1. Chapter two The International Monetary System Chapter Objective:  This chapter serves to introduce the student to the institutional framework within which: –International payments are made. –The movement of capital is accommodated. –Exchange rates are determined.

2.  Evolution of the International Monetary System  Current Exchange Rate Arrangements  Euro and the European Monetary Union  Fixed versus Flexible Exchange Rate Regimes Chapter Two Outline

3. Evolution of the International Monetary System  Bimetallism: Before 1875  Classical Gold Standard: 1875-1914  Interwar Period: 1915-1944  Bretton Woods System: 1945-1972  The Experience of the Floating Exchange Rates, 1973-Present

4. Bimetallism: Before 1875  A “double standard” in the sense that both gold and silver were used as money.  Some countries were on the gold standard, some on the silver standard, some on both.  Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents.  Gresham’s Law implied that it would be the least valuable metal that would tend to circulate.

5. Classical Gold Standard: 1875-1914  During this period in most major countries: –Gold alone was assured of unrestricted coinage –There was two-way convertibility between gold and national currencies at a stable ratio. –Gold could be freely exported or imported.  The exchange rate between two country’s currencies would be determined by their relative gold contents.

6. For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: Classical Gold Standard: 1875-1914 $30 = £6 $5 = £1

7. Classical Gold Standard: 1875-1914  Misalignment of exchange rates were corrected by cross-border flows of gold.  International imbalances of payment were automatically corrected by the price-specie-flow mechanism.  Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment.

8. Price Specie-Flow Mechanism (Hume David ) deficit Gold outflo w Money supply decreas e Price level decrease Export increase, import decrease surplus Gold inflo w Money supply increase Price level increase Export decreas e, import increase Internati onal imbalanc e corrected

9. Classical Gold Standard: 1875-1914  There are shortcomings: –The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. –Even if the world returned to a gold standard, any national government could abandon the standard.

10. Interwar Period: 1915-1944!!  Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market!!  Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”.!!  The result for international trade and investment was profoundly detrimental.

11. Bretton Woods System: 1945-1972  Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire.  The purpose was to design a postwar international monetary system.  The goal was exchange rate stability without the gold standard (save gold).  The result was the creation of the IMF and the World Bank.

12. Bretton Woods System: 1945-1972  The Bretton Woods system was a dollar-based gold exchange standard. The US dollar was fixed at $35 per ounce of gold. Other currencies would establish a par value against the dollar and maintain the exchange rate within 1% around the par value. For example, the British pound was fixed at an official par value of $2.80/ ￡ and was allowed to fluctuate between $2.778/ ￡ and $2.828/ ￡. The US dollar was fixed at $35 per ounce of gold. Other currencies would establish a par value against the dollar and maintain the exchange rate within 1% around the par value. For example, the British pound was fixed at an official par value of $2.80/ ￡ and was allowed to fluctuate between $2.778/ ￡ and $2.828/ ￡.  US dollar is used as the intervention currency and keep official reserves in US Treasury bonds.  Permit free convertibility of currencies for current transactions.  A new institution, the International Monetary Fund (IMF)would be established. Its major purpose would be to maintain the fixed exchange rate system by lending foreign exchange to its member countries.  A member would be change its par value only if its balance of payments was in fundamental disequilibrium and only with IMF approval.

13. The Breakdown of Bretton Woods  In order to succeed, a regime of fixed exchange rates requires coordinated economic policies, especially monetary policies. By the end of 1960s, both DM and Japanese Yen had become undervalued against the USD. As a result, the US trade balance and current account balance deteriorated sharply.  The stage was set for a dramatic change. On August 15, 1971, President Richard Nixon closed the gold window, suspending purchases or sales of gold by US Treasure at the official rate.  In December 1971, Group of Ten reached the Smithsonian Agreement to set a new set of exchange rate parities and return to pegging. The dollar was devalued to $38 per ounce of gold. But this agreement met with limited success.  In June 1972, the Bank of England allowed its pound to float. SF was allowed to float in January 1973. The currency market were in crisis as fixed exchange rates were no longer considered defensible.

14. Triffin paradox  Under the gold-exchange system, the reserve- currency country should run balance-of-payments deficits to supply reserve, but they can lead to a crisis of confidence in the currency, causing the downfall of the system.  The Bretton woods system collapse in 1973 mainly because of U.S domestic inflation and the persistent balance-of-payments deficits

15. Jamaica Agreement, January 1976  Floating rates declared acceptable.  Gold demonetized as a reserve asset  IMF quotas increased

16. The Flexible Exchange Rate Regime: 1973-Present. Jamaica Agreement, January 1976  Flexible exchange rates were declared acceptable to the IMF members. –Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities.  Gold was abandoned as an international reserve asset.  Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

17. The Experience of the Floating Exchange Rates, 1973- Present  Oil Crisis,1973-1974 OPEC imposed oil embargo, eventually quadrupling the world oil price OPEC imposed oil embargo, eventually quadrupling the world oil price  US dollar Depreciation, 1977-1978 US inflation rose sharply, causing continued depreciation of the US dollar US inflation rose sharply, causing continued depreciation of the US dollar  European Monetary System, March 1979 EMS was created, establishing a cooperation exchange rate system for participating members of the EEC EMS was created, establishing a cooperation exchange rate system for participating members of the EEC  International Debt Crisis, August 1982 Mexico announced that it would not be able to make debt service payment; Brazil and Argentina followed in months. Mexico announced that it would not be able to make debt service payment; Brazil and Argentina followed in months.  Rise of the US dollar, 1982-1985 The dollar continued to rise, hitting record highs against the DM and other European currencies by February 1985. The strong dollar caused US export firms to lose international competitiveness and the US trade balance deteriorated. The dollar continued to rise, hitting record highs against the DM and other European currencies by February 1985. The strong dollar caused US export firms to lose international competitiveness and the US trade balance deteriorated.

18. The Experience of the Floating Exchange Rates, 1973- Present(cont’d)  Plaza Agreement, September 1985 Group of Five(Britain, France, West Germany, Japan and US)decided to jointly intervene to weaken the dollar; the agreement sent a clear signal to the markets that the major central banks were willing to intervene in a coordinated effort to influence exchange rate Group of Five(Britain, France, West Germany, Japan and US)decided to jointly intervene to weaken the dollar; the agreement sent a clear signal to the markets that the major central banks were willing to intervene in a coordinated effort to influence exchange rate  Louvre Accords, February 1987 Exchange rate target zones or ranges were established and the central banks agreed to defend them using active foreign exchange intervention, though the exact target zones were never published Exchange rate target zones or ranges were established and the central banks agreed to defend them using active foreign exchange intervention, though the exact target zones were never published Treaty of Marstricht, 1991 Treaty of Marstricht, 1991  EMS Crisis, September 1992 High German interest rates induced massive capital flows into Germany and DM- denominated assets, eventually causing the withdrawal of the Italian Lira and British pound from the EMS’s Exchange Rate Mechanism(ERM) High German interest rates induced massive capital flows into Germany and DM- denominated assets, eventually causing the withdrawal of the Italian Lira and British pound from the EMS’s Exchange Rate Mechanism(ERM)

19. The Experience of the Floating Exchange Rates, 1973-Present(cont’d)  Mexican Peso Crisis, December 1994 Mexican Peso suffered major devaluation as a result of increasing pressure on the managed devaluation policy; the peso’s collapse led to a fall in most major Latin American exchange rates. Mexican Peso suffered major devaluation as a result of increasing pressure on the managed devaluation policy; the peso’s collapse led to a fall in most major Latin American exchange rates.  Yen Peaks, August 1995 The Yen reached an all-time high versus the US dollar at Yen 79/USD The Yen reached an all-time high versus the US dollar at Yen 79/USD  Asian Currency Crisis, 1997  Euro launched, January1,1999  Euro coinage introduced, January 2002

20. Current Exchange Rate Arrangements  1. Independent Floating The exchange rates are determined by the market. However, no floating is truly free. Government may intervene in the foreign exchange market when necessary. The exchange rates are determined by the market. However, no floating is truly free. Government may intervene in the foreign exchange market when necessary.  2. Managed Floating The governments influence the movements of the exchange rates through active intervention in the foreign exchange market without specifying a pre- announced path for the exchange rate. A government may manipulate its exchange rates such that its own country benefits at the expense of others. The governments influence the movements of the exchange rates through active intervention in the foreign exchange market without specifying a pre- announced path for the exchange rate. A government may manipulate its exchange rates such that its own country benefits at the expense of others.  3. Crawling Bands or Pegs The currency is maintained with certain fluctuation margins around a central rate that is adjusted periodically at a fixed pre-announced rate. The currency is maintained with certain fluctuation margins around a central rate that is adjusted periodically at a fixed pre-announced rate.  4. Fixed Peg The currency is pegged to a major currency such as the US dollar or euro at a fixed rate, where the exchange rates are allowed to fluctuate within a narrow boundary around the central rate. The currency is pegged to a major currency such as the US dollar or euro at a fixed rate, where the exchange rates are allowed to fluctuate within a narrow boundary around the central rate.

21. Some Special Arrangements(1)  Currency Board Currency board represents a very strict pegged exchange rate arrangement. For example, the Hongkong dollar has been strictly pegged to the US dollar at HK$7.8/USD since 1983. A currency board requires that every HKD to be issued by the gold or the USD. Argentina had tied the value of its peso to the USD(1 peso= 1 dollar) since 1991, but allowed peso to float in 2002. Currency board represents a very strict pegged exchange rate arrangement. For example, the Hongkong dollar has been strictly pegged to the US dollar at HK$7.8/USD since 1983. A currency board requires that every HKD to be issued by the gold or the USD. Argentina had tied the value of its peso to the USD(1 peso= 1 dollar) since 1991, but allowed peso to float in 2002. A country that uses a currency board does not have complete control over its local interest rates, as the rates must be aligned with the interest rates of the currency to which the local currency is tied. Note that the two interest rates may not be exactly the same because of different risk. A country that uses a currency board does not have complete control over its local interest rates, as the rates must be aligned with the interest rates of the currency to which the local currency is tied. Note that the two interest rates may not be exactly the same because of different risk.

22. Some Special Arrangements(2)  European common currency for 12 European nations In 1991, the Maastricht treaty called for a single European currency. On Jan 1,1999, the euro was adopted by Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. Greece joined the system in 2001. On Jan 1,2002, the national currencies of the 12 participating countries were withdrawal and completely replaced with the euro. In 1991, the Maastricht treaty called for a single European currency. On Jan 1,1999, the euro was adopted by Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. Greece joined the system in 2001. On Jan 1,2002, the national currencies of the 12 participating countries were withdrawal and completely replaced with the euro.  Dollarization Dollarization refers to the replacement of a local currency with the US dollars. Dollarization goes beyond a currency board, as the country no longer has a local currency. For example, Ecuador implemented dollarization in 2000. Dollarization refers to the replacement of a local currency with the US dollars. Dollarization goes beyond a currency board, as the country no longer has a local currency. For example, Ecuador implemented dollarization in 2000..

23. Fixed versus Flexible Exchange Rate Regimes  Arguments in favor of flexible exchange rates: –Easier external adjustments. –National policy autonomy.  Arguments against flexible exchange rates: –Exchange rate uncertainty may hamper international trade. –No safeguards to prevent crises.