Monetary system

UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS

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1. The Bretton Woods System – Period From 1944 until 1971/73

2. Flexible Exchange Rate System – From 1973 Onwards

CONTENTS AND PURPOSE

purpose: analysis of the forms of international monetary system after

World War II



1. The Bretton Woods System – PeriodFrom 1944 until 1971/73

Creation of the System

process of establishing after-war arrangement was influenced by: economic circumstances in the world at that time negative experiences from the interwar period:

establish a complete arrangement and hence put a stop to instabilities and economic nationalism

establish a stable exchange rate

system

ensure additional international

liquidity

set up a mechanism for efficient elimination of balance-of-payments

disequilibria



Creation of the System

Great Britain’s suggestion: new international currency

“bancor”, accepted as equivalent to gold

international clearing union would guarantee automatic elimination of balance-of-payments disequilibria

functioning of the system similar to the functioning of the gold standard, but more flexible

USA’s suggestion: restoration of the gold

exchange standard establishment of a special

fund, into which countries would pay their financial quota and from which they could borrow in times of temporary balance-of-payments difficulties

eradication of trade and payment restrictions

Bretton Woods conference, July 1944:



Basic Elements of the System

Bretton Woods international monetary system reflected mostly US interests

typical case of a n–1 international monetary system with $ as the N-th currency: price of gold fixed at $35 per ounce, convertibility limited to

foreign monetary authorities n–1 countries fixed the price of their currencies in terms of dollars

and thus implicitly in terms of gold countries let an international organization accept decisions

about exchange rates for the first time in history by signing the IMF statute

N-th currency problem




convertibility of dollars for gold at $35=1 ounce fixing the par value of each national currency in terms of $ exchange rate could fluctuate within a band of 1 percent

above or below the par valuepossibility of changing the par value in case of

fundamental disequilibria




establishment of the International Monetary Fund, based on a quota and/or drawing rights system of all member countries: each nation was assigned a quota; each was to pay 25% of its

quota in gold or $, and the remainder in its own currency a member nation could borrow from the IMF to finance temporary

balance-of-payments deficits: restrictions on the amount of borrowing from the IMF conditioning

international liquidity too small for normal functioning of the world economy




restrictions on international liquid capital flows were explicitly permitted in the statute to allow nations to protect their currencies against large destabilizing international money flows

removal of all restrictions on the current account transactions: a period of transition (article XIV of the IMF statute)




Bretton Woods system turned out to be immensely asymmetrical, even though it was meant to be a system in which both groups of countries are responsible for the elimination of the balance-of-payments disequilibria: rare currency principle:

ongoing balance-of-payments surplus member nations could take discriminatory action against imports of

goods and services from a nation with rare currency




central goal of the IMF: making a stable exchange rates system come true providing borrowing facilities for nations in temporary balance-of-

payments difficulties



Functioning of the System From 1944 – 1959: Period of the Dollar Shortage

reasons for the dollar shortage: enormous world demand for American goods in combination with

very limited export possibilities of other countries and their low foreign exchange reserves

overcoming the dollar shortage problem: Marshall Plan (program of financial aid to Europe, 1948) European Payments Union (1950) trade and foreign exchange restrictions



Functioning of the System From 1944 – 1959: Period of the Dollar Shortage

vital changes in the balance-of-payments position of the USA and Europe: improvement in economic growth and balance-of-payments of

Europe and Japan worsening of the balance-of-payments of the USA redistribution of foreign exchange reserves from the USA into

other parts of the world

role of the IMF in the 1950s: passive role at solving the problems of the international economic

agreement



Functioning of the System From 1959 – 1971: Period of the Dollar Glut

abolition of the European Payments Union and restoration of convertibility of European currencies: exchange rates of the most important currencies relatively stable all economically important countries removed exchange

restrictions for current account transactions macroeconomic stability, accompanied by high growth rates of

world trade

balance-of-payments adjustment problem, problem of facilitating international liquidity and problem of confidence into the system



Functioning of the System From 1959 – 1971: Period of the Dollar Glut

balance-of-payments adjustment problem: increasing balance-of-payments deficit in the USA continuing balance-of-payments surpluses in Germany and Japan nations with balance-of-payments deficit are under more pressure

than countries with balance-of-payments surplus dollar devaluation impossible because of its specific role in the

Bretton Woods monetary system

problem of facilitating international liquidity and problem of confidence into the system: Triffin dillemma



Measures for Protection and Reforms for Improvement of the Bretton Woods System

Measures for protection: Measures of American authorities, focused on reducing the

balance-of-payments deficit: Interest Equalization Tax Foreign Credit Restraint Program Federal Reserve's Regulation Q

cooperation among countries and central banks of key countries: swap arrangements gold pool and parallel gold market Roosa bonds political agreements



Measures for Protection and Reforms for Improvement of the Bretton Woods System

IMF measures: increase in the member nations quotas General Arrangement to Borrow (GAB)

reforms for the improvement of the system: creation of a new form of international liquidity – Special

Drawing Rights (SDR), that should enhance the existing international liquidity (gold and dollars):

SDRs distributed among member nations proportional to their share in the IMF quota of all member countries

a country can use SDR whenever it has balance-of-payments difficulties and/or wants to increase its international monetary reserves



Collapse of the System and the Smithsonian Agreement (1971 – 1973)

dollar not convertible for gold, reduction in American gold exchange reserves and reduction in coverage of liquid dollar liabilities of the USA with gold: speculative transfers from weak dollar into other currencies negative consequences of sterilization of dollar inflows in

countries with strong currencies on inflation USA reneged on their obligation to buy and sell dollars for gold at

a fixed price of 35 USD = 1 ounce de-iure discontinuation of convertibility of $ for gold



Smithsonian Agreement (December 1971): establish a new group of stable exchange rates (central rates), on

the basis of which a balance-of-payments equilibrium would be reached again for the most important countries

elements: devaluation of $ of 8,5%, from $35 to $38 an ounce revaluation of DEM and ¥ by 17 and 14% exchange rate fluctuation band expanded to +/-2,25 percent USA discontinued their 10 percent import tariff

valid only for 14 months, another devaluation of dollar did not bring confidence into it

Collapse of the System and the Smithsonian Agreement (1971 – 1973)



Final Assessment of the Functioning of theBretton Woods System

inappropriateness of the balance-of-payments adjustment mechanism and large difficulties with the functioning of the system of fixed, but adjustable exchange rates

shortage of international liquidity and a built-in systemic mistake in the form of the Triffin dillemma

importance of international cooperation for successful functioning of the international monetary system



2. Flexible Exchange Rate System –From 1973 Onwards

transition to flexible exchange rates system was not planned or even asked for: maintaining the par values of currencies in the increased capital

flow liberalization circumstances required bigger and bigger interventions of monetary authorities in foreign exchange markets and more of their cooperation, but monetary authorities did not want to intervene in the foreign exchange markets anymore



Basic Trends in the Foreign Exchange Rate Regimes After the Collapse of the Bretton Woods System

smaller and economically more open countries: fixing the currency to another currency or a composite of

currencies continuation and reinforcing of capital inflow/outflow controls

trends of accelerated development of financial markets and globalization of international finance

fixing the currency to another currency: currency board monetary union (Maastricht Agreement)



1973 – 1985: Period of More or Less Pure Floating of Exchange Rates

failure of the Group 20 work (1972-1974): searching for a solution to ensure more international liquidity,

needed for the functioning of the system re-establishment of the fixed exchange rates system with new

central rates when the flexible exchange rates will settle down second amendment to the IMF statute (1976-1978):

flexible exchange rates system became formally valid with its ratification in 1978

member country has to notify the IMF which exchange rate regime it will implement

defines the role of the IMF in supervising the functioning of the international monetary system




exchange rates fluctuations until the end of 1970s: oil shocks re-establishment of the fixed exchange rates system unrealistic alternative Euro-currency markets became a crucial segment of functioning of the

entire international monetary system exchange rates of key world currencies reflected their economic

foundations despite the transition to the flexible exchange rates system: willingness for coordination of economic policies willingness for accepting the facts that originate in the foreign exchange

market willingness and ability for effective usage of capital transactions control

instruments




exchange rates fluctuations in the first half of the 1980s: key change in the economic policy of the USA (50% dollar

appreciation relative to other leading world currencies): restrictive monetary and expansive fiscal policy dollar appreciated mainly as a consequence of quick growth of the

government budget deficit of the USA cause for the emergence of debt crisis in developing countries



After 1985: Period of Managed Floating of Exchange Rates

Plaza and Louvre Agreements (1985-1987): $ still too strong; coordinated action needed for its continuing

depreciation Plaza Agreement made way for the acceptance of a wide-ranging

program of deregulation and economic liberalization for the American administration, other countries continued to have incessant access to the huge American market

Louvre: exchange rates of the most important currencies around the right level; continued depreciation of $ not necessary:

verbal agreement according to which the dollar exchange rate relative to DEM and yen should fluctuate within a 5 percent band



After 1985: Period of Managed Floating of Exchange Rates

period of exchange rates instability in the 1990s: period of the biggest exchange rates instabilities, and period in

which most exchange rates crises happened ever since the establishment of the flexible exchange rates system in 1973

efficiency of intervening in the foreign exchange markets was crucially reduced in the circumstances of financial globalization and accelerated capital flows liberalization

exchange rates instability: oscillations in the fluctuations of dollar exchange rates relative to

DEM and yen, the other two important world currencies European monetary system crisis in 1992 exchange rates crises in numerous developing countries and countries

in transition in the period from 1995 onwards



Final Assessment of the Functioning of the International Monetary System Under flexible

Exchange Rates Systemperiod of flexible exchange rates, in which especially the

European countries were trying to cooperate more with each other

characteristics: currencies of several, especially smaller countries, remained fixed

to another currency or a composite of “main” currencies exchange rates fluctuate much more during this period than they

have during the Bretton Woods system, with all the negative consequences accompanying these fluctuations

balance-of-payments disequilibria between economically powerful countries were greater in the 1980s than ever before

Economy & Finance

Monetary system