The International Monetary System: History and Where we are Today

Recall the Definition of an Exchange Rate Regime Defined: The way in which a country manages its currency and thus the arrangement by the price of that country’s currency is determined on foreign exchange markets. Arrangements ranging from: Floating Rate Managed Rate (AKA “Dirty Float”) Pegged Rate Arrangement is determining by governments.

History of Exchange Rate Regimes Over the past 200+ years, the world has gone though major changes its global exchange rate environment. Starting with the gold standard regime of the latter part of the 19th century to today’s somewhat “mixed system” we can identify there 3 distinct periods: Gold Standard: 1816 - 1914 Bretton Woods: 1945 - 1973 Mixed System: 1973 – the present

Gold Standard: 1816 - 1914 During the 1800s the industrial revolution brought about a vast increase in the production of goods and widened the basis of world trade. At that time, trading countries believed that a necessary condition to facilitate world trade was a stable exchange rate system. Stable exchange rates were seen as necessary for encouraging and settling commercial transactions across borders (both by companies and by governments). So by the second half of the 19th century, most countries had adopted the gold standard exchange rate regime.

Basics of the Gold Standard The gold standard regime required that domestic currencies (national money) be defined in terms of a specific weight of gold. For example: The British pound was fixed at .23546% of an ounce of pure gold (in 1816). The U.S. dollar was fixed at 0.048379% of an ounce of pure gold (in 1879). Thus, the dollar pound “parity” (i.e., the exchange rate) was set at $4.867 .23546/.048379 = 4.867 The Gold Standard also required that each country adjust its domestic money supply in direct relation to the amount of gold it held. Increase in gold would increase the domestic money and a reduction in its gold supply would reduce the money supply. How it worked: Assume the United Kingdom ran a trade deficit with the United States. As a result, gold would flow from the UK to the US (gold financed trade imbalances). Each country’s domestic money supply was tied into the amount of gold it held, thus the U.S. money supply would rise. The increase money supply would increase prices in the United States, which in turn would make U.S. goods less attractive to the UK. The net result was that the trade surplus of the US would decrease and the trade deficit of the UK would decrease.

World War I (1914) Through World War II (1944) World War I marks the beginning of the end of the Gold Standard . During the war, countries suspended the convertibility of their currencies into gold. After WW I, various attempts were made to restore the “classical” gold standard. 1919: United States returned to a gold standard. 1925: Great Britain joined, followed by France and Switzerland. These attempts proved unsuccessful. Why: During this time, most countries were more concerned with their national economies than exchange rate stability. Especially during the Great Depression (1929 – 1930s) As a result, countries abandoned their attempts to return to an interwar gold standard. Britain and Japan dropped it in 1931, the U.S. in 1933.

Bretton Woods: A Pegged Regime In July of 1944, as World War II is coming to an end, all 44 allied countries meet in Bretton Woods, New Hampshire for the purpose of establishing a new international monetary system. At Bretton Woods, countries agree that fixed exchange rates were necessary for “restarting” world trade and global investment (both of which had fallen dramatically). It is also obvious that the US dollar would become the cornerstone of any new international monetary system. Key points of the Bretton Woods were: Pegging the U.S. dollar to gold at $35 per ounce (with the USD the only currency convertible into gold). All other countries peg their currencies to the U.S. dollar. Their par values are set in relation to the U.S. dollar GBP = $2.80; JPY = 360 (1in 1949) Countries agreed to “support” their exchange rates within + or – 1% of these par values. This is done through the buying or selling of foreign exchange when market forces needed to be offset.

The Yen During Bretton Woods

Sterling During Bretton Woods

The Seeds of Bretton Woods’ Demise In the 1960s, Bretton Woods begins to unravel. President Lyndon Johnson tries to finance both his “Great Society” programs at home and the American war in Vietnam. This produces a large US Federal budget deficit, which, coupled with easy monetary policy, results in: High inflation in the United States and An increase in U.S. spending for cheaper imports As a result, the United States balance of payments moves from a surplus into a deficit. Dollar is seen by the market as “overvalued.” Foreigners become concerned about holding overvalued U.S. dollars at a rate of $35 an ounce. Markets are suggesting it should take more than $35 to buy 1 oz of gold.

U.S. Balance of Payments: 1965 - By the mid-1960, the U.S. balance of payment (e.g., trade balance) started to deteriorate (a declining surplus). By 1971, the U.S. merchandise trade balance moved into deficit.

The Last Years of Bretton Woods: 1970 -1973 By 1970, financial markets are reluctant to hold the “overvalued” U.S. dollar. Markets sell USD on foreign exchange markets. This puts downward pressure on the exchange rate for dollars. And upward pressure on the exchange rate for foreign currencies. Central banks engage in massive intervention in an attempt to hold their Bretton Woods par values. Central banks buy U.S. dollars as they are sold in markets. As a result, foreign holdings of dollars increase dramatically and eventually exceed U.S. gold holdings. By 1971, gold coverage for U.S. dollars had dropped to 22%. In August 1971, President Nixon suspends dollar convertibility into gold. In response, more dollars are sold on foreign exchange markets pushing the dollar lower (and foreign currencies higher).

Smithsonian Agreements, December 1971 In December 1971, ten major counties meet in Washington, D.C. with the aim of restoring stability to the international monetary system. Meeting concludes with the Smithsonian Agreements, whereby: Key countries agree to revalue their currencies and in essence set new par values against the US dollar (e.g., yen +17%, mark +13.5%, pound and franc +9%) The U.S. also agrees to raise the dollar price of gold from $35 to $38 an ounce (represents a further devaluation of the dollar). It was also agreed that currencies could now fluctuate + or – 2.25% around their new par values.

The Final Collapse of the Dollar, February 1973 13 months after the Smithsonian Agreements, the dollar comes under renewed attack for being overvalued. In February 1973, markets sell off dollars again. As before, central banks intervene and buy dollars. On February, 12th, 1973 the dollar is devalued further to $42 per ounce. But the price of gold on the London gold markets trades at $70 per ounce. Japan and Italy finally let their currencies “float” on February 13th. France and Germany continue to manage their currencies in relation to the dollar. In response to mounting speculative currency flows, foreign exchange markets are closed on March 1, 1973, and reopen on March 19, 1973.

The End of Bretton Woods On March, 19, 1973, when foreign exchange markets reopen, major countries announce that they are “floating” their currencies: On March 19, 1973, the list of countries floating their currencies includes Japan, Canada, and those in Western Europe. The Bretton Woods fixed exchange rate system effectively ends on this date. Approximately 3 months later, by June 1973, the dollar has “floated” down an average of 10% against the major currencies of the world.

Yen Immediately After the Collapse of Bretton Woods 1971 - 1980 Annual Data: % in USD 1971 349.33 -2.96% 1972 303.17 -13.21% 1973 271.70 -10.38% 1974 292.08 7.50% 1975 296.79 1.61% 1976 296.55 -0.08% 1977 268.51 -9.46% 1978 210.44 -21.63% 1979 219.14 4.13% 1980 226.74 3.47%

Sterling Immediately After the Collapse of Bretton Woods 1971 - 1980 Annual Data: % in GBP 1971 2.4336 1.41% 1972 2.4975 2.62% 1973 2.4497 -1.91% 1974 2.3375 -4.58% 1975 2.2124 -5.35% 1976 1.7969 -18.78% 1977 1.7443 -2.93% 1978 1.9176 9.93% 1979 2.1177 10.44% 1980 2.3239 9.74%

The Yen After Bretton Woods

Sterling After Bretton Woods

Exchange Rate Regimes Today Currently, current exchange rate regimes fall along a spectrum as represented by national government involvement in affecting (managing) their currency’s exchange rate. Very Little (if any) Involvement Active Involvement Forex Market is Determining Exchange rate Government is Managing or Pegging Exchange rate

Where are we Today in Terms of Exchange Rate Regimes? “Mixed” International Monetary System consisting of: Floating exchange rate regimes: Market forces determine the relative value of a currency. Managed (dirty float) rate regimes: Governments managing their currency’s value with regard to a reference currency. Market moves these currencies, but governments are managing the process and intervening when necessary. Pegged exchange rate regimes: Government fixes (links) the value of its currency relative to a reference currency. Fewer of these regimes than in the past.

Post Bretton Woods Summary Since March 1973, the major currencies of the world have operated under a floating exchange rate system. While central banks of these major countries have occasionally interviewed in support of their currencies, this intervention has become less over the years. The US last intervened in 1998. In addition to the major currencies of the world, a growing number of other developing country currencies have also moved to a floating rate system. Thus: more and more, market forces are driving currency values. The post Bretton Woods’ period has resulted exchange rates become much more volatile and , perhaps, less predictable then they were during previous fixed exchange rate eras. This currency volatility complicates the management of global companies.

Freely Floating Currencies by Country or Region, IMF data, 2006 Albania Congo, Dem. Rep. of Indonesia Uganda Australia Brazil Canada Chile Iceland Israel Korea Mexico New Zealand Norway Philippines Poland South Africa Sweden Turkey United Kingdom Tanzania Japan Somalia Switzerland United States Eurozone

Useful Web Sites Link to the history of foreign exchange regime changes of many countries. http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=8 Quarterly report on U.S. Intervention in foreign exchange markets http://www.ny.frb.org/markets/foreignex.html Go to archives, July 30, 1998 to view intervention activity.