34 The International Monetary System: Order or Disorder? Cecily, you will read your Political Economy in my absence. The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational. MISS PRISM IN OSCAR WILDE’S THE IMPORTANCE OF BEING EARNEST The International Monetary System: Order or Disorder? Cecily, you will read your Political Economy in my absence. The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational. MISS PRISM IN OSCAR WILDE’S THE IMPORTANCE OF BEING EARNEST

●What Are Exchange Rates? ●Exchange Rate Determination in a Free Market ●Fixed Exchange Rates and the Balance of Payments ●A Bit of History: The Gold Standard and the Bretton Woods System ●What Are Exchange Rates? ●Exchange Rate Determination in a Free Market ●Fixed Exchange Rates and the Balance of Payments ●A Bit of History: The Gold Standard and the Bretton Woods System Contents Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

●Adjustment Mechanism Under Fixed Exchange Rates ●Why Try to Fix Exchange Rates? ●The Current “Nonsystem” ●Adjustment Mechanism Under Fixed Exchange Rates ●Why Try to Fix Exchange Rates? ●The Current “Nonsystem” Contents (continued) Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

●Exchange rate = price, in terms of one currency, at which another currency can be bought ●A currency appreciates when it becomes more expensive in terms of another; the other currency depreciates. ●Exchange rate = price, in terms of one currency, at which another currency can be bought ●A currency appreciates when it becomes more expensive in terms of another; the other currency depreciates. What are Exchange Rates?

TABLE 34-1 Exchange Rates with the U.S. Dollar Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

What are Exchange Rates? ●Appreciation and depreciation refer to exchange rate changes in free markets. ●In a system of fixed exchange rates, the corresponding movements are called revaluation and devaluation. ●Appreciation and depreciation refer to exchange rate changes in free markets. ●In a system of fixed exchange rates, the corresponding movements are called revaluation and devaluation.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●The exchange rate of a currency is determined by its supply and demand. Exchange Rate Determination in Free Market

FIGURE 34-1 Determination of Exchange Rates in a Free Market Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Number of Euros D D S S $0.90 Price of a Euro E

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Sources of demand: ♦A country’s exports ♦Foreign demand for its financial instruments like stocks and bonds ♦Capital inflow to acquire physical assets like factories and machines ●Sources of demand: ♦A country’s exports ♦Foreign demand for its financial instruments like stocks and bonds ♦Capital inflow to acquire physical assets like factories and machines Exchange Rate Determination in Free Market

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Sources of supply: ♦A country’s imports ♦Capital outflows for both financial and physical assets ●Sources of supply: ♦A country’s imports ♦Capital outflows for both financial and physical assets Exchange Rate Determination in Free Market

FIGURE 34-2 Stock Market Boom on the Exchange Rate Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Number of Euros D D S 1 S Price of a Euro (in dollars) $0.90 E S 2 S 2 A

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Exchange Rate Determination in Free Market ●Interest Rates and Exchange Rates: The Short Run ♦Massive amounts of liquid capital cross national boundaries in search of interest rate differentials. ♦Thus, a country that increases its interest rates will experience a capital inflow ■  demand for its bonds ■Appreciation of its currency ●Interest Rates and Exchange Rates: The Short Run ♦Massive amounts of liquid capital cross national boundaries in search of interest rate differentials. ♦Thus, a country that increases its interest rates will experience a capital inflow ■  demand for its bonds ■Appreciation of its currency

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Exchange Rate Determination in Free Market ●The Medium-Run: Economic Activity and Exchange Rates ♦A country’s imports will rise quickly when its economy booms, but rise only slowly when its economy stagnates. ●The Medium-Run: Economic Activity and Exchange Rates ♦A country’s imports will rise quickly when its economy booms, but rise only slowly when its economy stagnates.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Exchange Rate Determination in Free Market ●The Medium-Run: Economic Activity and Exchange Rates ♦Thus, a country with a relatively high growth rate will experience: ■  imports ■  demand for foreign currency ■Depreciation of its own currency ●The Medium-Run: Economic Activity and Exchange Rates ♦Thus, a country with a relatively high growth rate will experience: ■  imports ■  demand for foreign currency ■Depreciation of its own currency

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Exchange Rate Determination in Free Market ●The Purchasing-Power Parity Theory: The Long Run ♦Purchasing-power parity = exchange rates adjust so that the same good costs the same, whatever currency it is measured in ■Only applies over the long run ■Thus, the exchange rate should reflect differences in price levels ●The Purchasing-Power Parity Theory: The Long Run ♦Purchasing-power parity = exchange rates adjust so that the same good costs the same, whatever currency it is measured in ■Only applies over the long run ■Thus, the exchange rate should reflect differences in price levels

Deviations from Big Mac PPP, December 2001 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 34-3 The Effect of a Rise in U.S. Interest Rates Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Number of Pounds D 1 D 1 S 1 S Price of a Pound D 2 D 2 S 2 S 2 $1.60 E 1 E 2

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Exchange Rate Determination in Free Market ●Market Determination of Exchange Rates: Summary ♦Exchange rates will appreciate in countries whose: ■Inflation rates are lower than other countries’ ■Economic growth rates are slower ■Interest rates are higher ●Market Determination of Exchange Rates: Summary ♦Exchange rates will appreciate in countries whose: ■Inflation rates are lower than other countries’ ■Economic growth rates are slower ■Interest rates are higher

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Countries can maintain fixed exchange rates by buying or selling reserves. ♦Compensates for shifts in the demand or supply of their currencies ●Countries can maintain fixed exchange rates by buying or selling reserves. ♦Compensates for shifts in the demand or supply of their currencies Fixed Exchange Rates and the Balance of Payments

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Fixed Exchange Rates and the Balance of Payments ●With a fixed exchange rate, the balance of payments will likely be in either surplus or deficit. ●A deficit cannot be maintained forever since the country will run out of reserves. ●With a fixed exchange rate, the balance of payments will likely be in either surplus or deficit. ●A deficit cannot be maintained forever since the country will run out of reserves.

FIGURE 34-5 A Balance of Payments Deficit Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Balance of payments deficit 84 Billions of Pesos per Year D D S S 0.50 Price of a Peso 1.00 E AB

FIGURE 34-6 A Speculative Run on the Peso Copyright © 2003 South-Western/Thomson Learning. All rights reserved Billions of Pesos per Year D D S 1 S 1 Price of a Peso $1.00 B S 2 S 2 C A

FIGURE 34-7 A Balance of Payments Surplus Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Balance of payments surplus E AB 0.33 D S S 5040 Billions of Marks per Year D Price of a Mark $0.50

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Fixed Exchange Rates and the Balance of Payments ●Defining the Balance of Payments in Practice ♦The current account totes up exports and imports of goods and services. ■The United States has been running large current account deficits for years. ●Defining the Balance of Payments in Practice ♦The current account totes up exports and imports of goods and services. ■The United States has been running large current account deficits for years.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Fixed Exchange Rates and the Balance of Payments ●Defining the Balance of Payments in Practice ♦The capital account includes purchases and sales of financial assets to and from citizens and companies of other countries. ■In recent years, this part of our balance of payments accounts has registered persistently large surpluses, as foreigners have acquired U.S. assets. ●Defining the Balance of Payments in Practice ♦The capital account includes purchases and sales of financial assets to and from citizens and companies of other countries. ■In recent years, this part of our balance of payments accounts has registered persistently large surpluses, as foreigners have acquired U.S. assets.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Fixed Exchange Rates and the Balance of Payments ●Defining the Balance of Payments in Practice ♦In a system of floating exchange rates, the exchange rates adjust in order to balance the balance of payments. ♦In a system of fixed exchange rates, the balance of payments need not balance. ●Defining the Balance of Payments in Practice ♦In a system of floating exchange rates, the exchange rates adjust in order to balance the balance of payments. ♦In a system of fixed exchange rates, the balance of payments need not balance.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Gold Standard and the Bretton Woods System ●The Bretton Woods System ♦Readjustments in exchange rates were permitted only in cases of “fundamental disequilibrium.” ♦Deficit nations were expected to follow restrictive monetary and fiscal policies voluntarily just as they would have done automatically under the gold standard. ●The Bretton Woods System ♦Readjustments in exchange rates were permitted only in cases of “fundamental disequilibrium.” ♦Deficit nations were expected to follow restrictive monetary and fiscal policies voluntarily just as they would have done automatically under the gold standard.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Gold Standard and the Bretton Woods System ●The Bretton Woods System ♦However, just as under the gold standard, this medicine was often unpalatable. ♦The Bretton Woods system collapsed in 1971 in the face of the U.S. chronic balance of payments deficit. ●The Bretton Woods System ♦However, just as under the gold standard, this medicine was often unpalatable. ♦The Bretton Woods system collapsed in 1971 in the face of the U.S. chronic balance of payments deficit.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Under a system of fixed exchange rates, a country’s government loses some control over its domestic economy. Adjustment Mechanisms Under Fixed Exchange Rates

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●There may be times when balance of payments considerations force it to contract its economy even though domestic needs call for expansion ♦  AD ♦  demand for imports ♦  demand for foreign currency ●There may be times when balance of payments considerations force it to contract its economy even though domestic needs call for expansion ♦  AD ♦  demand for imports ♦  demand for foreign currency Adjustment Mechanisms Under Fixed Exchange Rates

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Adjustment Mechanisms Under Fixed Exchange Rates ●Conversely, there may be times when the domestic economy needs to be reined in, but balance of payments considerations suggest expansion.

FIGURE 34-8 Adjusting to Balance of Payments Deficits Copyright © 2003 South-Western/Thomson Learning. All rights reserved. (b) D D 1.00 Number of Pesos 0.50 S 1 S 1 (a) D 1 D Number of Pesos 0.50 S S Price of a Peso in Dollars D 2 D 2 ABC S 2 S 2 BCA

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Why Try to Fix Exchange Rates? ●Those in favor of fixed rates think that floating rates are so unpredictable that they reduce the amount of international trade. ●However, the experience with so-called “fixed rates” was that they were unpredictable and unstable. ●Those in favor of fixed rates think that floating rates are so unpredictable that they reduce the amount of international trade. ●However, the experience with so-called “fixed rates” was that they were unpredictable and unstable.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Why Try to Fix Exchange Rates? ●Speculation in foreign exchange markets smoothes out the highs and lows. ●Speculators can destabilize prices only if they are systematically willing to lose money. ●Consequently, floating rates are usually less variable than feared. ●Speculation in foreign exchange markets smoothes out the highs and lows. ●Speculators can destabilize prices only if they are systematically willing to lose money. ●Consequently, floating rates are usually less variable than feared.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Current “Nonsystem” ●Currently, some exchange rates are fixed and some are floating. ●Few people think that rates can or should be fixed for a long time. ●Even in the case of floating rates, central banks often intervene. ●Currently, some exchange rates are fixed and some are floating. ●Few people think that rates can or should be fixed for a long time. ●Even in the case of floating rates, central banks often intervene.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Current “Nonsystem” ●Today, gold is a purely private commodity. ♦Has virtually no role in international finance ●Today, gold is a purely private commodity. ♦Has virtually no role in international finance

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Current “Nonsystem” ●The Role of the IMF ♦The role of the International Monetary Fund (IMF) in the current non-system is quite different from what it was under the old Bretton Woods system. ■No longer the policeman of fixed exchange rates ■IMF has evolved into a general-purpose international fire-and-rescue squad ●The Role of the IMF ♦The role of the International Monetary Fund (IMF) in the current non-system is quite different from what it was under the old Bretton Woods system. ■No longer the policeman of fixed exchange rates ■IMF has evolved into a general-purpose international fire-and-rescue squad

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Current “Nonsystem” ●The Volatile Dollar ♦The U.S. dollar depreciated in 1977 and 1978 ♦Appreciated sharply from 1980 through 1985 ♦Depreciated even more sharply from 1985 to 1988 ♦Fluctuated without much trend since then ●The Volatile Dollar ♦The U.S. dollar depreciated in 1977 and 1978 ♦Appreciated sharply from 1980 through 1985 ♦Depreciated even more sharply from 1985 to 1988 ♦Fluctuated without much trend since then

FIGURE 34-9 The Ups and Downs of the Dollar Copyright © 2003 South-Western/Thomson Learning. All rights reserved Years Exchange Rate

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Current “Nonsystem” ●The Birth of the Euro ♦As part of the long-range goal of the European Union (EU) to create a unified market like that of the U.S., the EU perceived a need to establish a single currency for all member countries--a monetary union. ●The Birth of the Euro ♦As part of the long-range goal of the European Union (EU) to create a unified market like that of the U.S., the EU perceived a need to establish a single currency for all member countries--a monetary union.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Current “Nonsystem” ●The Birth of the Euro ♦Since January 1999, electronic and checking transactions in eleven of the fifteen EU nations have been denominated in euro rather than in national currencies. ●The Birth of the Euro ♦Since January 1999, electronic and checking transactions in eleven of the fifteen EU nations have been denominated in euro rather than in national currencies.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Current “Nonsystem” ●The Birth of the Euro ♦Three member nations (the United Kingdom, Sweden, and Denmark) have decided to opt out of the common currency project for now. ♦One country (Greece) has so far been unable to qualify because its inflation rate and budget deficit are too high. ●The Birth of the Euro ♦Three member nations (the United Kingdom, Sweden, and Denmark) have decided to opt out of the common currency project for now. ♦One country (Greece) has so far been unable to qualify because its inflation rate and budget deficit are too high.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Current “Nonsystem” ●The Birth of the Euro ♦In the year 2002, euro coins and paper money are scheduled to be introduced. ♦Then French francs, German marks, Italian lira, and at least eight other national currencies will be withdrawn from circulation--and will become relics of the past. ●The Birth of the Euro ♦In the year 2002, euro coins and paper money are scheduled to be introduced. ♦Then French francs, German marks, Italian lira, and at least eight other national currencies will be withdrawn from circulation--and will become relics of the past.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Current “Nonsystem” ●The Birth of the Euro ♦The establishment of the euro marks a giant step beyond fixed exchange rates. ■Abolishes exchange rates among the participating nations ■Just as there has long been no exchange rate between New York and New Jersey, there is now no exchange rate between Germany and France. ●The Birth of the Euro ♦The establishment of the euro marks a giant step beyond fixed exchange rates. ■Abolishes exchange rates among the participating nations ■Just as there has long been no exchange rate between New York and New Jersey, there is now no exchange rate between Germany and France.