International Monetary System. Organization of Lecture ALTERNATIVE EXCHANGE RATE SYSTEMS ALTERNATIVE EXCHANGE RATE SYSTEMS A BRIEF HISTORY OF THE INTERNATIONAL

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<ul><li> Slide 1 </li> <li> International Monetary System </li> <li> Slide 2 </li> <li> Organization of Lecture ALTERNATIVE EXCHANGE RATE SYSTEMS ALTERNATIVE EXCHANGE RATE SYSTEMS A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM THE EUROPEAN MONETARY SYSTEM THE EUROPEAN MONETARY SYSTEM Costs and benefits of a single currency Costs and benefits of a single currency </li> <li> Slide 3 </li> <li> Alternative Exchange Rate Systems Overview : If people who dont ordinarily use the same currency are going to trade, there must be some way of exchanging currency. (If you want a Porsche, youve got to get German marks, or now the euro). There are an enormous number of exchange rate systems, but generally they can be sorted into one of these categories Overview : If people who dont ordinarily use the same currency are going to trade, there must be some way of exchanging currency. (If you want a Porsche, youve got to get German marks, or now the euro). There are an enormous number of exchange rate systems, but generally they can be sorted into one of these categories Freely Floating Managed Float Target Zone Fixed Rate Hybrid </li> <li> Slide 4 </li> <li> Under a floating rate system, exchange rates are set by demand and supply. The model of demand and supply is extremely useful in explaining exchange rates under a floating system (just make sure you keep track of what currency is purchased and what is sold). The model of demand and supply is extremely useful in explaining exchange rates under a floating system (just make sure you keep track of what currency is purchased and what is sold). Any number of factors might influence exchange rates, including Any number of factors might influence exchange rates, including price levels interest rates economic growth </li> <li> Slide 5 </li> <li> Important Note: Even though we may call it free float in fact the government can still control the exchange rate by manipulating the factors that affect the exchange rate (i.e., monetary policy) Even though we may call it free float in fact the government can still control the exchange rate by manipulating the factors that affect the exchange rate (i.e., monetary policy) </li> <li> Slide 6 </li> <li> Alternate exchange rate systems: Managed Float (Dirty Float) Market forces set rates unless excess volatility occurs, then, central bank determines rate by buying or selling currency. Managed float isnt really a single system, but describes a continuum of systems Market forces set rates unless excess volatility occurs, then, central bank determines rate by buying or selling currency. Managed float isnt really a single system, but describes a continuum of systems Smoothing daily fluctuations Leaning against the wind slowing the change to a different rate Unofficial pegging: actually fixing the rate without saying so. Target-Zone Arrangement: countries agree to maintain exchange rates within a certain bound What makes target zone arrangements special is the understanding that countries will adjust real economic policies to maintain the zone. </li> <li> Slide 7 </li> <li> Alternate exchange rate systems: Fixed Rate System One way to do this is to dictate an exchange rate and shoot people who try to trade currency at anything other than the official exchange rate. Price controls are hard to enforce (and even if they could be enforced lead to a misallocation of resources). One way to do this is to dictate an exchange rate and shoot people who try to trade currency at anything other than the official exchange rate. Price controls are hard to enforce (and even if they could be enforced lead to a misallocation of resources). </li> <li> Slide 8 </li> <li> An alternative is to simply instruct the monetary authority to buy stand willing to buy or sell currency at the desired rate. A fixed rate system is the ultimate good news bad news joke. The good is very good and the bad is very bad. A fixed rate system is the ultimate good news bad news joke. The good is very good and the bad is very bad. Advantage: stability and predictability Disadvantage: the country loses control of monetary policy (note that monetary policy can always be used to control an exchange rate). At some point a fixed rate may become unsupportable and one country may devalue. (Argentina is the most dramatic recent example.) As an alternative to devaluation, the country may impose currency controls. At some point a fixed rate may become unsupportable and one country may devalue. (Argentina is the most dramatic recent example.) As an alternative to devaluation, the country may impose currency controls. </li> <li> Slide 9 </li> <li> Final note Not every exchange relationship has to be the same Not every exchange relationship has to be the same </li> <li> Slide 10 </li> <li> A Brief History of the International Monetary System Overview Overview Pre 1875 Bimetalism 1875-1914: Classical Gold Standard 1915-1944: Interwar Period 1945-1972: Bretton Woods System 1973-Present: Flexible (Hybrid) System </li> <li> Slide 11 </li> <li> The Intrinsic Value of Money At present the money of most countries has no intrinsic value (if you melt a quarter, you dont get $.25 worth of metal). But historically many countries have backed their currency with valuable commodities (usually gold or silver)if the U.S. 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 intrinsic value. At present the money of most countries has no intrinsic value (if you melt a quarter, you dont get $.25 worth of metal). But historically many countries have backed their currency with valuable commodities (usually gold or silver)if the U.S. 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 intrinsic value. When a countrys currency has some intrinsic value, then the 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 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 make an unlimited profit buying gold in one country and selling it in another) When a countrys currency has some intrinsic value, then the 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 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 make an unlimited profit buying gold in one country and selling it in another) </li> <li> Slide 12 </li> <li> At various times some countries have minted coins in both gold and silver (referred to as bimetallism) The U.S., for example, has circulated gold and silver coins at the same time. In principle such a system can function effectively in an environment where different countries back their currency with different metal. For example, during part of the 19th Century, Great Britain was on a gold standard, Germany was on a silver standard, and France minted both 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 by the relative silver values of the currency. (Think about how such a system implicitly sets the pound/mark rate.) In principle such a system can function effectively in an environment where different countries back their currency with different metal. For example, during part of the 19th Century, Great Britain was on a gold standard, Germany was on a silver standard, and France minted both 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 by the relative silver values of the currency. (Think about how such a system implicitly sets the pound/mark rate.) Greshams Law, however, creates a potential problem. People will tend 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 Australia in the mid 19th Century, the intrinsic value of gold fell 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. Greshams Law, however, creates a potential problem. People will tend 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 Australia in the mid 19th Century, the intrinsic value of gold fell 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. </li> <li> Slide 13 </li> <li> The Classical Gold Standard (1875-1914) The Classical Gold Standard had two essential features The Classical Gold Standard had two essential features Nations fixed the value of the currency in terms of Gold is freely transferable between countries Essentially a fixed rate system (Suppose the US announces a willingness to buy gold for $200/oz and Great Britain announces a willingness to buy gold for 100. Then 1=$2) Essentially a fixed rate system (Suppose the US announces a willingness to buy gold for $200/oz and Great Britain announces a willingness to buy gold for 100. Then 1=$2) </li> <li> Slide 14 </li> <li> Advantage of Gold System Disturbances in Price Levels Would be offset by the price-specie-flow mechanism. When a balance of payments surplus led to a gold inflow Gold inflow (country with surplus) led to higher prices which reduced surplus Gold outflow led to lower prices and increased surplus Disturbances in Price Levels Would be offset by the price-specie-flow mechanism. When a balance of payments surplus led to a gold inflow Gold inflow (country with surplus) led to higher prices which reduced surplus Gold outflow led to lower prices and increased surplus </li> <li> Slide 15 </li> <li> Interwar Period Periods of serious chaos such as German hyperinflation and the use of exchange rates as a way to gain trade advantage. Periods of serious chaos such as German hyperinflation and the use of exchange rates as a way to gain trade advantage. Britain and US adopt a kind of gold standard (but tried to prevent the species adjustment mechanism from working). Britain and US adopt a kind of gold standard (but tried to prevent the species adjustment mechanism from working). </li> <li> Slide 16 </li> <li> Bretton Woods System: 1945-1972 German mark British pound French franc U.S. dollar Gold Pegged at $35/oz. Par Value </li> <li> Slide 17 </li> <li> The Bretton Woods System (1946-1971) U.S.$ was key currency valued at $1 = 1/35 oz. of gold U.S.$ was key currency valued at $1 = 1/35 oz. of gold All currencies linked to that price in a fixed rate system. All currencies linked to that price in a fixed rate system. In effect, rather than hold gold as a reserve asset, other countries hold US dollars (which are backed by gold) In effect, rather than hold gold as a reserve asset, other countries hold US dollars (which are backed by gold) </li> <li> Slide 18 </li> <li> Real GDP in German During B-W Period </li> <li> Slide 19 </li> <li> Collapse of Bretton Woods (1971) U.S. high inflation rate U.S. high inflation rate U.S.$ depreciated sharply. U.S.$ depreciated sharply. Smithsonian Agreement (1971) US$ devalued to 1/38 oz. of gold. Smithsonian Agreement (1971) US$ devalued to 1/38 oz. of gold. 1973 The US dollar is under heavy pressure, European and Japanese currencies are allowed to float 1973 The US dollar is under heavy pressure, European and Japanese currencies are allowed to float 1976 Jamaica Agreement 1976 Jamaica Agreement Flexible exchange rates declared acceptable Gold abandoned as an international reserve </li> <li> Slide 20 </li> <li> Current Exchange Rate Arrangements (IMF Classification No national currency (e.g., dollars in Panama and Euros in Italy) No national currency (e.g., dollars in Panama and Euros in Italy) Currency Board: Explicit commitment to fix exchange rates to some foreign currency (Hong Kong fixed to dollar) Currency Board: Explicit commitment to fix exchange rates to some foreign currency (Hong Kong fixed to dollar) Other fixed rate systems fixing the countries currency to a single currency or some basket of currencies (allowing some narrow fluctuations of less than 1%) Other fixed rate systems fixing the countries currency to a single currency or some basket of currencies (allowing some narrow fluctuations of less than 1%) </li> <li> Slide 21 </li> <li> Current Exchange Rate Arrangements (IMF Classification Crawling pegs: exchange rate adjusted at a preannounced rate, usually in response to some objective qualitative indicator (e.g., Costa Rica). Crawling pegs: exchange rate adjusted at a preannounced rate, usually in response to some objective qualitative indicator (e.g., Costa Rica). Floating within crawling bands Floating within crawling bands Managed float: authorities manipulate the exchange rate but do not announce their intentions Managed float: authorities manipulate the exchange rate but do not announce their intentions Independent float. Independent float. </li> <li> Slide 22 </li> <li> The Mexican Peso Crisis On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency traders expectations about the future value of the peso. This decision changed currency traders expectations 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 percent. In their rush to get out the peso fell by as much as 40 percent. </li> <li> Slide 23 </li> <li> The Mexican Peso Crisis The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. Two lessons emerge: Two lessons emerge: It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. An influx of foreign capital can lead to an overvaluation in the first place. </li> <li> Slide 24 </li> <li> The Asian Currency Crisis (1997) In 1996 several Asian countries experienced an inflow of nearly $100 billion in foreign capital. In 1996 several Asian countries experienced an inflow of nearly $100 billion in foreign capital. This explosion of credit led to a kind of speculative bubble in some sectors (e.g., real estate). This explosion of credit led to a kind of speculative bubble in some sectors (e.g., real estate). I...</li></ul>