1. Exchange Rate Systems; Past, Present, and Future FIN 40500: International Finance

2. The evolution of the international financial structure is really an extension of the evolution of domestic monetary systems Recall that money must satisfy three basic properties: Unit of Account Store of Value Medium of Exchange One US Dollar = 0.056 ounces of Gold Initially, currencies were defined as standardized weights of metal Paper currency was initially a proxy for the underlying metal Nixon removed dollar convertibility completely in 1971 – the beginning of the current international system! Price of Gold = $17.86 per ounce

3. Households choose money holdings based on income, interest rates and prices In the long run, the price level equates supply and demand During the days of commodity money (i.e. gold coins), the money supply was essentially fixed.

4. One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold! When gold production outpaces economic growth (which drives money demand), prices rise.

5. One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold! However, when gold production cant keep up with economic growth, prices must fall.

6. One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold! During the late 1800s to the early 1900s, US growth averaged around 3% per year REAL GDP PER CAPITA (000s)

7. Gold Discovered at Sutters Mill, CA – California gold rush begins New mining technologies rapidly increase gold production One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold!

8. Correspondingly, we had severe deflation followed by severe inflation!!

9. American ships set sail for England – loaded with gold to buy British goods (US Imports = Outflow of gold) British ships sail to the US with gold to buy American goods (US Exports = Inflow of gold) International trade will dictate the international flow of gold.

10. If the US runs a trade deficit with Britain, then gold is flowing out of the US and into Britain US prices fall relative to British prices which reduces the trade deficit Note: the exchange rate is fixed at 1!!

11. AssetsLiabilities Individual deposits $100 worth of gold $100 As early as 1600, paper money began to be used as a proxy for gold. Reserve Ratio = 100% Bank issues $100 worth of notes Acme National Bank

12. AssetsLiabilities $100 (Gold)$100 (Notes) + $100 (Loan) However, banks would create more notes than it held in gold! Reserve Ratio = 50% The notes are loaned out to create a business loan The bank prints $100 worth of new notes The reserve ratio is dependant on the banks loan policy + $100 (Notes) $200 Acme National Bank

13. Now the supply of money us related to the supply of gold, but that relationship can change! (rr = reserve ratio) Households choose money holdings based on income, interest rates and prices

14. The trade adjustment process was unaffected because international transactions were done in gold. AssetsLiabilities - $50 (Gold)- $50(Notes) A $50 import would require a conversion of notes into gold The conversion would pull $50 in notes out of circulation in the US That gold would flow to England to be exchanged for British gold notes Acme National Bank

15. Therefore, bank notes didnt interfere with the stabilizing force of gold flows – trade deficit countries would see a net outflow of gold which would contract the money supply US prices fall relative to British prices which reduces the trade deficit Note: the exchange rate is still fixed at 1!!

16. AssetsLiabilities $100 (Gold)$200 (Notes) However, reserves/money supplies were influenced by gold prices Suppose that Acme bank is currently maintaining a 50% reserve ratio An increase in gold prices causes individuals to return their bank notes and redeem them for gold (say, $50 worth) AssetsLiabilities $100 (Gold)$200 (Notes) -$50 (Gold)-$50 (Notes)

17. AssetsLiabilities $100 (Gold)$200 (Notes) -$50 (Gold)-$50 (Notes) $50 (Gold)$150 (Notes) The loss of gold reserves causes the reserve ratio to drop to 33% The increase in gold supplies returns the price of gold to its initial level The contraction of gold notes lowers the money supply – forcing down prices

18. By 1860, most countries had adopted national currencies (i.e. had turned their money supply process over to a single entity.) The values of these currencies were maintained by tying them to gold – the beginning of the gold standard era In the US, we went through three phases of money supply: 1.The US Treasury 2.Nationally Chartered Banks 3.The Federal Reserve System

19. The Gold Standard had three basic rules: In each country, currency was convertible into gold on demand at a fixed, pre-specified rate ($20.67 = 1 oz) Each country allowed for coinage of gold at a mint No restrictions on imports/exports of gold AssetsLiabilities 10 tons (320,000 oz) x $20.67/oz $6,614,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) US Federal Reserve System The US maintained approximately an 11.7% reserve ration during the gold standard era

20. The key property of the gold standard is that the central bank is left with very little flexibility to control the supply of its nations currency : AssetsLiabilities $6,614,400 (Gold)$56,222,400 (US Currency) $49,608,000 (T-Bills) US Federal Reserve System + $10,000,000 (Gold)+ $10,000,000 (US Currency) Suppose that the federal reserve wishes to increase the supply of currency – it undertakes an open market purchase of gold

21. AssetsLiabilities $6,614,400 (Gold)$56,222,400 (US Currency) $49,608,000 (T-Bills) US Federal Reserve System + $10,000,000 (Gold)+ $10,000,000 (US Currency) Rising gold prices causes individuals to redeem their currency for gold. – This contracts the money supply and returns to price of gold to parity - $10,000,000 (Gold)- $10,000,000 (US Currency)

22. AssetsLiabilities $6,614,400 (Gold)$56,222,400 (US Currency) $49,608,000 (T-Bills) US Federal Reserve System + $10,000,000 (TBills)+ $10,000,000 (US Currency) Alternatively, the Federal could use the newly printed money to buy Treasury Bills – however, this influences the reserve ratio A drop in the reserve ratio lowers the value of a currency

23. AssetsLiabilities 10 tons (320,000 oz) x $20.67/oz $6,614,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) US Federal Reserve System Reserve Ratio Suppose that the Federal Reserve raised the price of gold to $35 AssetsLiabilities 10 tons (320,000 oz) x $35.00/oz $11,200,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) US Federal Reserve System Reserve Ratio

24. Devaluations also allow the central bank to increase the money supply AssetsLiabilities 10 tons (320,000 oz) x $35.00/oz $11,200,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) US Federal Reserve System Reserve Ratio $25 If the fed increases the price of gold to $35 while in private markets, the price of gold is $25, individuals will buy gold in private markets (demand for gold rises) $35 + Gold+ Currency in Circ.

25. P = $20.67 P* = L 4.87 e = $20.67 L 4.87 = 4.25 If e = $5.00 (the pound is overvalued), an arbitrage opportunity exists Buy gold in US ($1 = 1/20.67 oz) Sell gold in Britain (1/20.67)*L4.87 = L.2356 Convert Pounds back to $s ( L.2356 * 5.00 = $1.18) The gold standard created an implied exchange rate system

26. P = $20.67 P* = L 4.87 e = $20.67 L 4.87 = 4.25 Trade deficits would tend to depreciate the dollar in currency markets – this would lead to gold flowing out of the US through arbitrage AssetsLiabilities 10 tons (320,000 oz) x $35.00/oz $11,200,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) US Federal Reserve System - Gold- Currency in Circ. These gold flows will contract the money supply in the US and lower US reserve assets – what can the Fed do about this?

27. Monetary systems such as the gold standard left currencies open to speculative attacks. AssetsLiabilities 10 tons (320,000 oz) x $35.00/oz $11,200,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) US Federal Reserve System - Gold- Currency in Circ. Suppose that speculators believed that the US Fed would devalue its currency (i.e. raise the price of gold). The correct move would be to buy gold in preparation. $35 $45 As current gold prices rose above the central banks conversion rate, individuals buy gold from the fed and sell it in open markets – the money supply contracts and the Feds reserves drop.

28. Currency pegs operate exactly like a gold standard except that the reserve asset becomes another countrys currency: AssetsLiabilities 10 Million Euro x $1.12/Euro $11,200,000 (Euro) $60,808,000 (US Currency) $49,608,000 (T-Bills) For example, if the US decided to peg to the Euro at a price of $1.12 per Euro, we would need to acquire Euro assets (either cash or Euro bonds) Reserve Ratio There is one big difference here…what is it?

29. Mama knows best! If Billy jumped off the Brooklyn Bridge, would you do it to? Under a gold standard, the commodity to which you are pegged is in relatively fixed supply – Euros ARE NOT in fixed supply, but are controlled by the ECB.

30. Currency pegs force you to adopt the monetary policy of the country to which you are pegging: AssetsLiabilities 10 Million Euro x $1.12/Euro $11,200,000 (Euro) $60,808,000 (US Currency) $49,608,000 (T-Bills) Reserve Ratio Suppose that the ECB increases the supply of Euros – this will (all else equal) cause the dollar to appreciate – the Fed would need to buy Euro in currency markets + Euro Reserves+ US Currency

31. Further, currencies that are pegged are subject to speculative attacks. AssetsLiabilities 10 Million Euro x $1.12/Euro $11,200,000 (Euro) $60,808,000 (US Currency) $49,608,000 (T-Bills) Reserve Ratio - Euro Reserves- US Currency Suppose that the markets believe that the dollar is overvalued (i.e. that the $1.12 per Euro is too low) The profitable move would be to buy Euro from the Fed with the intention of selling them back later at a higher price – this will cost the Fed its Euro reserves!!

32. The Bretton Woods System (1945 – 1972) $35/oz. 1L = $2.80 625 Lira = $1 DM 2 = $1 The dollar became the nominal anchor - tying (indirectly) every other currency to gold

33. AssetsLiabilities $100M (Gold)$500M (Currency) $400M (T-Bills) AssetsLiabilities $30M ($)DM 100M (Currency) DM 10 (Gold) $35/oz. DM 2 = $1 DM 30M (Bonds) While gold would be the primary reserve asset in the US, $s were the primary reserve asset in Europe

34. Suppose that trade imbalances were causing a Deutschemark depreciation. Germany would be obliged to use its dollar reserves to buy back its currency – this costs them reserves!! AssetsLiabilities $100M (Gold)$500M (Currency) $400M (T-Bills) AssetsLiabilities $30M ($)DM 100M (Currency) DM 10 (Gold) $35/oz. DM 2 = $1 DM 30M (Bonds) - Dollar Reserves- DM

35. However, if the US ran a trade deficit that was causing the dollar to depreciate (all other currencies are appreciating), again Germany would need to respond – buying dollars AssetsLiabilities $100M (Gold)$500M (Currency) $400M (T-Bills) AssetsLiabilities $30M ($)DM 100M (Currency) DM 10 (Gold) $35/oz. DM 2 = $1 DM 30M (Bonds) + Dollar Reserves+ DM

36. Trade Balance Government Deficit The Twin Deficits With the Vietnam War and Johnsons Great Society programs, the US began running sizable trade deficits and government deficits – this creates a perceived weakness in the dollar.

37. The perceived weakness of the dollar materializes in two ways: AssetsLiabilities $100M (Gold)$500M (Currency) $400M (T-Bills) AssetsLiabilities $30M ($)DM 100M (Currency) DM 10 (Gold) $35/oz. DM 2 = $1 DM 30M (Bonds) + Dollar Reserves+ DM Downward pressure on the dollar forces European countries to buy dollars – increasing their dollar reserves Upward pressure on gold prices forces the Fed to sell gold – losing reserves - Gold- US Dollars

38. 1972 1971 1970 1969 1968 1967 In 1967-1968: the British pound devalues to $2.40 (-14%). This triggers a massive run on US gold. The US loses $3.2B (20% of reserves) in three months! Private market prices of gold rise as high as $45! Convertibility of gold is suspended in open markets 1969-1971: The US enters a recession. This creates even more speculation against the dollar. 1970-1971: In an effort to stimulate the economy (and to get re-elected), Nixon pressures the Fed to cut interest rates August 15, 1971: Nixon officially closes the gold window. Without implicit gold backing, the system totally collapses. 1966

39. The ERM (European Exchange Rate Mechanism) was the precursor to the Euro. The Basis of the ERM was the ECU (European Currency Unit) CurrencyAmountExchange Rate (per dollar) - 1971 Dollar Equivalent Belgian Franc3.8049.64.0766 German Mark.8283.637.2277 Danish Krone.2177.485.0290 French Franc1.155.5192.2084 British Pound.0885.4177.2112 Irish Punt.00759.4156.0182 Italian Lira109623.26.1749 Dutch Guilder.2863.5946.0796 Total = $1.02 Per ECU

40. AssetsLiabilities 30M ECUDM 100M (Currency) DM 10 (Gold) DM 3.64 = 1 ECU DM 30M (Bonds) Each country in the mechanism pegged to the ECU at a specified rate (essentially the same rate as the dollar) Each countrys foreign exchange reserves were made up of cash/assets of all the member countries

41. 2002 2000 1998 1995 1992 1979 1972 1979: European Community Members agree to the European Exchange Rate Mechanism 1992: George Soros speculates against the pound. The pound is devalued by 25%. Italy and Britain drop out of the ERM 1998: Euro introduced. ECU converted to Euros at 1:1 rate. January 2002: Euros begin circulating

42. Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain Will Join…. (2007 Slovenia (2008) Estonia, Cyprus, Latvia, Malta (2009) Slovakia, Lithuania (2010) Czech Republic, Hungary (2011) Poland (Not Before 2012) Sweden (???) Bulgaria, Romania The Euro-zone consists of 12 countries

43. A Budget Deficit of no more than 3% of GDP National debt of no more than 60% of GDP Inflation within 1.5% of 3 best performing EU countries Long term interest rates within 2% of 3 lowest interest rate EU countries The Eurozone is an example of a currency union – the strictest of exchange rate systems. A currency union is very much a permanent peg. Its important that countries pegged to one another are similar in economic structure Eurozone countries must meet strict entry requirements Note: France and Germany routinely violate these conditions!

44. What does the future hold for exchange systems? Currency unions seem to be the trend! Currency Unions Currently in Operation European Union: Euro West African Economic and Monetary Union (7 countries): CFA Franc East Caribbean Monetary Union (8 countries): East Caribbean Dollar Gulf Cooperation Council Monetary Union Unions Still in the Planning Stages Central American Monetary Union Asia Currency Union North American Monetary Union: Amero?