1. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University Economics of International Finance Econ. 315 Chapter 8 The International Monetary System: Past, Present and Future

2. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University International Monetary System: Refers to rules, customs, instruments, facilities and organizations for affecting international payments. It can be classified according to: 1- The exchange rate system into: Fixed with narrow band (Bretton Woods)Fixed with narrow band (Bretton Woods) Fixed with wide bandFixed with wide band Adjustable bandAdjustable band A crawling pegA crawling peg A managed floatingA managed floating A freely floatingA freely floating 2- International reserves into: Gold standard (only gold)Gold standard (only gold) Pure fiduciary (paper currency only)Pure fiduciary (paper currency only) Gold-exchange standard (a combination of the two)Gold-exchange standard (a combination of the two)

3. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University These two classifications can be combined in various ways, e.g., Fixed exchange rate without gold (e.g., using $ instead as reserves)Fixed exchange rate without gold (e.g., using $ instead as reserves) Adjustable peg of managed float with gold and foreign exchange, or foreign exchange only.Adjustable peg of managed float with gold and foreign exchange, or foreign exchange only. But note that (theoretically) under freely floating system there will be no need for reserves to adjust BOP. A good international monetary system: A system that: - Maximizes the flow of world trade and investment - Guarantees an equitable distribution of the gains from trade among the nations. The international monetary system can be evaluated in terms of: 1.Adjustment; correct for BOP disequilibria. 2.Liquidity; provide adequate reserves to nations to correct BOP deficits without a need to devalue their currencies.

4. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University 3.Confidence; the adjustment mechanism works adequately and international reserves retain their absolute (quantity) and relative values (no or very limited devaluations). 1- The Gold Standard Period (1880-1914) -Each nation defines the gold content of its currency (mint parity) -Stands ready to buy or sell any amount of gold at that price (mint parity) -Exchange rate could fluctuate within the gold points (gold export and import points) by demand and supply forces. - The tendency of the currency to depreciate (past the gold export point), will be halted by gold outflows, which represent the deficit of the nation. - The tendency of the currency to appreciate (past the gold import point) will be halted by gold inflows, which represent the surplus of the nation.

5. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University The Adjustment Mechanism Under the Gold Standard: Is the automatic price-specie-mechanism, explained by David Hume as follows: Is the automatic price-specie-mechanism, explained by David Hume as follows: -The nation’s money supply is composed of gold or paper currency backed by gold. -Money supply will fall in the deficit nation (prices will fall) and rise in the surplus nation (price will rise) – remember the quantity theory. -Exports of the deficit nation would be encouraged and its imports discouraged until deficit is eliminated. The opposite in the surplus nation. -The money supply will change for BOP considerations. Therefore the country will not have a monetary policy to achieve full employment without inflation. This is a basic classical hypothesis. For the system to operate, the nations are not supposed to sterilize (neutralize) the effect of a BOP deficit (by expanding the credit D) or surplus (by restricting credit D) on the nations money supply. Rules of the game indicates that the deficit nation should reinforce the adjustment process by restricting credit, and the surplus country to further expand credit.

6. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University This adjustment mechanism was supposed to work under the system. Taussige in the 1920s found that the adjustment process worked much too quickly and smoothly with little, if any, gold transfers. Why? BOP disequilibria are adjusted by capital flows not gold shipments. A deficit nation will have lower money supply  higher interest rates  capital inflows to cover the deficit. A supporting condition for the system was due to the special conditions in the world because of great economic growth and stability in almost all the nations during this era. 2- The Interwar Experience The gold standard ended by the outbreak of the WWI. During 1914-1924, exchange rates fluctuated widely and there was a desire to return to stability. The United Kingdom:  In 1925 the UK returned back to the gold standard at the prewar price, as well as other nations.  The system was more of a gold-exchange standard, than pure gold standard, where gold and other convertible currencies (£, $ and FFR) are used. This economizes the use of gold which supply has become a smaller percentage of the world trade (not enough gold to finance deficits).

7. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University  Losing much of its competitiveness, the UK liquidated most of its international investments to reestablish the pound PPP, the pound was relatively overvalued which led to BOP deficits and deflation. France:  Faced large BOP surplus after the stabilization of the Franc.  Seeking to make Paris an international financial center, France decided to settle its BOP surplus in gold rather than pounds,  This put more pressures on the gold reserves of the UK, such that the latter decided in 1931 to suspend converting the pound into gold, devalued the pound and the gold-exchange standard came to an end.  Why the system collapsed?  Lack of adequate adjustment mechanism as nations sterilized the effect of BOP disequilibria in the face of inappropriate practices.  The huge destabilizing capital flows between London and the emerging international monetary centers in Paris and New York.  The outbreak of the Great Depression in 1929.

8. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University  Form 1931-1936 there was great instability as each nation tried to “export” its unemployment (devaluation race).  The US devalued the US$ from $20.67 to 35$ an ounce of gold (75%) to stimulate exports.  By 1936 exchange rates among major currencies were the same as 1930, due to the devaluation race.  The value of gold reserves increase and most foreign exchange reserves were eliminated by mass conversions into gold to protect against devaluation.  Nations also impose very high tariffs and other serious import restrictions and international trade was cut almost in half. The Bretton Woods System The Gold standard 1947-1971: Establishment of the IMF to: 1.Overseeing the nations followed the rules of conduct in international trade and finance. 2.Providing borrowing facilities for nations in temporary BOP difficulties.

9. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University The Bretton woods was a gold-exchange standard. The following were the rules of the system The USA 1.The US was to maintain the price of gold fixed at $ 35 an ounce 2.The US stands ready to exchange dollars for gold at that price without restrictions or limitations. Other Nations 1.Fix the rate of their currencies in terms of the dollars. (thus implicitly in terms of the gold). 2.Intervene in foreign exchange markets to keep the exchange rate from moving by more than 1% above or below the par value. Within the allowed band the exchange rate was determined by market forces. 3.A nation would have to draw down its dollar reserves to purchase its own currency to prevent it from depreciation or purchase dollars to prevent an appreciation by more than the 1%. Therefore the $ was the intervention currency.

10. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University 4.Other nations finance their BOP deficits out of international reserves (gold and US dollars) or by borrowing from the IMF. 5.Only in a case of fundamental disequilibrium (large and persistent) was a nation allowed, after the approval of the IMF to change the par value of its currency. Borrowing from the IMF 1.Upon joining the IMF each country is assigned a quota (of the IMF capital) based on its economic importance and value of its trade. 2.Quota determines the country’s voting power and its ability to borrow from the fund. 3.The nation will pay 25% of its quota in gold and the remainder in its own currency. 4.In borrowing from the fund the nation would get convertible currencies and deposit an equivalent amounts of its own currency.

11. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University 5.Originally the nation could borrow its gold tranche (25%) automatically (and deposit its domestic currency). For other tranches (extra 25% each), the IMF charges higher interest rates, and imposed more supervision and conditions to ensure that the deficit nation is taken appropriate measures to eliminate the deficit. 6.If the IMF hold less than 75% of a country’s currency, the country can borrow the difference without having to pay back its loan (known as the super gold tranche). Operation of the Bretton woods system.  Though the system allows for changes in the par value in cases of fundamental disequilibrium, industrial nations were reluctant to change the par value until they are forced (by destabilizing speciation) to do so (change occurs only under accumulating pressures).

12. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University  Deficit nations resisted devaluation as it is seen as a sign of weakness. Surplus nations resisted needed revaluation and prefer accumulated reserves. This has two important effects: 1.It robbed the system of most of its flexibility and the mechanism of adjustment of BOP disequilibria (lack of an effective mechanism). 2.It gave rise to huge destabilizing international capital flows by providing an excellent one-way gamble for speculators. (e.g., refusal to devalue the pound sterling led to huge liquid capital outflows in the expectation that the pound would be devalued, W. Germany received huge capital inflow on the expectation to revalue the Mark. Therefore, the post war era was characterized by huge destabilizing capital flows, culminating in the collapse of the system in 1971.

13. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University  In 1961, the so called gold pool was started by a group of industrial nations under the leadership of the US to sell officially held gold in the London market to prevent the price of the gold from rising above $ 35/ounce (devaluation of the US $). This was discontinued in 1968 when a two-tier gold market was established ($35 in official market and another (higher) price in commercial market) to prevent the depletion of US gold reserves.  The most significant change was the creation of the Special Drawing Rights SDRs to supplement the international reserves. Sometimes called the paper gold, SDRs are accounting entries in the books of the IMF. The value of SDRs arises because members agreed to use SDRs in dealings among member central banks to settle BOP deficits and surpluses, and not in private commercial dealings.

14. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University Evolution of the Bretton Woods System.  In 1962 the IMF negotiated the General Arrangements to Borrow, by which a group of ten countries are to provide $ 6 billion to help the nations with BOP problems.  Starting in early 1960s member nations began to negotiate standby arrangements; a nation is allowed to borrow from fund resources. Standby arrangements were considered as a first line of defense against anticipated destabilizing hot money flows.  National central banks began to negotiate “swap arrangements” to exchange each other’s currency to be used to intervene in foreign exchange markets to combat hot money flows. A central bank facing large liquid capital flows could then sell the foreign currency forward in order to increase the forward discount or reduce the forward premium on the foreign currency and discourage destabilizing hot money flows.

15. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University Collapse of the Bretton Woods System  Huge US BOP deficit fed expectations about devaluation of the $. This led to huge capital flows outside US. Richard Nixon suspended the convertibility of the $ in August 1971.  In December 1971 the Group of 10 met in the Smithsonian institution in US and agreed to increase the price of the gold from 35 an ounce to 38 an ounce. The range of Par value was also increase from 1% to 2.5%. Since there was no convertibility, this system was now a Dollar Standard.  US BOP continued to have a deficit, and there was another need to devalue the $ by 10%, from $ 38/ounce to 42.22/ounce.  The European common market decided to let their currencies float jointly against the dollar with a total band of 2.25% only (instead of 4.5%), this is known as the European snake (snake in a tunnel) till March 1973.

16. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University  Speculation against the $ increased again in 1973, industrial nations decided to let their currencies float either independently, or jointly. The present managed floating system was born (end of Bretton Woods system).  The main reasons for the collapse of the system are: 1. US BOP huge deficit especially in 1970 and 1971. 2. The liquidity problem (gold, foreign exchange and SDRs), inadequate liquidity hampers the growth of international trade. Most of the liquidity increases came from increase in foreign currencies, the US $ arises from US BOP deficit. Though in 1950s there was a Dollar shortage, in 1960s the world suffered from a Dollar glut. 3. Adjustment mechanism, the US was unable to correct its BOP problem because it was unable to devalue its currency. The Bretton Woods was lacking an adjustment mechanism. 4. Confidence problem was less as increases in liquidity are due to the accumulated unwanted US $.

17. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University