1. Chapter 19: International Monetary Regimes

2. 1. The Trilemma or Impossible Trinity Only two may be achieved at any one time The Trilemma Fixed Exchange Rate Discretionary Monetary Policy International Capital Mobility

3. 1. The Trilemma or Impossible Trinity To achieve: Fixed exchange rate Trade-off: Discretionary monetary policy to create elasticity of supply of currency or International capital mobility to create inelasticity of demand for currency

4. 1. The Trilemma or Impossible Trinity To achieve: Discretionary monetary policy Trade-off: Fixed exchange rate to allow for inelasticity of supply of currency or International capital mobility to create inelasticity of demand for currency

5. 1. The Trilemma or Impossible Trinity To achieve: International capital mobility Trade-off: Fixed exchange rate to allow for equilibrium price (floating exchange rate) or Discretionary monetary policy to create elasticity of supply for currency

6. 1. The Trilemma or Impossible Trinity International monetary regimes Specie standard Fixed rate International capital mobility Managed fixed exchange rate Fixed rate Discretionary monetary policy Free float Discretionary monetary policy International capital mobility Managed float International capital mobility Switch between monetary policy discretion and fixed exchange rate

7. 2. Two Systems of Fixed Exchange Rates Gold standard Domestic units of account were in terms of gold— by weight and purity Allowed gold and bills of exchange to flow between nations unfettered U.S. 1 oz. gold = $20.00; Great Britain 1 oz. gold = £4 Exchange rates were dictated by the supply and demand conditions in the sterling bills market

8. 2. Two Systems of Fixed Exchange Rates Gold standard system: Self-equilibrating Functioned without government intervention Had exchange rate stability

9. 2. Two Systems of Fixed Exchange Rates Bretton Woods System Adopted by the first world countries in the final stages of World War II Designed to overcome the flaws of the GS while maintaining the stability of fixed exchange rates

10. 2. Two Systems of Fixed Exchange Rates Bretton Woods System USD substituted gold as the free world's currency Ensured a more elastic supply of international reserves Allowed the U. S. to earn seigniorage to help offset the costs it incurred from fighting wars U.S. was rendered the banker to more than half of the world’s economy

11. 2. Two Systems of Fixed Exchange Rates Bretton Woods Agreement, July 1944 Established the International Bank for Reconstruction and Development (now the World Bank) “…the absence of a high degree of economic collaboration among the leading nations will…inevitably result in economic warfare that will be but the prelude and instigator of military warfare on an even vaster scale.” -- Harry Dexter White, US Department of the Treasury 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, NH (USA) for the United Nations Monetary and Financial Conference

12. 2. Two Systems of Fixed Exchange Rates Bretton Woods Agreement, July 1944 Established the International Monetary Fund “The nations should consult and agree on international monetary changes which affect each other. They should outlaw practices which are agreed to be harmful to world prosperity, and they should assist each other to overcome short-term exchange difficulties.” July 22, 1944 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, NH (USA) for the United Nations Monetary and Financial Conference

13. 2. Two Systems of Fixed Exchange Rates Bretton Woods Agreement, July 1944 Adopted the General Agreement on Tariffs and Trade (GATT) to regulate international trade. Proposed establishment of The International Trade Organization to regulate GATT. The ITO Charter was agreed to by the U.N. in March 1948, but never ratified by the U.S. Senate. In 1995, the World Trade Organization (WTO) was established. 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, NH (USA) for the United Nations Monetary and Financial Conference

14. 3. The Managed or Dirty Float To achieve: Discretionary monetary policy and International capital mobility Trade-off: Fixed exchange rate Use managed float: the central bank allows market forces to determine second-to-second (day-to-day) fluctuations in exchange rates but intervenes if the currency grows too weak or too strong.

15. 3. The Managed or Dirty Float Central bank intervention: Unsterilized foreign exchange intervention Exchange: International reserves Assets denominated in foreign currencies Gold, and SDRs (Special Drawing Rights)for domestic currency

16. 3. The Managed or Dirty Float Central bank intervention: Unsterilized foreign exchange intervention Influence the FX rate via changes in MB: Selling international reserves for domestic currency to appreciate the domestic currency. Shift the demand for domestic currency in FX markets

17. 3. The Managed or Dirty Float Central bank intervention: Sterilized foreign exchange intervention No net change in MB, no long-term impact on exchange rate Uses: Short-term ruse Signal to market

18. 3. The Managed or Dirty Float Central bank intervention: Disadvantages Run out of international reserves in a fruitless attempt to – prevent depreciation or – create appreciation Require increasing or decreasing the MB counter to the needs of the domestic economy.

19. 4. The Choice of International Policy Regime Fixed rate or managed float: Costs Run out of international reserves: Unable to use unsterilized foreign exchange intervention IMF lends, but:  Not lender of last resort  Requires fiscal austerity  Creates moral hazard

20. 4. The Choice of International Policy Regime Fixed rate or managed float: Benefits = monetary policy target similar to an inflation or money supply target: Allows the developing nation’s central bank to figure out whether to increase or decrease MB and by how much Effectively ties the domestic inflation rate to that of the anchor country Instills confidence in the developing country’s macroeconomic performance

21. 4. The Choice of International Policy Regime Fixed rate or managed float: Benefits Dollarization = adopting an anchor currency = (- seigniorage revenue) + outsource monetary policy Hard peg = pegged to an anchor currency = outsource monetary policy

22. 4. The Choice of International Policy Regime Fixed rate or managed float: Benefits  Dollarization  Hard peg Difficult to maintain because: Can create persistent imbalances between the developing and the anchor currencies due to changes in – Interest rates – Trade – Productivity