chapter 5 the international monetary system and exchange rate arrangements
TRANSCRIPT
Chapter 5
The International Monetary System and Exchange Rate Arrangements
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 2
Objectives
• To classify international monetary systems.
• To outline the history of exchange rate arrangements.
• To outline the pros and cons of fixed and flexible exchange rates.
• To examine the Australian exchange rate arrangements.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Definition
• The IMS refers to the framework of rules, regulations and conventions that govern the financial relations among countries.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Components of the IMS
• Public component consisting of a series of agreements
• Private component represented by the banking and finance industry
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Classification According to Reverse Assets
• Pure commodity standards (e.g. the gold standard)
• Pure fiat standards• Mixed standards (e.g. the Bretton
Woods system)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Classification According to Flexibility of Exchange Rates
• Several systems may arise by restricting, or otherwise, the exchange rate.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Fixed Exchange Rates
• The exchange rate is fixed by the central bank and is not allowed to move.
• The FX market is likely to be out of equilibrium.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Perfectly Flexible Exchange Rates
• The exchange rate moves continuously, propelled by market forces, to maintain equilibrium in the FX market.
• Under this system, currencies appreciate and depreciate.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Fixed but Adjustable Exchange Rates
• Countries alter the fixed values of their exchange rates.
• Devaluation and revaluation are implemented to ‘correct’ some economic fundamentals such as the BOP.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Fixed Exchange Rates and Flexible Within a Band
• Exchange rates are flexible within upper and lower limits defined by a band around the par value.
• Central bank intervention is required to keep the exchange rate within the band.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Crawling Peg
• The par value of the exchange rate is revised periodically according to its recent behaviour or economic indicators such as inflation.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Dual Exchange Rates
• A commercial (fixed) rate is used for imports and exports.
• A financial (flexible) rate is used for trading in financial assets.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Managed Floating
• The exchange rate is flexible, but the central bank intervenes to limit the frequency and amplitude of exchange rate fluctuations.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Target Zones
• Major countries establish a set of mutually consistent targets for real effective exchange rates.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Classical Gold Standard
• This system operated between approximately 1870 and 1914.
• It is remembered with nostalgia because the world economy prospered during that period.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Pillars of the Gold Standard
• The monetary authorities fix the price of gold in terms of their currencies, which gives a fixed exchange rate.
• The market exchange rate can move above or below the fixed rate by certain limits: the gold points.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Collapse of the Gold Standard
• The gold standard collapsed in 1914 as the warring countries suspended the convertibility of their currencies and prohibited the export of gold.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Interwar Period
• Between the end of World War I and 1926 a system of flexible exchange rates was adopted.
• In 1925, Britain re-established the convertibility of the pound into gold.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Collapse of the Gold Exchange Standard
• In 1931, Britain abolished the convertibility of the pound.
• This was followed by the decade of the Great Depression (1931-1939).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Failure of the Interwar Experiment: Reasons
• The golden age was a myth.• The world economy experienced
significant changes.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Bretton Woods System
• Forty-four countries signed the BW agreement in 1944.
• The creation of the system was accompanied by the creation of international institutions (the IMF and IBRD).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The BW Exchange Rate System
• Fixed but adjustable exchange rates.• The US dollar was pegged to gold,
whereas other currencies were pegged to the dollar.
• Exchange rates could move within a 1% band.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Problems of the BW System
• The adjustment mechanism lacked flexibility and stability.
• Speculation could be destabilising.• There were defects in the liquidity
creation mechanism (Triffin Paradox).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Collapse of the BW System
• In 1971, the United States suspended the convertibility of the dollar into gold. As a result, the system collapsed.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Present System
• In 1971, the Smithsonian Agreement was signed, but it failed to salvage the BW system.
• In 1973, floating became widespread.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The 1980s and 1990s
• Plaza Accord (1985)• Louvre Accord (1987)• The EMS crisis (1992)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The US Dollar’s Effective Exchange Rate
70.0
90.0
110.0
130.0
150.0
Mar-80 Mar-84 Mar-88 Mar-92 Mar-96 Mar-00
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Current Exchange Rate Arrangements
• Arrangements without separate legal tender
• Currency boards• Other conventional fixed pegs
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Current Exchange Rate Arrangements (cont.)
• Pegged exchange rates with horizontal bands
• Crawling peg• Crawling bands• Managed floating without
predetermined path
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The EMS
• The system started functioning in March 1979 when the Snake ceased to exist.
• It is a system of fixed but adjustable exchange rates as governed by the exchange rate mechanism (ERM).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Realignments
• The first realignment involving all currencies took place in March 1983.
• The period January 1987-September 1992 was tranquil.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Speculative Attacks
• In September 1992, speculative attacks forced the pound and the lira out of the ERM.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The EMU and the Euro
• The EMU was established by the 1991 Maastricht Treaty.
• In January 1999, the euro was introduced.
• In January 2002, the euro replaced national currencies.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The EUR/USD Exchange Rate
0.80
0.90
1.00
1.10
1.20
Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Arguments for the Euro
• Currency stability reduces inflation• Reduction in transaction and hedging
costs• Efficiency gains • Transparency gains• Benefits to trade and capital markets
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Arguments Against the Euro
• For the system to work well, countries should be similar.
• Individual countries have to give up national interest and exchange rate policies.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Financial Crises
• Since the mid-1990s, financial crises have hit Asia, Latin America and Russia.
• The crises have led to bank failures, corporate bankruptcies, unemployment, fiscal burdens and depletion of reserves.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Causes of the Asian Crisis (1997-1998)
• Availability of substantial short-term funds at low interest rates
• Fixed exchange rates gave borrowers a false sense of security
• Weakness of exports by the mid-1990s
• Financial fragility
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The AUD Exchange Rate Arrangements
• Until December 1971, the AUD was pegged to the pound.
• Until September 1974, the AUD was pegged to the US dollar.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The AUD Exchange Rate Arrangements (cont.)
• Until December 1983, the AUD was pegged to a basket.
• In December 1983, the AUD was floated.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The USD/AUD Exchange Rate
0.40
0.60
0.80
1.00
1.20
1.40
1.60
Mar-60 Mar-66 Mar-72 Mar-78 Mar-84 Mar-90 Mar-96 Mar-02
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Arguments for Flexible Exchange Rates
• The BOP adjustment mechanism is smoother and less painful.
• Large and persistent BOP deficits will not arise.
• Liquidity problems do not arise or are less acute.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 43
Arguments for Flexible Exchange Rates (cont.)
• Flexible rates are conducive to free trade.
• Flexible rates are conducive to policy independence.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Arguments Against Flexible Exchange Rates
• They cause uncertainty and inhibit international trade and investment.
• They cause destabilising speculation.• They are not suitable for small
countries.• They are unstable.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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New International Financial Architecture
• Linking IMF loans to crisis prevention efforts
• Imposition of holding-period taxes on short-term capital flows in countries characterised by financial fragility
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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New International Financial Architecture (cont.)
• Making the private sector partly responsible for the consequences of sovereign bond issues
• Discouraging fixed but adjustable exchange rates in favour of either managed floating or currency boards
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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New International Financial Architecture (cont.)
• Directing the IMF to lend less freely and to distinguish between country crises and systemic crises
• Removing overlap from the responsibilities of the IMF and the World Bank
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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A Global Currency?
• Convenience• Loss of exchange rate policy• A small open economy has more to
gain from the convenience