International Monetary SystemInternational Monetary System

Organization of LectureOrganization of Lecture

ALTERNATIVE EXCHANGE RATE SYSTEMSALTERNATIVE EXCHANGE RATE SYSTEMS A BRIEF HISTORY OF THE INTERNATIONAL A BRIEF HISTORY OF THE INTERNATIONAL

MONETARY SYSTEMMONETARY SYSTEM THE EUROPEAN MONETARY SYSTEMTHE EUROPEAN MONETARY SYSTEM Costs and benefits of a single currencyCosts and benefits of a single currency

Alternative Exchange Rate SystemsAlternative Exchange Rate Systems

OverviewOverview : If people who don’t ordinarily use the same : If people who don’t ordinarily use the same currency are going to trade, there must be some way of currency are going to trade, there must be some way of exchanging currency. (If you want a Porsche, you’ve got exchanging currency. (If you want a Porsche, you’ve got to get German marks, or now the euro). There are an to get German marks, or now the euro). There are an enormous number of exchange rate systems, but generally enormous number of exchange rate systems, but generally they can be sorted into one of these categoriesthey can be sorted into one of these categories– Freely Floating Freely Floating – Managed FloatManaged Float– Target ZoneTarget Zone– Fixed RateFixed Rate– Hybrid Hybrid

Under a Under a floating rate systemfloating rate system, exchange , exchange rates are set by demand and supply.rates are set by demand and supply.

The model of demand and supply is extremely The model of demand and supply is extremely useful in explaining exchange rates under a useful in explaining exchange rates under a floating system (just make sure you keep track floating system (just make sure you keep track of what currency is purchased and what is of what currency is purchased and what is sold). sold).

Any number of factors might influence exchange Any number of factors might influence exchange rates, includingrates, including

– price levels price levels

– interest ratesinterest rates

– economic growtheconomic growth

Important Note:Important Note:

Even though we may call it “free float” in fact the Even though we may call it “free float” in fact the government can still control the exchange rate by government can still control the exchange rate by manipulating the factors that affect the exchange rate manipulating the factors that affect the exchange rate (i.e., monetary policy)(i.e., monetary policy)

Alternate exchange rate systems: Alternate exchange rate systems: Managed Managed Float (“Dirty Float”)Float (“Dirty Float”)

Market forces set rates unless excess volatility occurs, then, Market forces set rates unless excess volatility occurs, then, central bank determines rate by buying or selling currency. central bank determines rate by buying or selling currency. Managed float isn’t really a single system, but describes a Managed float isn’t really a single system, but describes a continuum of systemscontinuum of systems

– Smoothing daily fluctuationsSmoothing daily fluctuations

– ““Leaning against the wind” slowing the change to a different Leaning against the wind” slowing the change to a different raterate

– Unofficial pegging: actually fixing the rate without Unofficial pegging: actually fixing the rate without saying so.saying so.

– Target-Zone ArrangementTarget-Zone Arrangement: countries agree to maintain : countries agree to maintain exchange rates within a certain bound What makes target exchange rates within a certain bound What makes target zone arrangements special is the understanding that zone arrangements special is the understanding that countries will adjust real economic policies to maintain the countries will adjust real economic policies to maintain the zone.zone.

Alternate exchange rate systems: Alternate exchange rate systems: Fixed Rate Fixed Rate SystemSystem

One way to do this is to dictate an exchange rate and One way to do this is to dictate an exchange rate and shoot people who try to trade currency at anything shoot people who try to trade currency at anything other than the official exchange rate. Price controls other than the official exchange rate. Price controls are hard to enforce (and even if they could be are hard to enforce (and even if they could be enforced lead to a misallocation of resources).enforced lead to a misallocation of resources).

An alternative is to simply instruct the An alternative is to simply instruct the monetary authority to buy stand willing to buy monetary authority to buy stand willing to buy or sell currency at the desired rate.or sell currency at the desired rate.

A fixed rate system is the ultimate good news bad news joke. A fixed rate system is the ultimate good news bad news joke. The good is very good and the bad is very bad.The good is very good and the bad is very bad.

– Advantage: stability and predictabilityAdvantage: stability and predictability

– Disadvantage: the country loses control of monetary policy Disadvantage: the country loses control of monetary policy (note that monetary policy can always be used to control an (note that monetary policy can always be used to control an exchange rate).exchange rate).

At some point a fixed rate may become unsupportable At some point a fixed rate may become unsupportable and one country may devalue. (Argentina is the most and one country may devalue. (Argentina is the most dramatic recent example.) As an alternative to dramatic recent example.) As an alternative to devaluation, the country may impose currency controls. devaluation, the country may impose currency controls.

Final noteFinal note

Not every exchange relationship has to be the sameNot every exchange relationship has to be the same

A Brief History of the International A Brief History of the International Monetary SystemMonetary System

OverviewOverview

– Pre 1875 BimetalismPre 1875 Bimetalism

– 1875-1914: Classical Gold Standard1875-1914: Classical Gold Standard

– 1915-1944: Interwar Period1915-1944: Interwar Period

– 1945-1972: Bretton Woods System1945-1972: Bretton Woods System

– 1973-Present: Flexible (Hybrid) System1973-Present: Flexible (Hybrid) System

The Intrinsic Value of MoneyThe Intrinsic Value of Money

At present the money of most countries has no intrinsic value (if At present the money of most countries has no intrinsic value (if you melt a quarter, you don’t get $.25 worth of metal). But you melt a quarter, you don’t get $.25 worth of metal). But historically many countries have backed their currency with historically many countries have backed their currency with valuable commodities (usually gold or silver)—if the U.S. valuable commodities (usually gold or silver)—if the U.S. treasury were to mint gold coins that had 1/35th ounces of gold treasury were to mint gold coins that had 1/35th ounces of gold and sold these for $1.00, then a dollar bill would have an and sold these for $1.00, then a dollar bill would have an intrinsic value. intrinsic value.

When a country’s currency has some intrinsic value, then the When a country’s currency has some intrinsic value, then the exchange rate between the two countries is fixed. For example, exchange rate between the two countries is fixed. For example, if the U.S. mints $1.00 coins that contain 1/35th ounces of gold if the U.S. mints $1.00 coins that contain 1/35th ounces of gold and Great Britain mints £1.00 coins that contain 4/35th ounces and Great Britain mints £1.00 coins that contain 4/35th ounces of gold, then it must be the case that £1 = $4 (if not, people could of gold, then it must be the case that £1 = $4 (if not, people could make an unlimited profit buying gold in one country and selling make an unlimited profit buying gold in one country and selling it in another) it in another)

At various times some countries have minted At various times some countries have minted coins in both gold and silver (referred to as coins in both gold and silver (referred to as bimetallism) The U.S., for example, has bimetallism) The U.S., for example, has circulated gold and silver coins at the same circulated gold and silver coins at the same time. time.

In principle such a system can function effectively in an environment In principle such a system can function effectively in an environment where different countries back their currency with different metal. For where different countries back their currency with different metal. For example, during part of the 19th Century, Great Britain was on a gold example, during part of the 19th Century, Great Britain was on a gold standard, Germany was on a silver standard, and France minted both standard, Germany was on a silver standard, and France minted both gold and silver coins. The franc/pound exchange rate was set by the gold and silver coins. The franc/pound exchange rate was set by the relative gold values of the currencies while the franc/mark rate was set relative gold values of the currencies while the franc/mark rate was set by the relative silver values of the currency. (Think about how such a by the relative silver values of the currency. (Think about how such a system implicitly sets the pound/mark rate.)system implicitly sets the pound/mark rate.)

Gresham’s LawGresham’s Law, however, creates a potential problem. People will tend , however, creates a potential problem. People will tend to horde the currency that is relatively valuable and spend the currency to horde the currency that is relatively valuable and spend the currency that has less value. Following discoveries of gold in the U.S and that has less value. Following discoveries of gold in the U.S and Australia in the mid 19th Century, the intrinsic value of gold fell Australia in the mid 19th Century, the intrinsic value of gold fell relative to the value of silver. The French people, quite sensibly, held relative to the value of silver. The French people, quite sensibly, held on to their silver coins (or melted them down) and spent their gold.on to their silver coins (or melted them down) and spent their gold.

The Classical Gold Standard (1875-1914)The Classical Gold Standard (1875-1914)

The Classical Gold Standard had two essential The Classical Gold Standard had two essential featuresfeatures

– Nations fixed the value of the currency in terms of Nations fixed the value of the currency in terms of

– Gold is freely transferable between countries Gold is freely transferable between countries Essentially a fixed rate system (Suppose the US Essentially a fixed rate system (Suppose the US

announces a willingness to buy gold for $200/oz announces a willingness to buy gold for $200/oz and Great Britain announces a willingness to and Great Britain announces a willingness to buy gold for £100. Then £1=$2)buy gold for £100. Then £1=$2)

Advantage of Gold SystemAdvantage of Gold System

Disturbances in Price Levels Would be offset by the Disturbances in Price Levels Would be offset by the price-specie-flow mechanism. When a balance of price-specie-flow mechanism. When a balance of payments surplus led to a gold inflow Gold inflow payments surplus led to a gold inflow Gold inflow (country with surplus) led to higher prices which (country with surplus) led to higher prices which reduced surplus Gold outflow led to lower prices and reduced surplus Gold outflow led to lower prices and increased surplusincreased surplus

Interwar PeriodInterwar Period

Periods of serious chaos such as German Periods of serious chaos such as German hyperinflation and the use of exchange rates as a way hyperinflation and the use of exchange rates as a way to gain trade advantage.to gain trade advantage.

Britain and US adopt a kind of gold standard Britain and US adopt a kind of gold standard (but tried to prevent the species adjustment (but tried to prevent the species adjustment mechanism from working).mechanism from working).

Bretton Woods System: Bretton Woods System: 1945-19721945-1972

German markBritish

poundFrench franc

U.S. dollar

Gold

Pegged at $35/oz.

Par Value

Par ValuePar

Value

The Bretton Woods System The Bretton Woods System (1946-1971)(1946-1971)

U.S.$ was key currency valued at $1 = 1/35 oz. of goldU.S.$ was key currency valued at $1 = 1/35 oz. of gold All currencies linked to that price in a fixed rate All currencies linked to that price in a fixed rate

system.system. In effect, rather than hold gold as a reserve In effect, rather than hold gold as a reserve

asset, other countries hold US dollars (which asset, other countries hold US dollars (which are backed by gold)are backed by gold)

Real GDP in German During B-W PeriodReal GDP in German During B-W Period

Collapse of Bretton Woods (1971)Collapse of Bretton Woods (1971)

U.S. high inflation rateU.S. high inflation rate U.S.$ depreciated sharply.U.S.$ depreciated sharply. Smithsonian Agreement (1971) US$ devalued to 1/38 Smithsonian Agreement (1971) US$ devalued to 1/38

oz. of gold.oz. of gold. 1973 The US dollar is under heavy pressure, 1973 The US dollar is under heavy pressure,

European and Japanese currencies are allowed to European and Japanese currencies are allowed to floatfloat

1976 1976 Jamaica AgreementJamaica Agreement

– Flexible exchange rates declared acceptableFlexible exchange rates declared acceptable

– Gold abandoned as an international reserveGold abandoned as an international reserve

Current Exchange Rate Arrangements Current Exchange Rate Arrangements (IMF Classification(IMF Classification

No national currency (e.g., dollars in Panama and Euros No national currency (e.g., dollars in Panama and Euros in Italy)in Italy)

Currency Board: Explicit commitment to fix exchange Currency Board: Explicit commitment to fix exchange rates to some foreign currency (Hong Kong fixed to rates to some foreign currency (Hong Kong fixed to dollar)dollar)

Other fixed rate systems fixing the countries currency to Other fixed rate systems fixing the countries currency to a single currency or some basket of currencies (allowing a single currency or some basket of currencies (allowing some narrow fluctuations of less than 1%)some narrow fluctuations of less than 1%)

Current Exchange Rate Arrangements Current Exchange Rate Arrangements (IMF Classification(IMF Classification

Crawling pegs: exchange rate adjusted at a Crawling pegs: exchange rate adjusted at a preannounced rate, usually in response to some objective preannounced rate, usually in response to some objective qualitative indicator (e.g., Costa Rica).qualitative indicator (e.g., Costa Rica).

Floating within crawling bandsFloating within crawling bands Managed float: authorities manipulate the exchange rate Managed float: authorities manipulate the exchange rate

but do not announce their intentionsbut do not announce their intentions Independent float. Independent float.

The Mexican Peso CrisisThe Mexican Peso Crisis

On 20 December, 1994, the Mexican government On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar announced a plan to devalue the peso against the dollar by 14 percent.by 14 percent.

This decision changed currency trader’s expectations This decision changed currency trader’s expectations about the future value of the peso.about the future value of the peso.

They stampeded for the exits. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 In their rush to get out the peso fell by as much as 40

percent.percent.

The Mexican Peso CrisisThe Mexican Peso Crisis

The Mexican Peso crisis is unique in that it represents The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off the first serious international financial crisis touched off by cross-border flight of portfolio capital.by cross-border flight of portfolio capital.

Two lessons emerge:Two lessons emerge:– It is essential to have a multinational safety net in It is essential to have a multinational safety net in

place to safeguard the world financial system from place to safeguard the world financial system from such crises.such crises.

– An influx of foreign capital can lead to an An influx of foreign capital can lead to an overvaluation in the first place.overvaluation in the first place.

The Asian Currency Crisis (1997)The Asian Currency Crisis (1997)

In 1996 several Asian countries experienced an inflow In 1996 several Asian countries experienced an inflow of nearly $100 billion in foreign capital.of nearly $100 billion in foreign capital.

This explosion of credit led to a kind of speculative This explosion of credit led to a kind of speculative bubble in some sectors (e.g., real estate).bubble in some sectors (e.g., real estate).

In mid-1997 the Thai bhat came under much pressure. In mid-1997 the Thai bhat came under much pressure. The Thai Central Bank tried to defend the bhat by The Thai Central Bank tried to defend the bhat by drawing down foreign exchange reserves. In the end, drawing down foreign exchange reserves. In the end, however, they had to devalue and the bhat lost about however, they had to devalue and the bhat lost about 40% of its 40% of its

The Asian Currency CrisisThe Asian Currency Crisis

The Asian currency crisis turned out to be far more The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant extent of the contagion and the severity of the resultant economic and social costs.economic and social costs.

Many firms with foreign currency bonds were forced Many firms with foreign currency bonds were forced into bankruptcy.into bankruptcy.

The region experienced a deep, widespread recession.The region experienced a deep, widespread recession.

The Argentinean Peso CrisisThe Argentinean Peso Crisis

In 1991 the Argentine government passed a In 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar convertibility law that linked the peso to the U.S. dollar at parity.at parity.

The initial economic effects were positive:The initial economic effects were positive:

– Argentina’s chronic inflation was curtailedArgentina’s chronic inflation was curtailed

– Foreign investment poured inForeign investment poured in As the U.S. dollar appreciated on the world market the As the U.S. dollar appreciated on the world market the

Argentine peso became stronger as well.Argentine peso became stronger as well.

The Argentinean Peso CrisisThe Argentinean Peso Crisis

The strong peso hurt exports from Argentina and caused The strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the a protracted economic downturn that led to the abandonment of peso–dollar parity in January 2002.abandonment of peso–dollar parity in January 2002.

– The unemployment rate rose above 20 percentThe unemployment rate rose above 20 percent

– The inflation rate reached a The inflation rate reached a monthlymonthly rate of 20 rate of 20 percentpercent

The Argentinean Peso CrisisThe Argentinean Peso Crisis

There are at least three factors that are related to the There are at least three factors that are related to the collapse of the currency board arrangement and the collapse of the currency board arrangement and the ensuing economic crisis:ensuing economic crisis:

– Lack of fiscal discipline Lack of fiscal discipline

– Labor market inflexibilityLabor market inflexibility

– Contagion from the financial crises in Brazil and Contagion from the financial crises in Brazil and RussiaRussia

Currency Crisis ExplanationsCurrency Crisis Explanations

In theory, a currency’s value mirrors the fundamental strength of its In theory, a currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies. underlying economy, relative to other economies. In the long runIn the long run..

In the short runIn the short run, currency trader’s expectations play a much more , currency trader’s expectations play a much more important role.important role.

In today’s environment, traders and lenders, using the most modern In today’s environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian they expect others are about to sell Brazilian realsreals for U.S. dollars, for U.S. dollars, they want to “get to the exits first”. they want to “get to the exits first”.

Thus, fears of depreciation become self-fulfilling prophecies.Thus, fears of depreciation become self-fulfilling prophecies.

The European ExperienceThe European Experience

THE EUROPEAN MONETARY SYSTEMTHE EUROPEAN MONETARY SYSTEM (1979) established to provide (1979) established to provide exchange rate stability to all members by holding exchange rates within exchange rate stability to all members by holding exchange rates within specified limits by establishing a kind of target-zone methodspecified limits by establishing a kind of target-zone method– Close macroeconomic policy coordination required.Close macroeconomic policy coordination required.– Currency Crisis of Sept. 1992: System brakes down. Britain and Currency Crisis of Sept. 1992: System brakes down. Britain and

Italy forced to withdraw from EMS and finally collapses in 1993.Italy forced to withdraw from EMS and finally collapses in 1993.

Maastricht TreatyMaastricht Treaty– Called for Monetary Union by 1999 (moved to 2002)Called for Monetary Union by 1999 (moved to 2002)– Established a single currency (the euro)Established a single currency (the euro)– Called for creation of a single central EU bank (ECB)Called for creation of a single central EU bank (ECB)– Adopts tough fiscal standards for entering countries For example, Adopts tough fiscal standards for entering countries For example,

countries could not carry a total debt of more than 60% of GDP, countries could not carry a total debt of more than 60% of GDP, and inflation rates had to be no more than 1.5% than the average and inflation rates had to be no more than 1.5% than the average inflation of the three lowest inflation nations.inflation of the three lowest inflation nations.

Benefits of a single currencyBenefits of a single currency

Reduces exchange rate riskReduces exchange rate risk Allows for larger capital markets which may provide Allows for larger capital markets which may provide

greater liquiditygreater liquidity May promote a sense of political unity among nations May promote a sense of political unity among nations

sharing the currency.sharing the currency.

Costs of a Single CurrencyCosts of a Single Currency

Lack of national monetary flexibility.Lack of national monetary flexibility. Leaving countries vulnerable to “asymmetric shocks” Leaving countries vulnerable to “asymmetric shocks”

(problems in one country not common to all)(problems in one country not common to all)