1. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 19 Alternative International Monetary Standards

2. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-2 Topics to be Covered The Gold Standard 1880–1914 The Interwar Period 1918–1939 The Gold Exchange Standard 1944–1970 The Transition Years 1971–1973 Floating Exchange Rates Since 1973 Types of Exchange Rate Arrangements Choosing an Exchange Rate System Optimum Currency Area

3. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-3 Topics to be Covered (cont.) European Monetary System and the Euro Target Zones Currency Boards International Reserve Currencies Multiple Exchange Rates

4. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-4 History of International Monetary Systems The Gold Standard: 1880–1914 The Interwar Period: 1918–1939 The Gold Exchange Standard: 1944–1970 Transition to Floating Exchange Rates: 1971–1973 Floating Exchange Rates: Since 1973

5. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-5 The Gold Standard: 1880– 1914 Under a gold standard, currencies are valued in terms of a gold equivalent, or mint parity price. An ounce of gold was worth $20.67. Since each currency is defined in terms of its gold value, all currencies are linked in a fixed exchange rate system. Each participating country must be willing and ready to buy and sell gold to anyone at the fixed price.

6. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-6 Gold Standard (cont.) Gold is used as a monetary standard because it is a homogenous good, easily storable, portable, and divisible into standardized units, such as ounces. Another important feature of gold is that governments cannot easily increase its supply. A gold standard is a commodity money standard.

7. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-7 Gold Standard (cont.) A money standard based on a commodity such as gold with a relatively fixed supply will lead to long run price stability. This is because a country’s supply of money is limited by its supply of gold.

8. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-8 Solutions to BOP Disequilibria under a Gold Standard A country with a balance of payments deficit would experience net outflows of gold, thus reducing its money supply and, in turn, its prices. A country with a balance of payments surplus would have gold flowing in, raising its money supply and hence its prices. Falling prices in the deficit country would lead to increasing net exports, while the rising prices in the surplus country would reduce its net exports, eventually restoring BOP equilibrium.

9. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-9 Interwar Period: 1918–1939 World War I effectively ended the gold standard. Europe experienced inflation during and after the war so restoration of the gold standard at the old exchange values was not possible. The U.S. experienced little inflation and returned to the gold standard in 1919 at the old parity. In 1925, England returned to the gold standard despite inflation. Money supply fell as gold purchases soared, and by 1931 the British pound was declared inconvertible.

10. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-10 Interwar Period (cont.) Demand for gold focused on the U.S. market. A “run” on U.S. gold lead to the U.S. raising the official gold price to $35 an ounce. The depression years of the 1930s were characterized by international monetary warfare in the form of competitive devaluations and foreign exchange controls.

11. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-11 Gold Exchange Standard: 1944– 1970 An international conference in Bretton Woods, New Hampshire, in 1944 led to an agreement among participating countries to fix the values of their currencies to gold. The U.S. dollar was the key currency, and $1 was defined as equal in value to 1/35 ounce of gold. All currencies were linked to the dollar and each other in a fixed exchange rate system. Nations belonging to the system were committed to maintaining the parity value of the currency within +-1% of parity. The various central banks were to achieve this goal by buying and selling their currencies ( usually against $) on FEM.

12. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-12 Gold Exchange Standard (cont.) In the case of more fundamental BOP problems, a country was allowed to devalue its currency (refer to Table 19.1). The gold exchange standard is also called an adjustable peg system. Large U.S. balance of payments deficits and the consequent gold outflows as well as the unwillingness of major trading partners to realign currency values led to suspension of U.S. gold sales in 1971 and the end of fixed exchange rates.

13. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-13 TABLE 19.1 Exchange Rates of the Major Industrialized Countries over the Period of the Bretton Woods Agreement

14. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-14 Transition Years: 1971–1973 In 1971, an international monetary conference was held at the Smithsonian institution in Washington led to the Smithsonian agreement which raised the gold exchange value from $35 to $38. at the same time the $ was being devalued about 8%. also revalued the currencies of surplus countries. The system was to operate with fixed exchange rate, the CB would buy and sell their currencies to maintain the ER within +- 2.25% of the stated parity. In 1972 and early 1973, currency speculators sold large amounts of dollars leading to further dollar devaluation. By March 1973, all major currencies were floating.

15. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-15 Floating Exchange Rates: Since 1973 Although exchange rates since 1973 are described as floating (i.e., determined by market forces of demand and supply), the rates are effectively “managed float”, wherein central banks reserve the right to intervene at any time to obtain desirable rate levels. Today, different countries follow different exchange rate arrangements. See Table 19.2 for examples.

16. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-16 Types of Exchange Rate Arrangements Crawling peg—the rate is adjusted periodically in small amounts. Crawling band—the rate is maintained within fluctuation margins around a central rate which is adjusted periodically. Managed floating—the central bank intervenes in the foreign exchange market with no pre-announced path for the exchange rate. Independently floating—the rate is market- determined.

17. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-17 Types of XR Arrangements (cont.) No separate legal tender— another country’s currency circulates as legal tender. Currency board—a fixed rate is established by legislative commitment to exchange domestic currency for foreign currency at a fixed rate. Other conventional pegged arrangement—the rate is fixed against a major currency or market basket of currencies. Horizontal band—the rate fluctuates around a fixed central target rate.

18. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-18 Types of Monetary Policy Arrangements Exchange rate anchor – the central bank maintains limited exchange rate flexibility relative to a single currency or composite of currencies. Monetary aggregate target – the central bank targets a growth rate of the money supply. Inflation targeting framework – the central bank targets a range for domestic inflation. Other

19. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-19 Floating vs. Fixed Exchange Rates An argument in favor of flexible exchange rates is that a country can follow domestic macroeconomic policies independent from other countries. An argument in favor of fixed exchange rates is that fixed rates impose international discipline on the inflationary policies of countries. An argument against flexible rates is that such rates are subject to destabilizing speculation wherein speculators increase the variability or fluctuations of exchange rates.

20. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-20 Country Factors and Choice of Exchange Rate System Country size—Large countries tend to be more independent and less willing to subjugate own domestic policies to maintain a fixed rate system. Openness—More open economies tend to follow a pegged exchange rate to minimize foreign shocks, while closed economies prefer the floating rate. Trade pattern—A country that trades largely with one foreign country tends to peg its exchange rate to the other’s currency. A country with more diversified trade patterns might peg to a market basket of currencies.

21. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-21 Country Factors (cont.) Inflation rate—Countries with more harmonious or stable inflation rates will prefer fixed exchange rates. Money supply—The greater a country’s money supply fluctuations, the more likely the country will peg its exchange rate. See Table 19.3

22. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-22 TABLE 19.3 Characteristics Associated with Countries Choosing to Peg or Float

23. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-23 Optimum Currency Area Currency Area—an area where exchange rates are fixed within the area and floating exchange rates exist against currencies outside the area. The “optimum” currency area is the best grouping of countries to achieve some objective, such as ease of adjustment to real or nominal shocks.

24. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-24 Optimum Currency Area (cont.) The optimum currency area is the region characterized by free and relatively costless mobility of resources such as labor and capital. When factors are immobile, so that equilibrium is restored via changes in goods prices, then there is an advantage to flexible exchange rates.

25. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-25 International Reserve Currencies A reserve currency is a currency which serves the role of money in the international economy. As with any money, the reserve currency must serve as a unit of account, medium of exchange, and store of value. Refer to Table 19.5 Roles of a Reserve Currency

26. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-26 TABLE 19.5 Roles of a Reserve Currency

27. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-27 Reserve Currencies (cont.) Although the U.S. dollar is not the only reserve currency, it is the dominant reserve currency. Refer to Table 19.6

28. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-28 TABLE 19.6 Share of National Currencies in Total Identified Official Holdings of Foreign Exchange, End of Year (percentage)

29. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-29 Seigniorage Seigniorage is the difference between the cost to the reserve country of creating new balances and the real resources the reserve country is able to acquire with the new balances. It is a financial reward accruing to the reserve currency as a result of its being used as a world money.

30. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 19-30 Multiple Exchange Rates Some countries maintain multiple exchange rates. Arguments against multiple rates include: –Multiple rates harm both the countries imposing them and other countries. –They are costly in that people spend scarce resources to find ways to profit from the tiered exchange rates. –Maintenance of multiple exchange rate system requires a costly administrative structure.