1. Chapter 2 International Monetary System Management 3460 Institutions and Practices in International Finance Fall 2003 Greg Flanagan

2. September 16-18, 2003 2 Chapter Objectives: This chapter serves to introduce the student to the institutional framework within which: international payments are made; movement of capital is accommodated; exchange rates are determined.

3. September 16-18, 2003 3 Outline Money The evolution of the International Monetary System Current Exchange Rate Arrangements Euro and the European Monetary Union Currency Crisis Mexican Peso Crisis Asian Currency Crisis Fixed versus Flexible Exchange Rate Regimes

4. September 16-18, 2003 4 Money Means of exchange Unit of account Store of value Commodity money Fiat money Characteristics of good money:

5. September 16-18, 2003 5 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: ‘bad money drives out good money’ implied that it would be the least valuable metal that would tend to circulate. Not ‘systematic’-- many disruptions in trade.

6. September 16-18, 2003 6 Classical Gold Standard: 1875-1914 Gold standard est. 1821 Bank of England pound notes redeemable for gold. Full standard 100% partial: more notes than gold. 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.

7. September 16-18, 2003 7 Classical Gold Standard: 1875-1914 Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie- flow mechanism.

8. September 16-18, 2003 8 Price-specie-flow mechanism. Arbitrage will keep the exchange rates equal. Trade flows will adjust to exchange rates by the flow of gold. Money Supply X Velocity =Prices X Quantities. MsV=PQ M = f (Gold) If V and Q constant  G  Ms   P   eXports  iMports   G  until X=M (trade balance)

9. September 16-18, 2003 9 Price-specie-flow mechanism. Problems: Limited supply of new gold restricts the growth of world trade and investment due to insufficient medium of exchange. National economies respond to the exchange rate (gold reserves) rather than real production possibilities. any national government could abandon the standard.

10. September 16-18, 2003 10 Interwar Period: 1915-1944. Gold flow ceased due to WW1 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 in the 1920s to restore the gold standard, however, major countries (i.e.USA, GB) ‘sterilized’ gold in order to pursue domestic interests. Hyperinflation in Germany, the stock market crash, and the great depression result gold standard abandoned. international trade and investment was profoundly diminished.

11. September 16-18, 2003 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. The result was the creation of the International Monetary Fund (IMF) and the World Bank.

12. September 16-18, 2003 12 Bretton Woods System: 1945-1972 US$ based Gold exchange Standard: the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary.

13. September 16-18, 2003 13 Bretton Woods System: 1945-1972 Increasing U.S. trade deficits occurred in the late 1950s and 1960s. Triffin Paradox:  need for reserves  M > X  $ outflow  more $ than gold at $35 per ounce. France wants Gold for $  pressure on reserves  Interest Equalization Tax (1963) and the Foreign Credit Restraint Program (1965-68) Special Drawing Rights (SDR) established by IMF Smithsonian agreement: US$38/ounce; band  2.25% 1973 US$42/ounce 1973 the US$ is released from the gold standard.

14. September 16-18, 2003 14 Special Drawing Rights Weighted average of currencies Currency1981-851986-901991-951996- 2000 2001- 2005 US$42 403945 Euro29 German Mark 19 21 Japanese Yen 1315171815 British pound 131211 French Franc 131211