Lecture 21 International Monetary System Exchange Rate Systems Floating Rate System vs Fixed Exchange Rate Systems Brief History The Eurocurrency Market

Lecture 22 Exchange Rate Systems Classifications of exchange rate systems The IMF’s classification More Flexible Systems Limited Flexibility Systems Pegged systems An economist’s classification Floating Exchange Rate Systems Fixed Exchange Rate Systems

Lecture 23 Exchange Rate Systems cont’d Floating (Flexible) Exchange Rate Systems  Exchange rates determined by forces of demand and supply Demand for local currency Supply of local currency Depreciation and Appreciation  Movements in Exchange Rates correct BOP deficits or surpluses no need for external adjustment mechanism E.g. U.K in deficit against U.S => £ in excess supply => £ falls in value => Export cheaper Import expensive => Deficit eliminated D1 D0 S$/£ £

Lecture 24 Exchange Rate Systems cont’d Fixed Exchange Rate Systems  Exchange Rates Determined by Governments (Central Banks) Devaluation and Revaluation  Involve mechanisms to Correct Deficits or Surpluses in BOP Illustration of a price adjustment Mechanism Because exchange rate is not allowed to affect prices, government attempts to influence price levels Deficit requires decreasing money supply - reducing general price level Surplus requires increasing money supply - increasing general price level E.g. U.K. £ in a dollar standard exchange rate system. Say U.K. has deficit against U.S. Deficit requires buying local currency (decreasing money supply) Surplus requires selling local currency (increasing money supply) => £ in excess supply => U.K. buys £ in currency market => general price level in U.K. falls => deficit reduced => Speculation: Keep track of reserve (in currencies) - devaluation likely if country keeps losing reserve

Lecture 25 Exchange Rate Systems cont’d Advantages of Floating Rate Systems  Better adjustment for BOP imbalances  Insulates countries from changes in inflation, wage levels and unemployment in other countries  Independence of Monetary and Fiscal Policies  Better Liquidity No need to hold foreign exchange reserve  No need defending inappropriate exchange rate Disadvantage of Floating Rate Systems  Increased volatility of exchange rate foreign exchange risk  Inflationary

Lecture 26 Exchange Rate Systems cont’d Contemporary Currency Arrangements  Exchange arrangement (e.g. the Euro area) Dollarization  Pegged to a Currency (to dollar, FF, etc. ) - about 62 countries  Pegged to a Basket of Currencies (e.g. to the SDR) SDR (Special Drawing Right) - a unit of account created by IMF weighted value of currencies of 5 IMF countries with largest trade 39% U.S Dollar; 21% German Mark; 18% Japanese Yen; 11% FF; 11% British Pound  Flexible against a Single Currency  Managed Float Predominately market forces; Gov’t intervene to maintain “order”  Independently Floating

Lecture 27 Major Exchange Rate Agreements  1944 Bretton Woods Conference  1971 Smithsonian Agreement  1972 European Joint Float Agreement  1976 Jamaica Agreement  1979 European Monetary System (EMS) created  1985 Plaza Accord  1987Louvre Accord  1991Treaty of Maastricht

Lecture 28 Major Exchange Rate Agreements 1944 Bretton Woods Conference  The U.S. dollar is convertible into gold at $35/ounce  Other currencies pegged to the dollar  Created IMF and World Bank 1971 Exchange rate turmoil  dollar falls off the gold standard  most currencies begin to float on world markets 1971 Smithsonian Agreement (Group of Ten)  dollar devalued to $38/oz of gold  other currencies revalued against the dollar  4.5% band adopted 1972 European Joint Float Agreement  “The snake” adopted by EEC

Lecture 29 Major Exchange Rate Agreements 1976 Jamaica Agreement  Floating rates declared “acceptable” 1979 European Monetary System (EMS)  European Exchange Rate Mechanism (ERM) established to maintain currencies within a 2.25% band around central rates  European currency unit (ECU) created 1985Plaza Accord (Group of Ten)  The Group of Ten form an agreement to cooperate in controlling volatility and bringing down the value of the dollar 1987 Louvre Accord  The Group of Five agree to maintain current levels

Lecture Treaty of Maastricht  European community members agree to pursue a broad agenda of economic, financial and monetary reforms  A single European currency is proposed as the ultimate goal of monetary union 1999Introduction of the euro  Emu-zone currencies are pegged to the euro  European bonds convert to the euro 2002The euro begins public circulation

Lecture 211 Eurocurrency market Eurocurrency: bank deposits or loans residing outside of the country issuing the currency. E.g. Eurodollars: dollar denominated deposits residing in non-U.S. banks.  Few regulations No reserve requirements, No interest rate regulations or caps, No withholding taxes, No deposit insurance requirements, or credit allocation regulations; Less stringent disclosure requirements  Low risk Relatively short maturities: Maturities of less than 5 years Low interest rate risk: Interest rates tied to a variable rate base such as the London Interbank Offer Rate (LIBOR) Low default risk: Traded between large commercial banks, investment banks and multinational corporations  Highly competitive Daily volume of several hundred billion dollars ensures competitive bid and offer prices

Lecture 212 Spreads in domestic and Eurocurrency credit markets