Chapter 26: Learning Objectives The Bank for International Settlements: History & Operations The International Monetary Fund & World Bank: History and Operations European Institutions: EBRD, EMS & EMU The Workings of the EMS Target Zone

Why did International Financial Institutions Emerge? Began as a way of reducing the dangers associated with “beggar thy neighbour” policies Also, institutions were needed to coordinate post-war recovery and management of reparations The growth of international trade and capital movements also necessitated some international institutions

Bank for International Settlements Originally formed to deal with Germans reparations after WW I Became a forum for central bankers to discuss common issues Members include industrialized as well as other central banks representatives (25+ countries and growing) Managed by a Board which includes members from central banks and member countries Treasuries

BIS cont’d Activities include: Buying/selling of gold lending to member countries issuance and marketing of securities negotiate international financial agreements (e.g., BIS capital standards; CHAPTER 10) forum for discussion of international monetary issues

International Monetary Fund Outcome of post-war plans by the US and UK mainly Major goal was to improve financial coordination and avoid problems with the gold standard, namely deflation and lack of independence in monetary policy Member countries have voting rights roughly a function of the volume of trade in the world Created at Bretton Woods, NH, where the founders agreed to an “adjustable peg” system of exchange rates

The IMF Until Bretton Woods: A Chronology

IMF cont’d The BW system permitted a +/- 1% fluctuation in exchange rates around the “par” rate Devaluations permitted only if “chronic” BOP difficulties arose The US $ and UK £, along with gold, were the “reserve” currencies at first The “par” exchange rate was vis-à-vis the US $ and members could convert into $35/oz.

IMF cont’d BW was flawed because the system assumed the US would not inflate and that it would run a BOP deficit in perpetuity Germany, in particular, eventually had to revalue its currency continuously until it was no longer willing to do so The IMF is no stranger to controversy especially because of its “conditionality” programs Nixon took the US of the gold standard effectively ending BW

The Future of the IMF Most countries are adopting flexible exchange rates and full capital mobility, putting in question IMF’s mission International expectations for the IMF to ensure financial stability has increased, especially since the Mexican crisis and the Asian crisis of Should the IMF become an international lender of last resort? An international credit rating agency?

World Bank Created at the same time as the IMF to facilitate reconstruction and development through access to liquidity Borrows on the open market and makes different types of loans to developing countries Coordination with sister institution - the IMF - to monitor and assist in meeting conditionality requirements

The European Monetary System Organized with the ending of BW in 1972 Originally called the “snake” and consisted essentially of the Benelux, Germany, and France In 1979 renamed the EMS or ERM Member countries grew as the EC grew and eventually led to the Maastricht Treaty of Monetary Union in 1991 The EMS has essentially the same flaws as BW but is currently far more flexible (i.e., wider bands, more realignments)

Real Effective Exchange Rates in 5 EMS Countries

The Target Zone Model: Hypothetical Illustration Exchange rate TIME < realignment Target Zone Actual exchange rate Central parity

Franc/Deutschmark Exchange Rates

The EMS cont’d With Maastricht comes EMU or European Monetary Union In 1998, the members of EMU were announced (11 countries) EMU participants were thought to have satisfied the “convergence” requirements (inflation, interest rates, govt debt) The “Euro” was launched in 1999 while the European Central Bank was launched in 1998

Conversion rates to the Euro

European Central Bank Considered perhaps the most independent central bank in the world Its principal objective is price stability defined as inflation in “Euroland” < 2% To achieve its objective the ECB also monitors money growth and the exchange rate (two of the three “pillars” of monetary policy) The creation of the ECB has raised interest in currency unions, especially in Canada

Currency Unions What are the ideal determinants of a currency area? What is an optimum currency area? Labour mobility: allow movement to regions with greater labour demand Capital mobility: funds should be able to seek out highest available return for given risk Openness and regional interdependence: close trading relationship reduces need for separate currency Industrial and portfolio diversification: eases impact of shocks Wage and price flexibility: replaces the primary function of the exchange rate

Point Counterpoint: Should Canada drop its currency? POINT: Lower transactions costs Connection between fundamentals and exchange rate unclear Facilitates trade between countries More price competition Encourages labor mobility COUNTERPOINT: Transactions costs savings small BOC equation suggests that exchange rate is an important shock absorber Canada’s monetary policy pretty good Since NAFTA scope for price competition is small

Summary This chapter surveys international financial institutions The principal institutions are: BIS, IMF, World Bank The history of exchange rate arrangements since WW II is dominated by Bretton Woods and the EMS The 1990s see the ratification of the Maastricht Treaty of European Monetary Union The new ECB is created in 1998 with the Euro to be introduced in 1999 EMU has rekindled interest in currency unions