International Monetary Systems Chapter 13 International Monetary Systems

Topics to be Covered The Gold Standard:1880–1914 The Interwar Period:1918–1939 The Bretton Woods System:1944–1973 Floating Exchange Rates: 1973-Present The Choice of an Exchange Rate System

International Monetary System (IMS) The IMS refers to the framework of institutions and rules within which international financial transactions are conducted and balance of payments imbalances are settled. Principal institutions of the IMS are the major commercial banks, central banks, and the International Monetary Fund.

History of International Monetary Systems The Gold Standard: 1880–1914 The Interwar Period: 1918–1939 The Bretton Woods System: 1944–1973 Today’s IMS: Since 1973

The Gold Standard: 1880–1914 The first IMS arose as countries pegged their currencies to the price of gold. Rules of the gold standard: Central banks fix the price of their currencies in terms of a gold equivalent, or mint parity price. Each participating country must be willing and ready to buy and sell gold to anyone at the fixed price. The mint parity never changes.

Mint Parity and Shipping Cost of Gold The existence of shipping costs creates a price ceiling and price floor on foreign exchange. See Figure 13.1. Gold Export Point – the exchange rate or price ceiling at which a country experiences an official settlements balance deficit and loses gold. Gold Import Point – the price floor at which a country has a settlements surplus and gains gold.

Figure 13.1 Three Possible Foreign-Exchange Market Situations

Price-Specie Flow Mechanism Refers to the process by which a BOP imbalance self-corrects via international flows of gold and resultant price changes. A country with BOP surplus  gains gold  money supply and domestic prices go up country loses trade competitiveness. Opposite process happens in deficit country.

Solutions to BOP Disequilibria under a Gold Standard A country with a balance of payments deficit would experience net outflows of gold, thus reducing its money supply and, in turn, its prices. A country with a balance of payments surplus would have gold flowing in, raising its money supply and hence its prices. Falling prices in the deficit country would lead to increasing net exports, while the rising prices in the surplus country would reduce its net exports, eventually restoring BOP equilibrium.

Reasons for Stable Exchange Rates During Gold Standard IMS Central bankers used monetary policy to maintain mint parities. Currency traders engaged in stabilizing speculation.

Interwar Period: 1918–1939 World War I effectively ended the gold standard. Europe experienced inflation during and after the war so restoration of the gold standard at the old exchange values was not possible. The U.S. experienced little inflation and returned to the gold standard in 1919 at the old parity. At a 1922 conference, a gold exchange standard was proposed using both gold and government bonds as international reserves.

Interwar Period (cont.) In 1925, England returned to the gold standard despite inflation. In 1931, Britain suspended its ties to gold, followed by the U.S. in 1933. Whether countries’ attempts at fixing exchange rates led to the depression years of the 1930s, or whether the depression led to the collapse of the gold standard is unclear.

The Bretton Woods System: 1944–1973 An international conference in Bretton Woods, New Hampshire, in 1944 led to the creation of the World Bank and the International Monetary Fund (IMF). To participate in the Bretton Woods system, a country had to join the IMF and declare a par value for its currency in terms of the U.S. dollar. If Mexico has an excess demand for dollars, it should supply the dollars from its international reserves, or sell gold to the U.S. in exchange for dollars (at fixed price of $35 per ounce), or borrow funds from the IMF. Refer to Figure 13.2.

Figure 13.2 Three Possible Foreign-Exchange Market Situations

Rules of the IMF Each member country has to pay a quota depending on the size of its economy and importance in world trade. One quarter of the quota is paid in gold or dollars, and the rest in country’s currency. A country has automatic borrowing rights. IMF can impose policy conditions on borrowing countries (IMF conditionality).

Gold Standard vs. Bretton Woods In both systems, the exchange rate has limited flexibility around a par value. Under gold standard, the par value is immutable (central banks maintain a constant mint parity). Under Bretton Woods system, a member country can change its par value by up to 10% without IMF approval.

Devaluation vs. Revaluation Devaluation is an increase in the official price of foreign money under a fixed exchange rate system. Revaluation is a decrease in the official price of the foreign money.

Destabilizing Speculation Destabilizing speculation or run on a currency occurs when speculation activity forces the equilibrium exchange rate farther away from its par value.

End of Bretton Woods System Large U.S. balance of payments deficits and the consequent gold outflows as well as the unwillingness of major trading partners to realign currency values led to suspension of U.S. gold sales in 1971 and the end of fixed exchange rates. See Figure 13.3.

Figure 13.3 U.S. Official Gold Holdings: 1950-1980

End of Bretton Woods (cont.) In 1971, an international conference in Washington led to the Smithsonian Agreement which raised the gold exchange value from $35 to $38 and also revalued the currencies of surplus countries. Problems persisted leading to further dollar devaluation. By early 1973, the Bretton Woods system collapsed and all major currencies were floating.

Today’s International Monetary System: 1973-Present Today, different countries follow different exchange rate arrangements. See Table 13.1. The different exchange rate arrangements are classified as: - hard pegs - soft pegs - floating arrangements

Table 13.1 De Facto Exchange Rate Agreements (as of July 31, 2007)

Table 13.1 De Facto Exchange Rate Agreements (as of July 31, 2007) (cont.)

Table 13.1 De Facto Exchange Rate Agreements (as of July 31, 2007) (cont.)

Table 13.1 De Facto Exchange Rate Agreements (as of July 31, 2007) (cont.)

Table 13.1 De Facto Exchange Rate Agreements (as of July 31, 2007) (cont.)

Table 13.1 De Facto Exchange Rate Agreements (as of July 31, 2007) (cont.)

Table 13.1 De Facto Exchange Rate Agreements (as of July 31, 2007) (cont.)

Hard Pegs No separate legal tender— another country’s currency circulates as legal tender. Currency board arrangements—domestic currency is basked by government holdings of foreign currency in fixed proportions.

Soft Pegs Conventional fixed peg – currency fluctuates within band of no more than ±1% of par. Horizontal band – currency fluctuates within margins of more than ±1% of par. Crawling peg – currency fluctuates in a band ±1% of par, but par is adjusted periodically. Crawling band – currency fluctuates in a band of more than ±1% of par, but par is adjusted periodically.

Floating Arrangements Managed floating— the exchange rate follows no predetermined path, but the central bank intervenes in the foreign exchange market with no path or target. Independently floating—the rate is market-determined with limited intervention.

Country Exchange Rate Arrangements Half of IMF member countries use some form of fixed exchange rate policy. Most countries with floating exchange rates also manage their floats. Only 23 countries have market-determined exchange rates.

International Monetary Fund (IMF) Currently, IMF has 187 member countries. The IMF provides short-term loans, technical assistance, and training. The IMF has teams of economists specializing in various economic regions of the world.

The European Monetary System In 1970s, European Union countries fixed their currencies within a band of ±2.25% between the values of the strongest and weakest EU currencies. The European Monetary System (EMS) was established in 1979 to maintain currency values within a 2.25% band relative to the European Currency Unit (ECU).

Maastricht Treaty of 1991 Called for formation of a common currency (euro) and a European Central Bank Identified convergence criteria for members: Domestic inflation rates no more than 1.5% higher than the lowest three member countries. Long-term government bond interest rate no more than 2% higher than that of the three lowest inflation rate countries. Government deficit no more than 3% of GDP. Government debt no more than 60% of GDP.

The Euro The euro made its debut on January 1, 1999. Euro notes and coins began to circulate on January 1, 2002. Currently, the United Kingdom, Denmark, Czech Republic, Hungary, Poland, and Sweden have not adopted the euro. See Table 13.2 for Eurozone members’ conversion rates.

Table 13.2 Euro Conversion Exchange Rates

Table 13.2 Euro Conversion Exchange Rates (cont.)

Country Factors and Choice of Exchange Rate System Country size—Large countries tend to be less willing to subjugate own domestic policies to maintain a fixed rate system. Openness—More open economies tend to follow a pegged exchange rate to minimize foreign shocks, while closed economies prefer the floating rate. Inflation rate—Countries with more harmonious or stable inflation rates will prefer fixed exchange rates. Trade pattern – A country whose exports are concentrated based on trading partners or export types will maintain a fixed exchange rate.

Table 13.3 Characteristics Associated with Countries Choosing to Fix or Float

Floating vs. Fixed Exchange Rate System An argument in favor of flexible exchange rates is that a country can follow domestic macroeconomic policies (particularly monetary policy) independent from other countries. Another argument in favor of a flexible exchange rate system is that it minimizes unexpected fluctuations in the domestic economy (ex., prices).