International Financial System The Gold Standard

Gold Standard  Currencies valued in terms of their gold equivalent  Mid 1870’s most major economies pegged to gold  All currencies linked together in a system of fixed exchange rates

Gold Standard Example  Currency A worth 0.10 ounce gold  Currency B worth 0.20 ounce gold  1 unit of B worth twice as much as 1 unit of A.

Gold Standard pros and cons  To achieve long run price stability  Prices may rise and fall with swings in gold output  National money supplies constrained by growth of stock of gold  As long as gold stock steady prices steady  Countries with balance of payments deficits outflows of gold, m s reduce.

The Interwar Period  WW 1 ended the gold standard  Europe experienced rapid inflation  USA little inflation so returned to gold standard in  War ended Britain’s financial preeminicence  USA World’s dominent banker country

Interwar Period  1930’s depression years.  Trying to stimulate domestic economies by increasing exports country after country had to devalue.  Period of competitive devaluations.  Run on US gold holdings at the end of  USA abandoned the gold standard.

The Gold Exchange Standard  Desire to reform the international monetary system led to an international conference at Bretton Woods, New Hampshire.  US dollar key currency in the system.  1$= 1/35 ounce gold.  Primary architects Harry White of US and Keynes of UK.

Bretton Woods  For countries experiencing difficulty maintaining their parity value new institution created.  The International Monetary Fund

International Monetary Fund  Headquartered in Washington D.C  Had 30 original member now 180.  Given the task of promoting the growth of world trade, setting rules for maintenance of fixed exchange rates.making loans to countries facing balance of payments difficulties.  Collecting and standardizing int economic data.

IMF  oversees the international monetary system  promotes exchange stability and orderly exchange relations among its member countries  assists all members--both industrial and developing countries--that find themselves in temporary balance of payments difficulties by providing short- to medium-term credits

IMF  supplements the currency reserves of its members through the allocation of SDRs (special drawing rights); to date SDR 21.4 billion has been issued to member countries in proportion to their quotas  draws its financial resources principally from the quota subscriptions of its member countries  has at its disposal fully paid-in quotas now totaling SDR 145 billion (about $215 billion)  has a staff of 2,300 drawn from 182 member countries

World Bank  seeks to promote the economic development of the world's poorer countries  assists developing countries through long-term financing of development projects and programs  provides to the poorest developing countries whose per capita GNP is less than $865 a year special financial assistance through the International Development Association (IDA)

World Bank  encourages private enterprises in developing countries through its affiliate, the International Finance Corporation (IFC)  acquires most of its financial resources by borrowing on the international bond market  has an authorized capital of $184 billion, of which members pay in about 10 percent  has a staff of 7,000 drawn from 180 member countries 

1960’s  In 1960 USA ; dollar crises due to run large balance of payments deficits  By the late 1960’s foreign dollar liabilities of USA much larger than the US gold stock.  Pressures of this dollar glut terminated Nixon declared 1971 dollar incovertible  Close to the Bretton Woods era fixed exchange rates and convertible currencies.

Transition Years  Dec 1971 Smithsonian agreement dollar devalued by about 8%, surplus countrie’s curriencies revalued upward.  June 1972 countries like Germany and Switzerland experiencing large inflows of speculative capital.  They applied legal control to slow further movements of money.

Transition Years  Dollar still inconvertible.  Speculative capital flows of 1972 further devaluation of dollar.  An ounce of gold rose from $38 to $42.2 still speculative capital flows from weak to strong curr persisted.  March 1973 major currencies began to float.

Floating Exchange Rates 1973-to the Present  System best described as managed float.  Exchange rate systems; Flexible (floating),Managed Floating, Fixed Exchange Rate Systems.

Exchange Rate Systems Floating -Flexible  Flexible (floating) ; Value of the currency determined by the market.  By the interactions of banks, firms other institutions.Seeking to buy, sell currency for purposes of transactions clearing, hedging, arbitrage and speculation  Most OECD countries, US, Canada, Britain, Australia, European Monetary Union.

Managed Float  Hybrid of fixed exchange rate and flexible exchange rate system.  Central Bank holds stocks of foreign currency.  Intervenes in forex market by buying and selling foreign currency to keep exch rate at desired implicit target values.

Fixed (Pegged) Exchange Rates  Prior to 1970’s most countries operated under fixed exchange rate system.  Exchange Rate of member countries fixed against US dollar, with the dollar in turn worth a fixed amount of gold.  Why exch rates kept fixed??????

Fixed Exch Rates  To facilitate trade  Reducing fluctuations in relative prices.  Reducing uncertainty

Adjustable Pegged Exchange Rate Crawling Peg  Central Bank fixes the value of the currency when it desires  Crawling peg ; Fixed exchange rate system where fixed rate changes in a pre-determined manner.

Floating Exchange Rates SDR  SDR’s are special international reserve assets created by IMF.  If trade is not heavily concentrated with USA diversified across several countries.  More sensible to alter the currency value to a weighted average of foreign currencies.

SDR  Some countries choose to peg to the SDR (special drawing rights)  A basket peg is choosen.  Basket of currencies consisting of yen, euro, sterling, dollar.(today)

The Choice Of an Exchange Rate System  Country size in terms of economic activity or GDP important for choosing floating or pegging exchange rates.  Large countries more independent, foreign trade constitutes smaller part of GDP..

Choice Of Exchange Rate System  Openess of economy ;  the degree to which country depends on international trade.  The greater the fraction of tradable goods in GDP the more open the economy will be.  The more open economy tends to follow a pegged exchange rate.

Choice of Exc Rate  Inflation rates ; Countries inflation experience above average tend to choose floating exch rates.  Where exch rate is adjusted at short intervals to compensate for inflation differentials.  Countries that trade with one single currency pegs their exchange rate to that currency.

Conclusion  Peggers ; small size, open economy,Harmonious inflation rate, concentrated trade.  Floaters; Large Size, Closed economy, Divergent inflation rate, diversified trade.