Chapter 18 The International Monetary System Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Learning Objectives Revisit the determination of the exchange rate by briefly examining the polar extremes of freely flexible and fixed exchange rates. Explain and evaluate the various kinds of exchange rate systems that trading nations use. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Learning Objectives (cont.) Describe the gradual reform of the international monetary system, including the three different exchange rate systems that the nations of the world have used. Discuss the recent history of, and changes in, Australia's exchange rate. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Exchange Rate Systems Two types of exchange rate system: Flexible or floating exchange rates the exchange rate is determined by demand and supply Fixed exchange rates government intervention in the foreign exchange market offsets the changes in exchange rate caused by the demand and supply factors Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Freely Floating Exchange Rates Depreciation and Appreciation Depreciation in the exchange rate is an increase in the number of units of a country’s currency required to buy a single unit of some foreign currency Appreciation is a reduction in the number of units of a country’s currency required to buy a single unit of some foreign currency Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Flexible Rates and the Balance of Payments Flexible exchange rates automatically adjust so as to eliminate balance of payments deficits or surpluses Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Adjustments under Flexible, Fixed and the Gold Standard P D1 S1 D0 3 2 1 Dollar price of one pound C X B D1 A S1 D0 Q Pounds Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Flexible Exchange Rates Disadvantages of floating exchange rates: Uncertainty and diminished trade uncertainty on prices due to movements in the exchange rate Terms of trade Instability in the macroeconomic environment Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Fixed Exchange Rates Nations have often fixed or pegged the exchange rate to overcome the disadvantages from floating exchange rates Fixed exchange rates require adequate reserves to accommodate periodic balance of payment deficits Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Fixed Exchange Rates (cont.) To maintain a fixed exchange rate a country may enact protectionist trade policies to increase net exports Exchange controls: rationing restricting imports to the amount of foreign exchange earned by exports Domestic macroeconomic adjustments use fiscal and monetary policies to adjust GDP to a level consistent with the fixed exchange rate Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Gold Standard A system under which the value of a nation’s monetary unit was backed by gold rather than fiat Gold standard conditions define the monetary unit in terms of a certain quantity of gold fixed relationship between stock of gold and the domestic currency allow gold to be freely exported and imported Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Gold Standard (cont.) Gold flows Domestic macro adjustments Advantages of gold standard reduces uncertainty and risk automatically corrects balance of payments deficits or surpluses Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Gold Standard (cont.) Disadvantages of gold standard nations must accept domestic adjustments in the form of higher unemployment or inflation countries must have sufficient reserves of gold Demise of the gold standard during the Depression years of the 1930s Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Bretton Woods Monetary System Bretton Woods conference 1944 Adjustable peg system of exchange rate emerged a system by which members of the IMF were obligated to define their monetary units in terms of gold (or US dollars), establishing par rates of exchange between the currencies of all other members, and to keep their exchange rates within 1 per cent of these par values Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

IMF and Pegged Exchange Rates Stabilisation funds suppliers of both foreign and domestic monies and gold held with the central bank or treasury for the purpose of intervention in the foreign exchange market to maintain the par value of the exchange rate IMF credit Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Bretton Woods Monetary System (cont.) Fundamental imbalances: adjusting the peg Demise of the Bretton Wood Dilemma: dollars and the deficits Emergence of floating rates Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The ‘Managed Float’ An exchange rate system where central banks buy and sell foreign exchange to smooth out short-run or day-to-day fluctuations in rates Encourages international trade and finance, while allowing for trend or long-term exchange rate flexibility to correct fundamental payments disequilibria Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The ‘Managed Float’ (cont.) Liquidity and special drawing rights special drawing rights are bookkeeping entries at the IMF, available to IMF members in proportion to their IMF quotas, that may be used to settle payments deficits or satisfy reserve needs in place of foreign exchange or gold Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The ‘Managed Float’: An Evaluation Arguments for managed float Trade growth Managing turbulence Arguments against Volatility and adjustment Reinforcement of inflation Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Exchange Rate History: Australia Setting exchange rates in the 1970s Pegged to the US dollar Pegged to the trade-weighted index The floating of the exchange rate (1983) Floating and the current account crisis Recovery during the late 1980s The early 1990s and the 1990 recession The late 1990s and the Asian crisis Into the 2000s Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

END OF CHAPTERS Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University