Alternative International Monetary Standards

Chapter 19

Background of International Monetary System

• International monetary system has been in existence since late nineteenth century.– It was during this period that the gold standard began.

• The Gold Standard: 1880-1914– Under gold standard, currencies are valued in terms of

gold equivalent, known as mint parity price.• Each currency is defined in terms of its gold value. Thus, all

currencies are linked together in a system of fixed exchange rate.

• An ounce of gold was worth $20.76 in terms of U.S. dollars.

Gold Standard

• How it worked?– If 1 unit of currency A is worth 0.10 ounce of

gold,whereas 1 unit of currency B is worth 0.2 ounce gold, then 1 unit of currency B is worth twice as much as A.

• Exchange rate= 1 currency B=2 currency A

Gold Standard

• Maintaining gold standard requires a commitment from participating countries to buy and sell gold to anyone in the world at the fixed price.

• If the government does not stand willing to buy and sell at the mint parity price, then the price will fluctuate with changes in the supply and demand for money

The Interwar Period, 1918-1939

• World War I ended the gold standard.

• Europe had experienced rapid inflation during war and afterward and it was not possible to restore the gold standard.

• United Stated experienced little inflation during the war and thus returned to a gold standard.

The Gold Exchange Standard: 1944-1970

• After world war II, countries desired to establish an international monetary system based on mutual cooperation and freely convertible currencies.– Led to an international conference at Bretton

Woods, New Hampshire in 1944.– The result of this conference is to tie all

currencies together.

Bretton Woods Agreement

• The Bretton Woods agreement required that each country fix the value of its currency in terms of gold. – The U.S. dollar was the key currency in the

system.– $1 was defined as being equal to 1/35 ounce of

gold.

Bretton Woods Agreement

• Nations belonging to the system were committed to maintaining the parity value.

• The International Monetary Fund (IMF) was created to monitor the operation of the system.

The Transition Years: 1971-1973

• In 1971 international monetary conference was held in Washington to realign foreign-exchange values of the major currencies

• Change in dollar value in terms of gold from $35 to $38

• Dollar was being devalued by about 8%, currencies of countries with balance-of-payment surplus revalued upward

• In 1972 Britain allowed pound to float according demand and supply conditions

• By 1973 major currencies were all floating

Floating Exchange Rates: Since 1973

• In this system, exchange rate is determined by free market forces of demand and supply.

• Although we described the system since 1973 as floating system, it has never been fully determined by free market forces.

• The system in operation can be best described as managed float.

Exchange rate practices of some major countries

• Crawling Pegs: The exchange rate is adjusted periodically in small amount of pre-announced rate or in response to certain indicators.– Angola, Bolivia, Costa Rica, Nicaragua, Tunisia, and

Turkey

• Crawling bands: The exchange rate is maintained within certain fluctuation margins (9 countries).– Chile, Honduras, Hungary, Israel, Poland, Sri Lanka

Exchange rate practices of some major countries

• Managed Float: The monetary authority influences the exchange rate through active foreign market intervention with no preannounced path. (25 countries)– Example: Russia, Singapore, Czech Rep., Kenya, and

many FSU countries.

• Independently Floating: The exchange rate is market determined and any intervention is aimed at moderating fluctuations rather than determining levels. (48 countries)– Example: United States, UK, Korea, Australia

Exchange rate practices of some major countries

• No separate legal tender:Another country’s currency circulates as the legal tender or the country belongs to a monetary union where legal tender is shared by the members.– Example: Marshal Islands, Mirconesia, Panama– Euro area: Austria, France, Germany

• Fixed Peg: The exchange rate is fixed against a major currency or some basket of currencies.– Against a single currency (30 countries)

• Egypt, Jordan, Malaysia, Nepal, Saudi Arabia, Argentina

– Against a basket of currencies ( 13 countries)• Bangladesh, Kuwait, Latvia, Myanmar, Tonga

Choice of an Exchange Rate System

• Fixed/pegged vs Flexible/floating exchange rate system:– Under flexible exchange rate system, the

country can follow a domestic monetary policies independent of other countries. However, to maintain a fixed exchange rate, countries have to share a common inflation experience, in turn, requires similar monetary policies.

– Critics of flexible exchange rates have also argued that flexible exchange rates would be subject to destabilizing speculation.

Floating vs Fixed

• Research have shown that there are systematic differences between countries choosing fixed and floating exchange rates.– Country size: Large countries tend to be

independent in their monetary policies and prefer a flexible exchange rate system.

– Openness of a country: openness means the degree to which the country depends on international trade.

• The more open economy tends to follow a pegged exchange rate.

– Example: Singapore

Characteristics Associated with Countries Choosing to Peg or Float

• Peggers• Small size• Open economy• Harmonious inflation

rate• Concentrated Trade

• Floaters• Large size• Closed economy• Divergent inflation

rate• Diversified trade

Dollarization

• Dollarization occurs when another country or a territory outside the United States adopts the U.S. dollar as its official currency.

• Example: Panama, the Marshall Islands, Puerto Rico, Guam, Ecuador, El Salvador, and East Timor are officially dollarized.

• Central banks of Argentina, Brazil, and Mexico also have expressed interest in the potentials of dollarization.

Forms of Dollarization

• Dollarization usually takes on of three forms: official, unofficial, or semiofficial.

• Official dollarization: Occurs when a country formally adopts the U.S. dollar as its official unit of currency and abandons or removes from circulation its own currency. The U.S. dollar becomes the sole legal tender.

Forms of Dollarization

• Unofficial dollarization: Occurs when citizen of another country hold part of their assets in U.S. dollars or another foreign currency and part in domestic currency. This can occur without formal sanction by the foreign government. – Most of the Latin American and the Caribbean are

in this category.– Most of the FSU, Turkey, and Vietnam falls

under the same category.

Forms of Dollarization

• Semiofficial dollarization: Occurs when two currencies officially co-exist. The U.S. dollar is typically the legal tender and accounts for most bank deposits. The domestic currency is used for wages, payments and cash expenses.

• Examples: The Bahamas, Cambodia, Guatemala, Haiti, and Laos.

Motives for Dollarization

• International credibility and monetary policy discipline.

• Low interest rate, reduced inflation and greater financial stability may occur.

• May reduce capital outflow associated with a massive currency devaluation or economic crisis.

• Business transaction costs are reduced.

Major Obstacles for Dollarization

• Economic nationalism and pride in their own currency.

• Choice of the conversion rate between the domestic currency and the U.S. dollar.