The International Monetary System Final Term Lecture 4 The International Monetary System

Introduction The institutional arrangements that countries adopt to govern exchange rates are known as the international monetary system. When a country allows the foreign exchange market to determine the relative value of a currency, a floating exchange rate system exists. (4 Major Trading currencies) When a country fixes the value of its currency relative to a reference currency, a pegged exchange rate system exists. (Saudi pegs its currency with US Dollar) The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other. Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of government intervention.

Introduction When a country tries to hold the value of its currency within some range of a reference currency, dirty float exists. (Central Bank intervention in case of depreciation) Countries that adopt a fixed exchange rate system fix their currencies against each other. (After World War-II till 1973) Prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS).

The Gold Standard The gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value. Payment for imports was made in gold or silver. Later, as trade grew, payment was made in paper currency which was linked to gold at a fixed rate.

Mechanics Of The Gold Standard Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. In the 1880s, most of the world’s trading nations followed the gold standard. Under the gold standard one U.S. dollar was defined as equivalent to 23.22 grains of "fine (pure) gold. The amount of a currency needed to purchase one ounce of gold was called the gold par value.

How to Exchange Currencies 1 US dollar = 23.22 grains of gold 1 Ounce = 480 grains of gold One Ounce of Gold cost $20.67 (480/23.22) 1 British pound = 113 grains of gold One Ounce of Gold cost £4.25 (480/113) From the Gold par values of Dollars and Pounds, we can calculate what the exchange rate was for converting pounds into dollars. It was £1 = $4.87 (i.e: 20.67 / 4.25) From the above example it is clear to say that 1 British Pound will be exchanged for 4.87 US Dollars. OR If a person wants to get 1 Pound, he will have to present 4.87 Dollars to make the deal.

Strength Of The Gold Standard The great strength of the gold standard was that it contained a powerful mechanism for achieving balance-of-trade equilibrium (when the income a country’s residents earn from its exports is equal to the money its residents pay for imports) by all countries.

The Period Between The Wars: 1918-1939 The gold standard worked fairly well from the 1870s until the start of World War I in 1914. During the war, many governments financed their war expenditures by printing money, and in doing so, created inflation. (Exchange rate disturbed due to the reason that Per Ounce Gold which cost $ 20.67, now cost $35. and now £1=$8.24) People lost confidence in the system and started to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility. By 1939, the gold standard was dead. Post WWI, war heavy expenditures affected the value of dollars against gold. US raised dollars to gold from $20.67 to $35 per ounce. Other countries followed suit and devalued their currencies.

The Bretton Woods System In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system that would facilitate postwar economic growth. Under the new agreement: a fixed exchange rate system was established. all currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold. ($35 per Ounce) devaluations could not to be used for competitive purposes. a country could not devalue its currency by more than 10% without IMF approval. A key problem with the gold standard was that there was no multinational institution that could stop countries from engaging in competitive devaluations.

The Bretton Woods System The Bretton Woods agreement also established two multinational institutions: the International Monetary Fund (IMF) to maintain order in the international monetary system. the World Bank to promote general economic development .

The Role Of The IMF The IMF was charged with executing the main goal of the Bretton Woods agreement - avoiding a repetition of the chaos that occurred between the wars through a combination of discipline and flexibility. Discipline mean that: the need to maintain a fixed exchange rate put a brake on competitive devaluations and brought stability to the world trade environment. a fixed exchange rate regime imposed monetary discipline on countries, thereby curtailing price inflation. (What will happen if Great Britain starts printing pounds…?) The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars. The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility.

The Role Of The IMF Flexibility meant that: while monetary discipline was a central objective of the agreement, a rigid policy of fixed exchange rates would be too inflexible. the IMF was ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment.

The Role Of The World Bank The World Bank is also called the International Bank for Reconstruction and Development (IBRD) There are two ways to borrow from the World Bank: 1. under the IBRD scheme, money is raised through bond sales in the international capital market. borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses. 2. through the International Development Agency, an arm of the bank created in 1960. IDA loans go only to the poorest countries.

The Collapse Of The Fixed Exchange Rate System Bretton Woods worked well until the late 1960s. It collapsed when huge increases in welfare programs and the Vietnam War were financed by increasing the money supply and causing significant inflation. Other countries increased the value of their currencies relative to the dollar in response to speculation the dollar would be devalued. However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point. The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s. The US dollar was the only currency that could be converted into gold The US dollar served as the reference point for all other currencies Any pressure to devalue the dollar would cause problems through out the world Factors that led to the collapse of the fixed exchange system include: President Johnson financed both the Great Society and Vietnam by printing money High inflation and high spending on imports On August 8, 1971, President Nixon announces dollar no longer convertible into gold Countries agreed to revalue their currencies against the dollar On March 19, 1972, Japan and most of Europe floated their currencies In 1973, Bretton Woods fails because the key currency (dollar) is under speculative attack

The Floating Exchange Rate Regime In 1976, following the collapse of Bretton Woods, IMF members formalized a new exchange rate system at a meeting in Jamaica. The rules that were agreed on then, are still in place today.

The Jamaica Agreement Under the Jamaican agreement: floating rates were declared acceptable. gold was abandoned as a reserve asset. total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion.

Exchange Rates Since 1973 Since 1973, exchange rates have become more volatile and less predictable than they were between 1945 and 1973 Volatility has increased because of: The 1971 oil crisis The loss of confidence in the dollar that followed the rise of U.S. inflation in 1977 and 1978 The 1979 oil crisis The unexpected rise in the dollar between 1980 and 1985 The partial collapse of the European Monetary System in 1992 The 1997 Asian currency crisis