Economics of International Finance Econ. 315 Chapter 6: The International Monetary System: Past, Present and Future

I. Overview International Monetary System: Refers to rules, customs, instruments, facilities and organizations for affecting international payments. It can be classified according to: 1- The exchange rate system: - Fixed with narrow band (Bretton Woods) - Fixed with wide band - Adjustable peg - A crawling peg - A managed floating - A freely floating 2- International reserves : - Gold standard (only gold) - Pure fiduciary (paper currency only) - Gold& exchange standard (a combination of the two)

These two classifications can be combined in various ways, e.g., Note : These two classifications can be combined in various ways, e.g., - Fixed exchange rate without gold (e.g., using $ instead as reserves) - Adjustable peg ( or managed float) with gold and foreign exchange, or foreign exchange only. But note that (theoretically) under freely floating system there will be no need for reserves to adjust BOP. A good international monetary system: A system that: Maximizes the flow of world trade and investment Guarantees an equitable distribution of the gains from trade among the nations. The international monetary system can be evaluated in terms of: Adjustment; correct for BOP disequilibria. Liquidity; provide adequate reserves to nations to correct BOP deficits without a need to devalue their currencies. Confidence; the adjustment mechanism works adequately and international reserves retain their absolute (quantity) and relative values (no or very limited devaluations).

II. The Gold Standard & the Interwar Experience A- The Gold Standard Period (1880-1914) Each nation defines the gold content of its currency (mint parity) Stands ready to buy or sell any amount of gold at that price (mint parity) Exchange rate could fluctuate within the gold points (gold export and import points) by demand and supply forces. The tendency of the currency to depreciate (past the gold export point), will be halted by gold outflows, which represent the deficit of the nation. The tendency of the currency to appreciate (past the gold import point) will be halted by gold inflows, which represent the surplus of the nation.

B. The Adjustment Mechanism Under the Gold Standard: The automatic price-specie-mechanism (PSM) , explained by David Hume as follows: The nation’s money supply is composed of gold or paper currency backed by gold. Money supply will fall in the deficit nation (prices will fall) and rise in the surplus nation (price will rise) – remember the quantity theory. Exports of the deficit nation would be encouraged and its imports discouraged until deficit is eliminated. The opposite in the surplus nation. The money supply will change for BOP considerations. Therefore the country will not have a monetary policy to achieve full employment without inflation. This is a basic classical hypothesis.

- For the system to operate, the nations are not supposed to sterilize (neutralize) the effect of a BOP deficit (by expanding the credit D) or surplus (by restricting credit D) on the nations money supply. Rules of the game indicates that the deficit nation should reinforce the adjustment process by restricting credit, and the surplus country to further expand credit. - Taussige in the 1920s found that the adjustment process worked much too quickly and smoothly with little, if any, gold transfers. Why? BOP disequilibria are adjusted by capital flows not gold shipments. A deficit nation will have lower money supply  higher interest rates  capital inflows to cover the deficit. - A supporting condition for the system was due to the special conditions in the world because of great economic growth and stability in almost all the nations during this era.

C- The Interwar Experience The gold standard ended by the outbreak of the WWI. During 1914-1924, exchange rates fluctuated widely and there was a desire to return to stability. The United Kingdom: In 1925 the UK returned back to the gold standard at the prewar price, as well as other nations. The system was more of a gold-exchange standard, than pure gold standard, where gold and other convertible currencies (£, $ and FFR) are used. This economizes the use of gold which supply has become a smaller percentage of the world trade (not enough gold to finance deficits). Losing much of its competitiveness, the UK liquidated most of its international investments to reestablish the pound PPP, the pound was relatively overvalued which led to BOP deficits and deflation.

France: Faced large BOP surplus after the stabilization of the Franc. Seeking to make Paris an international financial center, France decided to settle its BOP surplus in gold rather than pounds, This put more pressures on the gold reserves of the UK, such that the latter decided in 1931 to suspend converting the pound into gold, devalued the pound and the gold-exchange standard came to an end.

Why the system collapsed? Lack of adequate adjustment mechanism as nations sterilized the effect of BOP disequilibria in the face of inappropriate practices. The huge destabilizing capital flows between London and the emerging international monetary centers in Paris and New York. The outbreak of the Great Depression in 1929. Form 1931-1936 there was great instability as each nation tried to “export” its unemployment (devaluation race). The US devalued the US$ from $20.67 to 35$ an ounce of gold (75%) to stimulate exports. By 1936 exchange rates among major currencies were the same as 1930, due to the devaluation race. The value of gold reserves increase and most foreign exchange reserves were eliminated by mass conversions into gold to protect against devaluation. Nations also impose very high tariffs and other serious import restrictions and international trade was cut almost in half.

III. The Bretton Woods System The Gold standard 1947-1971: A. Establishment of the IMF to: Overseeing the nations followed the rules of conduct in international trade and finance. Providing borrowing facilities for nations in temporary BOP difficulties. B. The Bretton woods was a gold-exchange standard. The following were the rules of the system The USA The US was to maintain the price of gold fixed at $ 35 an ounce The US stands ready to exchange dollars for gold at that price without restrictions or limitations.

Other Nations Fix the rate of their currencies in terms of the dollars. (thus implicitly in terms of the gold). Intervene in foreign exchange markets to keep the exchange rate from moving by more than 1% above or below the par value. Within the allowed band the exchange rate was determined by market forces. A nation would have to draw down its dollar reserves to purchase its own currency to prevent it from depreciation or purchase dollars to prevent an appreciation by more than the 1%. Therefore the $ was the intervention currency. Other nations finance their BOP deficits out of international reserves (gold and US dollars) or by borrowing from the IMF. Only in a case of fundamental disequilibrium (large and persistent) was a nation allowed, after the approval of the IMF to change the par value of its currency.

Borrowing from the IMF Upon joining the IMF each country is assigned a quota (of the IMF capital) based on its economic importance and value of its trade. Quota determines the country’s voting power and its ability to borrow from the fund. The nation will pay 25% of its quota in gold and the remainder in its own currency. In borrowing from the fund the nation would get convertible currencies and deposit an equivalent amounts of its own currency. Originally the nation could borrow its gold tranche (25%) automatically (and deposit its domestic currency). For other tranches (extra 25% each), the IMF charges higher interest rates, and imposed more supervision and conditions to ensure that the deficit nation is taken appropriate measures to eliminate the deficit. If the IMF hold less than 75% of a country’s currency, the country can borrow the difference without having to pay back its loan (known as the super gold tranche).

Operation of the Bretton woods system. Though the system allows for changes in the par value in cases of fundamental disequilibrium, industrial nations were reluctant to change the par value until they are forced (by destabilizing speciation) to do so (change occurs only under accumulating pressures).