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Chapter 8-9 International

Monetary System

You should master:

(1) Features of a good international monetary system;

(2) Rules of the games, and the advantages and

disadvantages of the three international monetary

systems;

(3) The fundamental and immediate cause for the

collapse of the Bretton Woods system;(4) Some terms, like gold points,


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1.1. What is an international

monetary system?

Narrowly speaking, it refers to international

exchange rate system.

There are three international exchange ratesystems in history: the gold standard, the

Bretton Woods, and the floating exchange

rate system.


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1.2. Features of a good international

monetary systemAdjustment : a good system must be able to adjust

imbalances in balance of payments quickly and at a

relatively lower cost;

Stability and Confidence: the system must be able tokeep exchange rates relatively fixed and people must

have confidence in the stability of the system;

Liquidity: the system must be able to provide enough

reserve assets for a nation to correct its balance of

payments deficits without making the nation run into

deflation or inflation.


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1.3 Classification of international

monetary system

gold standard,

gold exchange standard

fiduciary standardFloating exchange rate system

Fixed exchange rate system


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II. The gold standard system(1880---1914)

Fixed Rate System

The world economy operated under a

system of f ixed dollar exchange ratesbetween the end of World War II and 1973,

with central banks routinely trading foreign

exchange to hold their exchange rates atinternationally agreed levels.


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Two kinds of the fixed

exchange rates

1. The fixed exchange rate system under the gold

standard

2. Notes in circulation system of fixed exchange

rate system

3. Gold Standard: provisions of the gold content of

the monetary unit.

4. The gold content of the contrast determine theexchange rate.

5. Coins can freely casting; freely convertible;

freedom of input and output.


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2.1 Rules of the game

Fix an official gold price or mint parity and allow freeconvertibility between domestic money and gold at that

price.

Impose no restrictions on the import or export of gold byprivate citizens, or on the use of gold for international

transactions.Issue national currency and coins only with gold backing,and link the growth in national bank deposits to theavailability of national gold reserves.

In the event of a short-run liquidity crisis associated with

gold outflows, the central bank should lend freely todomestic banks at higher interest rates (Bagehots Rule).

If Rule I is ever temporarily suspended, restoreconvertibility at the original mint parity as soon as

practical.


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2.2 Factors that determine or affect

the exchange rates

Factors that determine the exchange rates:

the mint parity

E.g. US$1= British

Factors that influence the exchange rates:

gold points and the demand for and supplyof foreign exchange


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2.3 Adjustment of balance of

payments deficits or surpluses

Price-specie flow mechanism:

Deficit gold flow out of the country

gold reserve decrease moneysupply decrease quantity theory of moneyprice level decrease exchange rate fixedexport go up, import go down, deficit

disappearThe adjustment of surplus is the opposite.


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2.4 Remarks and comments

An international gold standard avoids the

asymmetry inherent in a reserve cur rency

standardby avoiding the Nth currencyproblem. Under a gold standard, each

country f ixes the price of its currency in

terms of goldby standing ready to trade

domestic currency for gold whenever

necessary to defend the official price.


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The collapse of the gold standard system

It is virtually a pound standard system :

Britain and British pounds position in the

systemOutbreak of World War I.


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Advantage of the Gold Standard

Because there are Ncurrency and Nprices of gold in terms of those currencies,

no single country occupies a privilegedposition wi thin the system: each isresponsible for pegging its currencysprice in terms of the official international

reserve asset, gold. Gold standard rulesalso require each country to allowunhindered imports and exports of goldacross its borders.


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Benefits and drawbacks of the

Gold Standard

Benefits:

1. Symmetry

2. Price level and value of national moneyare more stable and predictable

3. Enhance international transactions


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The Gold Exchange Standard

Halfway between the gold standard and a pure

reserve currency standard is the gold exchange

standard. Central banks reserves consist of gold

and currencies whose prices in terms of gold arefixed, and each central bank fixes its exchange

rate to a currency with a fixed gold price.

More flexibilityin the growth of internationalreserves.


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3. The Bretton Woods System1944-1973

3.1 How this system came into being

The harms and disasters that the two Wars

brought the world.


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Fix an official par value for domestic currency interms of gold or a currency tied to gold as anumeraire.

In the short run, keep the exchange rate peggedwithin 1% of its par value, but in the long-runleave open the option to adjust the par valueunilaterally if the IMF concurs.

Permit free convertibility of currencies for currentaccount transactions, but use capital controls tolimit currency speculation.


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Fixed Exchange Rates under

currency-circulation system

Notes in circulation under the Bretton Woods

system. 1944 Bretton Woods agreement

The result of a compromise by the UnitedKingdom to the United States "double hook"

system.

dollar

National

currenciesYen ...

Lire ...

1=35

1%


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How to sustain the Fixed Rate

1. Use gold reserves

2. By making use of discount policies

3. Foreign exchange controls

4. Official devaluationslast resort


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3.3 Features of the system

IMF to see that this system runs on

smoothly

More flexibility in exchange ratesMore channels to correct imbalances in

balance of payments


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payments imbalances

Offset short-run balance of payments

imbalances by use of official reserves and

IMF credits, and sterilize the impact ofexchange market interventions on the

domestic money supply

Adjust fundamental imbalances by change

the par value permanently, provided agreed

by the IMF


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payments imbalances

Subordinate domestic monetary and fiscal policiesto maintain fixed exchange rate (use monetary

policy to keep price level and fiscal policy---government expenditures minus tax revenues--- tooffset imbalances between private savings andinvestment):

Deficit contractionary monetary or fiscalpolicy price level decrease exchange ratefixed

export go up, import go down, deficitdisappear

The adjustment of surplus is the opposite.


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Triffin Paradox

U.S. run deficits

U.S. run surplus

liquidity

confidence


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3.6 Collapse of the Bretton Woods

System: Process of dollar devaluationDollar

value

per

ounce

ofgold

1944 1971 1973

1 35

3842.22


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Abandoned Gold Exchange

Standard

The post-World War II reserve currency systemcentered on the dollar was, in fact, originally set upas a gold exchange standard. While foreign central

banks did the job of pegging exchange rates, theU.S. Federal Reserve was responsible for holdingthe dollar price of gold at $35 an ounce. By themid-1960s, the system operated in practice more

like a pure reserve currency system than a goldstandard. President Nixon unilaterally severed thedollars link to gold in August 1971, shortly

before the system of fixed dollar exchange rates

was abandoned.


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4. The present Floating Exchange RateSystem (1973-present)

4.1 How this system came into being

A system of no system An order of no order----Features of this system

1. No par values, between home currency and foreign

currency or gold2. No upper or lower limits of exchange rate fluctuations

3. The government has no obligation to maintain exchangerate fixed, it can choose any kind of exchange ratesystem, flexible rates are legal

4. 5.


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Smooth short-term variability in the dollar exchange rate,but do not commit to an official par value or to long-termexchange rate stability

Permit free convertibility of currencies for current account

transactions, while endeavoring to eliminate all remainingrestrictions on capital account transactions

Use the U.S. dollar as the intervention currency and keepofficial reserves primarily in U.S. treasury bonds

Modify domestic monetary policy to support major

exchange rate interventions, reducing the money supplywhen the national currency is weak against the dollar andexpanding the money supply when the national currency isstrong


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4.3 Features of this system

More currencies can be used as reserveassets

Governments began to cooperate tointervene in the foreign exchange marketsand to coordinate their domestic policies toachieve common prosperity

Many different kinds of exchange ratesappear


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Types of floating exchange rates

Whether there is a dirty hand:

1. Free Float/Clean Float

2. Managed Float/Dirty FloatWhether there is a Connection with othercurrencies:

1. Single Float27

2. Pegged Float(1) (2)SDR; ECU;

3. Joint Float

4. Crawling peg


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5. Should we return to a fixed rate

system?

What kind of international monetary system

should we adopt?

What are the advantages and disadvantagesof fixed and floating exchange rate system

respectively?


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5.1 Arguments favoring floating rates

1. Better adjustment

2. Better confidence

3. Better liquidity4. Gains from freer trade

5. Avoiding the so-called Peso Problem

6. Increased independence of policy


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5.2 Arguments against floating

exchange rates: Flexible rates

1. Cause uncertainty and inhibit internationaltrade and investment

2. Cause destabilizing speculation

3. Will not work for open economies

4. Are inflationary

5. Are unstable because of small tradeelasticities

6. Cause structural unemployment


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Krugman & Obstfeld (1)

1. Discipl ine. Central banks freed from the

obligation to fix their exchange rates might

embark on inflationary policies.2. Destabi l izing speculation and money market

disturbances. Speculation on changes in

exchange rates could lead to instability in foreign

exchange markets.3. I njur y to international trade and investment.

Floating rates would make relative international

prices more unpredictable.


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Krugman & Obstfeld (2)

4. Uncoordinated economic policies. The door

would be opened to competitive currency practices

harmful to the would economy.5. The il lusion of greater autonomy. Floating

exchange rates would not really give countries

more policy autonomy. Changes in exchange rates

would have such pervasive macroeconomic effectsthat central banks would feel compelled to

intervene heavily in foreign exchange markets

even without a formal commitment to peg.


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5.3 Selection of Fixed & Floating

Exchange Rates

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