Chapter 3 The International Monetary System A.Exchange Rate Systems B.International Monetary System C.European Monetary System and Monetary Union D.Emerging

Chapter 3 The International Monetary System

A. Exchange Rate Systems

B. International Monetary System

C. European Monetary System and Monetary Union

D. Emerging Market Currency Crises

Chapter 3: The International Monetary System 2

3.A Exchange Rate Systems

Free (“clean”) float

– Exchange rates are determined by currency supply and demand with no government intervention.

– As economic parameters change, market participants adjust their current and expected future currency needs.

– Shifts in currency needs in turn shift currency supply and demand schedules, as seen in Chapter 2.

Managed (“dirty”) float

– Central banks intervene to reduce economic volatility.

– Three categories of intervention

1. Smoothing out daily fluctuations – central bank buys or sells currency to smooth exchange rate adjustments.

2. Leaning against the wind – measures taken to moderate or prevent short- or medium-term exchange rate fluctuations caused by random events.

3. Unofficial pegging – a country pegs the value of its currency to a foreign currency to protect the value of its exports.


3.A Exchange Rate Systems

Target zone arrangement

– Countries agree to adopt economic policies that maintain their exchange rates within a specific range.

– Designed to minimize exchange rate volatility and enhance economic stability in participating countries.

– Requires coordination of economic policy objectives and practices.

Fixed-rate system

– Governments maintain target exchange rates.

– Central banks buy/sell currency to increase (“revalue”)/decrease (“devalue”) exchange rates when exchange rates threaten to deviate from their stated par values by more than an agreed-on percentage.

– Monetary policy becomes subordinate to exchange rate policy.

Hybrid system – current international system consisting of free-float, managed-float, and pegged currencies.


3.B International Monetary System (1)

Gold Standard – participating countries fixed the prices of their currencies in terms of a specified amount of gold.

Because the value of gold is fairly stable over time, the gold standard ensured long-run price stability for both individual countries and groups of countries, aka Self-balancing feature in Econ303

Classical Gold Standard (1821-1914)

– Characterized by price-specie-flow mechanism

• Changes in the price level in one country were offset by an automatic balance of payments (“BOP”) adjustment.

– As U.S. exchange rate falls, exports rise, causing BOP surplus and inflow of foreign gold.

– U.S. prices rise, foreign prices fall

– U.S. exports fall, foreign exports rise

– BOP equilibrium achieved



Gold Exchange Standard (1925-1931)

– The U.S. and England could hold only gold reserves

– Other nations could hold both gold and dollars/pounds as reserves.

– In 1931, England departed from gold given massive gold and capital flows stemming from an unrealistic exchange rate, ending the Gold Exchange Standard.

1931-1944

– Beggar thy neighbor devaluations – countries devalued their currencies to maintain trade competitiveness, leading to a trade war.

http://en.wikipedia.org/wiki/Beggar_thy_neighbour



Bretton Woods System (1946-1971)

– Bretton Woods Conference, 1944

• New postwar monetary system

– Allied nations pledged to maintain a fixed (pegged) exchange rate in terms of the dollar or gold.

– 1 ounce of gold = $35

– Exchange rates could fluctuate only within 1% of their stated par values.

– Fixed rates were maintained by central bank intervention in foreign exchange markets.



Bretton Woods System (1946-1971), continued

– Bretton Woods Conference, 1944, continued

• Two new institutions created

– International Monetary Fund (IMF) – created to promote monetary stability

• Role has evolved over time

• Oversees exchange rate policies in 182 member countries

• Advises developing countries on economic policy

• Lender of last resort

• Moral hazard – expectation of IMF bailouts leads investors to underestimate risks of lending to governments that pursue irresponsible policies

– International Bank for Reconstruction and Development (World Bank) – created to lend money to countries to rebuild their war-damaged infrastructures



Bretton Woods System (1946-1971), continued

– Collapse of Bretton Woods system

• Inflation in the U.S. stemming from the Johnson Administration printing money instead of raising taxes to finance Viet Nam conflict.

• West Germany, Japan, and Switzerland would not accept the inflation that a fixed exchange rate with the dollar would have imposed on them.



Post-Bretton Woods System (1971-Present)

– Smithsonian Agreement

• Dollar was devalued to 1/38 of an ounce of gold.

• Other currencies revalued by agreed-on amounts in terms of the dollar.

– Attempts to set new fixed rates unsuccessful.

– International floating exchange rate system instituted in 1973.

• System supposed to reduce economic volatility and facilitate free trade.

– Floating rates would offset international differences in inflation.

– Real exchange rates would stabilize given gradual changes in underlying conditions affecting trade and productivity of capital.

– Nominal exchange rates would stabilize if countries coordinated their monetary policies to achieve inflation rate convergence.

• However, currency volatility has increased due to non-monetary global economic shocks (e.g., changing oil prices).


3.C European Monetary System (1)

European Monetary System (EMS)

– Began operating in March 1979.

– Purpose: Foster monetary stability in the European Community (EC)

– Members established the European Currency Unit (ECU), a composite currency consisting of fixed amounts of the 12 EC member currencies.

– The quantity of each currency reflected each country’s relative economic strength within the ECU.

– In 1992, the EC became the European Union (EU).

– The EU currently has 27 member states.



European Monetary Union (EMU, or EU)

– Maastricht Treaty

• Formalized the EC’s moved toward a monetary union

• EC nations would establish the European Central Bank with sole power to issue a single currency (euro).

– On January 1, 1999, the euro became a currency and conversion rates for the euro were locked in for member countries.

– On January 1, 2002, member countries’ currencies were replaced by euro bills and coins.

– To join the EU, countries were subjected to the Maastricht criteria

• Government debt ≤ 60% of GDP

• Budget deficit ≤ 3% of GDP

• Inflation ≤ 1.5 percentage points above the average rate of Europe’s three lowest-inflation countries

• Long-term interest rates ≤ 2 percentage points above the average interest rate in the three lowest-inflation countries



European Monetary Union (EMU, or EU), continued

– Consequences of EU

• Lower cross-border currency conversion costs

• Eliminated risk of currency fluctuations

• Facilitated cross-border price comparisons

• Encouraged flow of trade and investments among member countries

• Greater integration of Europe’s capital, labor, and commodity markets

• Increased Europe’s competitiveness

• Greater coordination of monetary policy


3.D Emerging Market Currency Crises (1)

Currency crises spread from one country to another by two means.

– Trade links – e.g., when Argentina is in crisis, it imports less from Brazil, causing Brazil’s economy to contract and its currency to weaken. Brazil’s contraction will in turn affect other trade partners.

– The financial system – distress in one emerging market causes investors to exit other countries with similar risk profiles.

Common denominator in promoting currency crises: Countries issue too much short-term debt closely linked to the dollar. When the dollar depreciates, the cost of repaying dollar-linked bonds soars.


3.D Emerging Market Currency Crises (2)

Circumventing emerging market crises

– Currency controls

• Abandoning free capital movement to insulate a country’s currency from speculative attacks, e.g. China

• However:

– Open capital markets channel savings to where they are most productive;

– Developing nations need foreign capital and know-how; and

– Currency controls have led to corruption.

– Freely floating currency – floating rates absorb the pressures created in emerging countries that simultaneously peg their exchange rates and pursue independent monetary policy.

– Permanently fix the exchange rate – through dollarization, use of a currency board, or a monetary union, an economy can permanently fix its exchange rate, e.g. Hong Kong

Documents

Chapter 3 The International Monetary System A.Exchange Rate Systems B.International Monetary System C.European Monetary System and Monetary Union D.Emerging