benefits and Costs of the Monetary Union

Transaction costs reduced and FX risk eliminated

Creates a Eurozone – goods, people and capital can move without restriction

Compete with the U.S. Approximately equal in terms

of population and GDP Price transparency and

competition

Loss of national monetary and exchange rate policy independence

Country-specific asymmetric shocks can lead to extended recessions

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The Long-Term Impact of the Euro

If the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a “United States of Europe” feasible.

It is likely that the U.S. dollar will lose its place as the dominant world currency.

The euro and the U.S. dollar will be the two major currencies.