An Overview of International Monetary Systems and Recent Developments in International Financial Markets 22 Prices and Policies Second Edition ©2001

An Overview of International Monetary Systems and Recent Developments in International Financial Markets

2

Prices and Policies

Second Edition ©2001

Richard M. Levich

International Financial Markets

McGraw Hill / Irwin

2 - 2

McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview

International Monetary Arrangements in Theory and Practice The International Gold Standard, 1879-1913 The Spirit of the Bretton Woods Agreement, 1945 The Fixed-Rate Dollar Standard, 1950-1970 The Floating-Rate Dollar Standard, 1973-1984 The Plaza-Louvre Intervention Accords and the

Floating-Rate Dollar Standard, 1985-1999

2 - 3


Overview

International Monetary Arrangements in Theory and Practice …continued The Spirit of the European Monetary System, 1979 The European Monetary System as a “Greater DM”

Area, 1979-1998 The Spirit of the European Economic and Monetary

Union, 1999

2 - 4


Overview

Recent Behavior of Prices in International Financial Markets Exchange Rate Developments Interest Rate Developments

Policy Matters - Private Enterprises The Conduct of Business under Pegged and

Floating Exchange Rates Greater Exchange Rate Variability under Floating Costs of Exchange Rate Variability

2 - 5


Overview

Policy Matters - Public Policymakers Exchange Rate Policies in Emerging Markets Beyond Currency Boards to Full Dollarization Concerns About EMU

2 - 6


International Monetary Arrangementsin Theory and Practice

The international financial system can promote the gains from international trade and the economic integration of regions …

… but it may also be a conduit for the transfer of macroeconomic shocks from one nation to another.

International financial systems based on rules have evolved to balance these trade-offs.

… and the Rules of the Game are ...

2 - 7


The International Gold Standard, 1879-1913

Countries unilaterally elected to follow the rules of the gold standard system, which lasted until the outbreak of World War I in 1914, when European governments ceased to allow their currencies to be convertible either into gold or other currencies.

Fix an official gold price or “mint parity” and allow free convertibility between domestic money and gold at that price.

2 - 8


The International Gold Standard, 1879-1913

With stable exchange rates and a common monetary policy, prices of tradable commodities were much equalized across countries.

Real rates of interest also tended toward equality across a broad range of countries.

On the other hand, the workings of the internal economy were subservient to balance in the external economy.

2 - 9


The Spirit of the Bretton Woods Agreement, 1945

In essence, the Agreement removed countries from the tyranny of the gold standard and permitted greater autonomy for national monetary policies

Fix an official par value for domestic currency in terms of gold or a currency tied to gold as a numeraire.

In the short run, keep the exchange rate pegged within 1% of its par value, but in the long-run leave open the option to adjust the par value unilaterally if the IMF concurs.

2 - 10



The Role of International Reserves inExchange Rate Determination

Price ofSterling

Quantity of sterling/Time

$2.82

$2.78

D

D

S

S

a

2 - 11



The Role of International Reserves inExchange Rate Determination

Price ofSterling

Quantity of sterling/Time

$2.82

$2.78

D

D

S

S

aD’

D’

ef g

The Bank of England uses

its US$ reserves to buy up fg £ each period.

S’

S’

hi j The Bank

must buy up ij £ each

period.

D”

D”

bc d

The Bank must supply

cd £ each period.

2 - 12


The Fixed-Rate Dollar Standard, 1950-1970

Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, and keep the exchange rate within 1% of this par value indefinitely.

United States : Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target.

In practice, the Bretton Woods system evolved into a fixed-rate dollar standard.

2 - 13


The Fixed-Rate Dollar Standard, 1950-1970

Redundancy arises because the policies of N-1 countries are sufficient to determine the policies of the N th country in a world with N countries.

So, the United States had to provide a stable world price level and a monetary policy that met the needs of the other N-1 countries.

In 1971, the U.S. renounced any commitment to exchange foreign dollar reserves for gold under the strain of capital outflows and widening trade deficits.

2 - 14


The Floating-Rate Dollar Standard, 1973-1984

Without an agreement on who would set the common monetary policy and how it would be set, a floating exchange rate system provided the only alternative to the Bretton Woods system.

2 - 15



Industrial countries other than the United States : Smooth short-term variability in the dollar exchange rate, but do not commit to an official par value or to long-term exchange rate stability.

United States : Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target. No need for sizable official foreign exchange reserves.

2 - 16



Essentially, the foreign exchange rate was left to play the role of a residual variable that did a great deal of the adjusting to offset the macroeconomic policy differences across countries.

2 - 17


Germany, Japan, and the United States (G-3) : Set broad target zones for the $/DM and $/¥ exchange rates. Do not announce the agreed-upon central rates, and allow for flexible zonal boundaries. Allow the implicit central rates to adjust when economic fundamentals among the G-3 countries change substantially.

Other industrial countries : Support or do not oppose interventions by the G-3 to keep the dollar within its target zone limits.

The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999

2 - 18


The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999

An episode started by an expansive U.S. fiscal policy introduced in 1981 combined with tight monetary control convinced policymakers that …

exchange rates were too important to be left to market forces intervention was deemed appropriate

exchange rates were too important to be the residual from uncoordinated economic policies better policy coordination was required.

2 - 19


The Spirit of the European Monetary System, 1979

This is a pursuit by European nations to limit exchange rate fluctuations against each other and to establish coordinated macroeconomic policies across Europe.

The European Monetary System (EMS) was built upon three building blocks: the European Currency Unit (ECU), the Exchange Rate Mechanism (ERM), and the European Monetary Cooperation Fund (EMCF).

2 - 20


All member countries : Fix a par value for each exchange rate in terms of the European Currency Unit, a basket weighted according to country size.

Keep exchange rates stable in the short-run by limiting movements in bilateral rates - the Exchange Rate Mechanism.

Hold foreign exchange reserves primarily in ECUs with the European Monetary Cooperation Fund, and reduce US$ reserves.


2 - 21



The three building blocks of the EMS linked together European exchange rates and monetary policies until the chaotic events of 1992 and 1993.

2 - 22


The European Monetary System as a “Greater DM” Area, 1979-1998

In practice, the DM was the centerpiece of the ERM, and German monetary policy formed the anchor for the EMS price level.

Member countries except Germany : Intervene to stabilize currency values vis-à-vis the DM.

Germany : Remain passive in the foreign exchange market with respect to other EMS countries. Set German monetary policy independently to serve as an anchor for the EMS price level.

2 - 23



Some European leaders wanted to achieve an even closer economic and social union. In 1989, a plan for a European Economic and

Monetary Union (EMU) was presented .

Under the EMU, a single central bank would set monetary policy for a single European money. The 1991 Maastricht Treaty spelled out the steps

needed to transfer the responsibilities for monetary policy and national monies to a new EC institution.

2 - 24



Doubts and debate about the economic feasibility and advisability of EMU persisted throughout the 1990s.

In 1992, currency speculators sensed that the treaty was in trouble and made attacks on various European currencies. The tensions persisted throughout 1993.

In November 1992, the Maastricht Treaty was adopted and the European Union (EU) was born.

2 - 25


The Spirit of the European Economic and Monetary Union, 1999

The EMU was launched on January 1, 1999 with 11 member countries.

The European Central Bank (ECB) has sole responsibility for monetary policy among EMU countries.

National governments set other economic policies such as taxation and expenditures within a set of commonly agreed rules.

Old “legacy currencies” are exchanged for the new surviving currency, the euro.

2 - 26


The Spirit of the European Economic and Monetary Union, 1999

The large initial EMU was made possible by a relaxed interpretation of the Maastricht criteria and a dose of creative accounting.

The selection of the ECB President was also marred by disagreement and perhaps, compromise of the Maastricht principles.

In terms of operation, the transition to the euro went smoothly. The last step is the replacement of physical notes and coins, which is scheduled to be completed by July 1, 2002.

2 - 27


The Value of the Euro in Terms of the Eleven Legacy Currencies of the EMU Countries

Irrevocable Conversion Rates Set on January 1, 1999

Country Units Equal to One Euro ( € )

Austria 13.7603 schillingsBelgium 40.3399 francsFinland 5.94573 markkaabFrance 6.55957 francs

Germany 1.95583 marksIreland 0.787564 punt

Italy 1,936.27 lireLuxembourg 40.3399 francsNetherlands 2.20371 guilders

Portugal 200.482 escudosSpain 166.386 pesetas

2 - 28


Recent Behavior of Prices inInternational Financial Markets

Exchange Rate Developments Nominal exchange rates against the US$, 1970-1999 Nominal exchange rates in the ERM: the FFr/DM and

Guilder/DM rates. Nominal exchange rates for Asian currencies against

the US$, 1990-1999 Volatility in spot exchange rates Real effective exchange rates for developed countries Real effective exchange rates for Asian currencies,

1990-1999

2 - 29


Recent Behavior of Prices inInternational Financial Markets

Interest Rate Developments Short-term nominal interest rate levels Nominal interest rate differentials Real interest rates

Recent developments

2 - 30


Policy Matters - Private Enterprises

The government’s choice of monetary system affects the decisions that firms face.

There is greater exchange rate variability under floating.

Nominal exchange rate variability raises the importance of the choice of currency of

denomination for cash flows and financial assets increases the demand for financial instruments that

can be used to hedge or offset currency risks.

2 - 31


Policy Matters - Private Enterprises

Real exchange rate variability affects the competitiveness of an individual firm, as

well as the “financial health” of suppliers and customers

and thus affects the operating decisions of the firm.

2 - 32


Policy Matters - Public Policymakers

Some emerging markets adopt currency boards as their exchange rate system. A currency board fixes its exchange rate by making

a commitment to exchange domestic currency for foreign currency at a pre-specified rate.

A currency board gains credibility by its commitment to forgo the devaluation option.

Examples of countries with currency boards include Argentina, Estonia, Hong Kong, and Lithuania.

2 - 33



A country with a currency board “pays” for its option to abandon the board and devalue, by being forced to pay higher interest on loans in domestic currency.

The high cost of the board to Argentina after the 1995 Mexican peso crisis and the 1998 Russian ruble crisis prompted its president to propose “dollarizing” its economy. The major cost of dollarization would be the lost of

seigniorage from the printing of domestic pesos.

2 - 34



At most, a country can only sustain two of the following three policies: pegged exchange rates free capital mobility scope for monetary policy independence

Keeping exchange rates pegged and stable is not a technological problem. However, the technology can be too constraining on

the local monetary authorities, as in the Asian currency and Russian ruble crises.

2 - 35



Many were skeptical about EMU. The European Union is not an ideal candidate for a

currency union because within the union, labor is immobile, business cycles are weakly correlated, and fiscal transfers are limited.

Others focused on the advantages and dynamic gains likely under EMU: lower transaction costs and exchange rate risk, and

greater capital mobility and depth of financial markets across Europe

2 - 36



Some Specific Concerns about the EMUThe lack of national exchange rate policy under

EMU can be a source of tension if national growth rates are not sufficiently correlated. Ireland found it helpful to make a small adjustment

to the Irish punt’s central rate in 1998.

The euro can challenge the dominant role played by the U.S. dollar over the last 50 years. Liquidity in the US$ market may be affected.

2 - 37



The euro changes some basic aspects of international financial management. To obtain diversification benefits, the investor must

turn to other markets.

Documents

An Overview of International Monetary Systems and Recent Developments in International Financial Markets 22 Prices and Policies Second Edition ©2001