2. The InternationalMonetary System

Start by looking at a typical domestic monetary system

Domestic Monetary Systems

Central Bank

Government

Retail Banks

Typically, the government establishes a central bank to….

Control the money supply

Regulate the banking system

Act as the bank for the government and for private retail banks

people

And ultimately, of course, money flows between the government, retail banks, people and businesses.

businesses

Domestic Monetary Policy

The objective(s) of monetary policy may be…

Low inflation (steady prices).

High GDP growth.

To fund (pay for) a government deficit.

To support a particular domestic retail interest rate.

To support a particular international exchange rate against another currency.

Monetary policy determines how, and how much money, the central bank inserts into, or takes out of, the economy.The central bank typically does this by raising or lowering the interest rate it charges retail banks; and/or buy buying or selling government debt.

Exchange RatesAn exchange rate is simply the price of one currency against another. For example…

Exchange rates are necessary to fund international trade and investment.

=3030 Thai baht per 1 US dollar

1

Or, 1 Thai baht = 1/30 US dollar

30 301 0.0333

Trade FlowsExample: A Thai exported sells some shoes to an American customer for Bt 3,000. The exchange rate is 30 baht per dollar.

$100

Bt 3,000 / (Bt30/$) = $100

Bt 3,000Depending upon the payment method, the dollars could be changed into Thai baht in the USA, in Thailand, or through the Bank of International Settlements (BIS) in Switzerland.

Discussion QuestionsConsider the baht/dollar exchange rates

$1 = ThB 25; $1 = ThB 30, $1 = ThB 40

Q1: Which exchange rate above indicates a “stronger” baht? A stronger dollar?

Q2: From Thailand’s point of view, which is the best exchange rate?

A1: $1 = ThB 25 makes the dollar weak and therefore the baht strong.Rewriting the exchange rates as ThB 1 = $.04,ThB 1 = $0.0333, ThB 1 = $.025, we can see that the first exchange rate $1 = ThB 25 makes the baht the strongest.

A2: Generally, a weak currency benefits exporters and the economy; but a strong currency benefits importers and lowers inflation.

But what is also important is the volatility of the exchange rate. Generally, a stable exchange rate is better than a volatile one.

History of Monetary Regimes

Bimetallism(pre-1875)

Gold Standard (1875-1914)

Interwar Period (1915-

1944)

Bretton Woods (1945-

1972)

Flexible Exchange

Rates (after 1973)

How exchange rates are determined depends in large part upon the international monetary regime under which it operates.

Gold Standard 1875-19141. Each country’s central bank holds gold reserves.

Bank of England

gold reserves

gold reserves

Bank of France

2. Each country sets its own domestic convertibility ratio between gold and its own currency.

£6 = 1 ounce gold FFr12 = 1 ounce gold

3. Exchange rates are determined by the currencies convertibility into gold.

1 ounce gold = £6 = FFr12…. so £6 = FFr12 or £1 = FFr2.

Importantly, trade imbalances are funded indirectly by flows of gold reserves!

If England exports goods to France……gold reserves will flow from France to England.

Discussion Questions

Q1: What is the equillibriating (adjusting) mechanism here for trade imbalances?A1: Flows of gold reserves between countries….causing domestic prices to adjust which should restore trade balances.

Q2: What’s good about this system?A2: Stability.A2: Legitimacy of currency & low inflation.

Q3: What’s bad about this system?

A3: For net importers (gold reserve exporters), a temptation to adjust downward the currency/gold exchange rate.A3: Systemic problems if equillibriating mechanisms don’t work and reserves get too low.

Generally speaking, we’ll see below that fixing a currency to gold – or to anything else, including another currency – can lead to trouble for net importing countries.

Bretton Woods 1945-72

The post-WWII international monetary system, created along with the International Monetary Fund (IMF) and the World Bank.

A dollar-based gold standardParticipating countries wanted…

stable exchange rates.

a gold-based system without the need for gold reserves.

The eventual solution was….

A dollar-based gold standard

Gold pegged at $35/ounce

German D-mark UK pound sterlingFrench franc

Par value Par valuePar value

Bretton Woods System: The US Dollar fixed to gold; and other currencies fixed at “par” to the US dollar.

As a result, the US dollar became the defacto world reserve currency.

A dollar-based gold standard

German D-mark UK pound sterlingFrench franc

To increase their reserves, other countries exported heavily to the US, getting dollars in return.

Persistent trade deficits weakened faith in the dollar, and encouraged exchanging dollars for gold.

Eventually, falling demand for US$, coupled with expansionary US monetary policy, forced the US Government to suspend convertibility of dollars for gold….

…and the free-floating, flexible exchange rate regime was born.