Chapter 19: International Monetary Regimes

1. The Trilemma or Impossible Trinity Only two may be achieved at any one time

The Trilemma

Fixed Exchange

Rate

Discretionary Monetary

Policy

International Capital

Mobility

1. The Trilemma or Impossible Trinity

To achieve:Fixed exchange rateTrade-off:• Discretionary monetary policy to create

elasticity of supply of currencyor• International capital mobility to create

inelasticity of demand for currency

1. The Trilemma or Impossible Trinity

To achieve:Discretionary monetary policyTrade-off:• Fixed exchange rate to allow for

inelasticity of supply of currencyor• International capital mobility to create

inelasticity of demand for currency

1. The Trilemma or Impossible Trinity

To achieve:International capital mobilityTrade-off:• Fixed exchange rate to allow for

equilibrium price (floating exchange rate)or• Discretionary monetary policy to create

elasticity of supply for currency

1. The Trilemma or Impossible Trinity

International monetary regimes

Specie standard

• Fixed rate• International

capital mobility

Managed fixed exchange rate

• Fixed rate• Discretionary

monetary policy

Free float

• Discretionary monetary policy

• International capital mobility

Managed float

• International capital mobility

• Switch between monetary policy discretion and fixed exchange rate

2. Two Systems of Fixed Exchange Rates

Gold standard• Domestic units of account were in terms of gold—

by weight and purity• Allowed gold and bills of exchange to flow between

nations unfetteredU.S. 1 oz. gold = $20.00; Great Britain 1 oz. gold = £4

Exchange rates were dictated by the supply and demand conditions in the sterling bills market

2. Two Systems of Fixed Exchange Rates

Gold standard system:• Self-equilibrating

• Functioned without government intervention• Had exchange rate stability

2. Two Systems of Fixed Exchange Rates

Bretton Woods System

• Adopted by the first world countries in the final stages of World War II

• Designed to overcome the flaws of the GS while maintaining the stability of fixed exchange rates

2. Two Systems of Fixed Exchange Rates

Bretton Woods System

• USD substituted gold as the free world's currency• Ensured a more elastic supply of international reserves• Allowed the U. S. to earn seigniorage to help offset the

costs it incurred from fighting wars• U.S. was rendered the banker to more than half of the

world’s economy

2. Two Systems of Fixed Exchange Rates

Bretton Woods Agreement, July 1944 Established the International Bank for

Reconstruction and Development (now the World Bank)

“…the absence of a high degree of economic collaboration among the

leading nations will…inevitably result in economic warfare that will be but the prelude and instigator of military

warfare on an even vaster scale.”-- Harry Dexter White, US Department of the Treasury

730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, NH (USA) for the United Nations Monetary and Financial Conference

2. Two Systems of Fixed Exchange Rates

Bretton Woods Agreement, July 1944 Established

the International Monetary Fund“The nations should consult and agree on international monetary changes which affect each other. They should outlaw practices which are agreed to be harmful to world prosperity, and they should assist each other to overcome short-term exchange difficulties.”July 22, 1944

730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, NH (USA) for the United Nations Monetary and Financial Conference

2. Two Systems of Fixed Exchange Rates

Bretton Woods Agreement, July 1944 Adopted the General Agreement on

Tariffs and Trade (GATT)to regulate international trade.Proposed establishment of

The International Trade Organizationto regulate GATT.

The ITO Charter was agreed to by the U.N. in March 1948, but never

ratified by the U.S. Senate.In 1995, the World Trade Organization

(WTO) was established.

730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, NH (USA) for the United Nations Monetary and Financial Conference

3. The Managed or Dirty Float

To achieve:• Discretionary monetary policy and• International capital mobility Trade-off:• Fixed exchange rate

Use managed float: the central bank allows market forces to determine second-to-second (day-to-day) fluctuations in exchange rates but intervenes if the currency grows too weak or too strong.

3. The Managed or Dirty Float

Central bank intervention:• Unsterilized foreign exchange intervention

Exchange:• International reserves• Assets denominated in foreign currencies• Gold, and • SDRs (Special Drawing Rights)for domestic

currency

3. The Managed or Dirty Float

Central bank intervention:• Unsterilized foreign exchange intervention

Influence the FX rate via changes in MB:• Selling international reserves for domestic

currency to appreciate the domestic currency.• Shift the demand for domestic currency in FX

markets

3. The Managed or Dirty Float

Central bank intervention:• Sterilized foreign exchange intervention• No net change in MB, no long-term impact on

exchange rateUses:• Short-term ruse• Signal to market

3. The Managed or Dirty Float

Central bank intervention: Disadvantages

• Run out of international reserves in a fruitless attempt to – prevent depreciation or – create appreciation

• Require increasing or decreasing the MB counter to the needs of the domestic economy.

4. The Choice of International Policy Regime

Fixed rate or managed float: CostsRun out of international reserves:• Unable to use unsterilized foreign exchange

interventionIMF lends, but: Not lender of last resort Requires fiscal austerity Creates moral hazard

4. The Choice of International Policy Regime

Fixed rate or managed float: Benefits = monetary policy target similar to an inflation or money

supply target: • Allows the developing nation’s central bank to figure

out whether to increase or decrease MB and by how much

• Effectively ties the domestic inflation rate to that of the anchor country

• Instills confidence in the developing country’s macroeconomic performance

4. The Choice of International Policy Regime

Fixed rate or managed float: Benefits Dollarization = adopting an anchor currency = (- seigniorage revenue) + outsource monetary policy

Hard peg= pegged to an anchor currency= outsource monetary policy

4. The Choice of International Policy Regime

Fixed rate or managed float: Benefits Dollarization Hard pegDifficult to maintain because: • Can create persistent imbalances between the

developing and the anchor currencies due to changes in – Interest rates– Trade– Productivity