Ch 3. International Monetary System

I. Alternative exchange rate systems

II. A brief history of the international monetary

system

III. The European Monetary System and Monetary Union

IV. Emerging market currency crises

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International Monetary Systems

Introduction:

1. Before 1971 (the Bretton Woods system), the international monetary system was mainly a relatively fixed exchange rate system (relative to the US dollar)

2. The current international monetary system is a system

of rapidly fluctuating exchange rates (hybrid system)

3. The purpose of this chapter is to understand: what the international monetary system is and how the choice of system affects currency value.

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International Monetary Systems

The international monetary system is the set of polices, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchanged for another.

There are five market mechanisms: (1) free float, (2) managed float, (3) target-zone arrangement, (4) fixed-rate system, and (5) the current hybrid system.

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International Monetary Systems

I. Part I: Five market mechanisms

A. Freely Floating (“Clean Float”) 1. Market forces of supply and demand determine exchange rates.

2. Forces are influenced by:a. price levelsb. interest ratesc. economic growth

3. Rates fluctuate randomly over time when new

information arrives → economic uncertainty

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Alternative Exchange Rate Systems

B. Managed Float (“Dirty Float”)1. Market forces set rates unless excess volatility occurs

2. Then, central bank determines exchange rate

Types of managed float:

- smoothing out daily fluctuation, if volatility exceeds

certain threshold

- “leaning against the wind” : prevent abrupt short- and

medium-term fluctuations

- “unofficial pegging”: there is no publicly announced

government commitment to a given exchange rate level

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Alternative Exchange Rate Systems

C. Target-Zone Arrangement

1. Rate Determination

a. Market forces constrained to upper and lower range of exchange rates

b. Members to the arrangement adjust their national economic policies to maintain target exchange rates

c. the precursor to the euro, European Monetary System, is one of the systems

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Alternative Exchange Rate Systems

D. Fixed Exchange Rate System (e.g., BW system)

1. Rate determination

a. Governments are committed to maintain target rates.

b. If rates threatened, central banks buy/sell currency.

c. Monetary policies are coordinated or subordinated. The problem is: monetary policy may be inconsistent

with desirable goals on interest rate, economic growth and unemployment (domestic economic development)

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Alternative Exchange Rate Systems

E. Current System - a hybrid systema. Major currencies: use freely-floating method

b. Other currencies move in and out of various

fixed-rate systems.

G. Trade-off : 1. If prefer economic stability - fixed exchange rate system

is better. However, if nations can not follow a consistent

policy, it may lead to currency crisis

2. Economic shocks can be absorbed easily when exchange

rates are allowed to float freely. However, freely floating

rates may exhibit excessive volatility

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Dynamics in an Economic System

Monetary policy

Exchange rate

Inflation rate

Interest rate

Devaluing currency often leads to high inflation rate

High interest rate is often related to currency appreciation

Loose money supply leads to high inflation rate

Loose money supply results in lower interest rate

Adjust money supply to intervene exchange rate

Economic growth, unemployment

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Part II. A Brief History of the International Monetary System

I. The Use of Gold

A. Desirable properties

B. In the short run: High production costs limit changes.

C. In the long run: Commodity money insures stability.

II. The Classical Gold Standard (1821-1914)A. Major global currencies on gold standard. 1. Nations fix the exchange rate in terms of a specific amount of gold.

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A Brief History

2. Maintenance involved the buying and selling of gold at that price.

3. Disturbances in Price Levels:- Would be offset by the price-specie*-

flow mechanism. * specie = gold coins

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A Brief History

a. Price-specie-flow mechanism adjustments were automatic:

1.) When a balance of payments surplus led to a gold inflow;

2.) Gold inflow led to higher commodity prices which reduced surplus;

3.) Gold outflow led to lower commodity prices and increased surplus.

However, gold does have a cost. With low inflation, the reduced demand for gold has lowered its usefulness.

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A Brief History

III.The Gold Exchange Standard (1925-1944)

A. U.S. and Britain only allowed to hold gold reserves.

B. Others could hold both gold, dollars or pound reserves. C. England currencies devalued in 1931 - led to trade wars.

D. Bretton Woods Conference (1944)- called in order to avoid future protectionist and

destructive economic policies

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A Brief HistoryV. The Bretton-Woods System (1946-1971)

1. U.S.$ was key currency;

valued at $1 - 1/35 oz. of gold.

2. All currencies linked to that price in a fixed rate system.

3. Exchange rates allowed to fluctuate by 1%

above or below initially set rates.

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A Brief History

B. The B-W system collapse in 1971. Why?

a. U.S. high inflation rate - difficult to maintain the fixed price of gold

b. West Germany, Japan refuse to accept the inflation that the fixed exchange rate imposes

V. Post-Bretton Woods System (1971-Present)

A. Smithsonian Agreement, 1971: US$ devalued to 1/38 oz. of gold. By 1973, world is on a freely floating exchange rate system

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A Brief History

B. OPEC and the Oil Crisis (1973-1974)

1. OPEC raised oil prices four fold;

2. Resulted in exchange rate turmoil;

C. Dollar Crisis (1977-78)

1. U.S. B-O-P difficulties

2. Result of inconsistent monetary policy in U.S.

3. Dollar value falls as confidence shrinks.

D. The Rising Dollar (1980-85)

1. U.S. inflation subsides as the Fed raises interest rates

2. Rising rates attracts global capital to U.S.

3. Result: Dollar value rises.

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A Brief History

Source Data: Reserve Bank of Australia

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A Brief History

E. The Sinking Dollar: (1985-87)

1. Dollar revaluated slowly downward;

2. Plaza Agreement (1985) : G-5 agree to depress US$ further.

3. Louvre Agreement (1987): G-7 support the falling US$.

F. Recent History (1988-Present)

1. 1988 US$ stabilized

2. Post-1991 Confidence resulted in stronger dollar

3. Trade deficit, Iraq war, US economy

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Part III. The European Monetary System

I. Introduction A. The European Monetary System (EMS) 1. A target-zone method (1979) 2. Close macroeconomic policy coordination required.

B. EMS Objective:

- to provide exchange rate stability to all members by

holding exchange rates within specified limits.

C. European Currency Unit (ECU)- a “cocktail” of European currencies with specified weights as the unit of account.

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The European Monetary System

1. Exchange rate mechanism (ERM)

- each member determines mutually agreed upon central cross rate for its currency.

2. Member Pledge: to keep within 15% margin above or below the central rate.

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The European Monetary System

D. EMS ups and downs

1. Foreign exchange interventions:

- failed due to lack of support by coordinated monetary policies.

2. Currency Crisis of Sept. 1992

a. System broke down

b. Britain and Italy forced to withdraw from EMS.

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The European Monetary System

G. Failure of the EMS:

- members allowed political priorities to dominate

exchange rate policies.

H. Maastricht Treaty1. Called for Monetary Union by 1999 (moved to 2002)2. Established a single currency: the euro

3. Calls for creation of a single central EU bank 4. Adopts tough fiscal standards

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The Euro System

I. Costs / Benefits of A Single Currency

A. Benefits1. Reduces cost of doing business2. Reduces exchange rate risk

B. Costs1. Lack of national monetary flexibility

2. Conflict of interest within EU

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Part IV. Emerging Market Currency Crises Crises in 1990s: e.g., Mexican (1994-1995), Asian (1997),

Russia (1998)

I. Transmission MechanismsA. Trade links - contagion spreads through trade to trade partners

B. Financial System - more important, serves as wakeup call to others - investors sell off to make up for initial losses

C. Short-term debt linked to US Dollar

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Emerging Market Currency Crisis II. Origins of Emerging Market Crises

A. Moral hazard – e.g., IMF bailing out Asia ($118 B)

B. Fundamental Policy Conflict in fixed exchange rate, monetary policy, and free capital movement

III. Policy Proposals for Dealing with Emerging Market crises

A. Currency Controls

B. Freely Floating Currency

C. Permanently Fixed Exchange Rate - e.g. monetary union (EU, Panama, HongKong)

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Study Questions

1. What are the main reasons for the collapse of Bretton-Woods System?

2. What are the benefits and costs from European Monetary Union?

Note that you don’t need to submit the answers for the study questions. These are to help you study the chapter. The answer key will be posted later.