HYSTORY OF EXCHANGE RATE
SYSTEMS
1
Lecture 8
LEARNING GOALS

Features and Mechanism of Gold Standard

Features and Mechanism of Dollar Standard

The Credit Money System
2
INTERNATIONAL MONETARY SYSTEMS
3
HISTORY OF THE INTERNATIONAL
MONETARY SYSTEM

Desirable properties

Raire, durable,
divisible, fungible

New phenomena in
crises: speculative!

Representative
money:Coins, notes

represented real
commodities strored
elsewhere
4
THE USE OF GOLD
In short run: High
production costs limit
short-run changes.
In long run:
Commodity money
insures stability.

Silver: the main
circulating medium


(Gresham)
Gold: medium of
reserve
5
THE CLASSICAL GOLD STANDARD
Major currencies on gold
standard.
Involved commitment by
nations to fix the price of
domestic currency in terms of
a specific amount of gold.
6
EXCHANGE RATE PARITY

The relationship between the value of one
currency and another
1 uncia gold = 86,58 RM
 1 uncia gold = 20,67 USD
 1 USD = ? RM
 1 USD = 4,19 RM

7
THE CLASSICAL GOLD STANDARD
(1875-1914)

1844 Britain:
Bank Charter Act
 Establishment of Bank of England notes backed by
gold


1871 Germany:
After unified, and Franco-Prussian war
 Mark defined its value in gold


By 1879 only gold coins were accepted in Latin
Monetary Union (France, Italy, Belgium,
Switzerland, Greece)
8
ARBITRAGE
Attempting to profit by exploiting price
differences of identical or similar financial
instruments, on different markets or in different
forms.
 The ideal version is riskless arbitrage.


A risk-free transaction consisting of purchasing an
asset at one price and simultaneously selling that
same asset at a higher price, generating a profit on
the difference.
9
THE CLASSICAL GOLD STANDARD 2
Maintenance involved:
the buying and selling
of gold at that price.
Besides the free flow
of capital free
exchange rate market
10
THE CLASSICAL GOLD STANDARD 3
Operating conditions:
1.
All national
currency is backed
by gold, and
growth in money
supply is linked to
gold reserves.
Growing
world
economies
Growing
money
demand
Growing gold
reserves
(colonies)
11
THE CLASSICAL GOLD STANDARD 4
Conditions:
2. Each currency convertible into gold at a fixed
price - the exchange rate between the two
currencies automatically fixed.
3. No fluctuation in the exchange rate unless either
country changes the local price of gold.
12
HOW???

From 4.19 the dollar rises to 5 Mark



Over or undervaluation of USD?
Cause: arbitrage
Example:
1 uncia gold = 86,58 RM
 1 uncia gold = 20,67 USD
 1 USD = 4,19 RM


Buy USD directly from 1000RM or make an
arbitrage?
11.55 uncia gold sold at the fixed rate
 Result: 238.74USD
 Dollar surplus push down the exchange rate: rise in dollar
volume, decrease in mark volume

13
PRICE-SPECIE-FLOW MECHANISM:
AUTOMATIC ADJUSTMENTS
When a balance of payments surplus led to
a gold inflow
Gold inflow led to higher prices which
reduced surplus
Gold outflow led to lower prices and
increased surplus.
14
THE GOLD EXCHANGE STANDARD (19251931)


Only U.S. and Britain
allowed to hold gold
reserves
Other countries could
hold both gold, dollars
or pound reserves.
15
BETWEEN WW1 AND WW2
Countries experimented with floating rates in the
1920’s and ’30
“If there is anything that the inter-war experience
has clearly demonstrated, it is that currency exchanges
cannot be left free to fluctuate from day to-day under the
influence of demand and supply. If currencies are left to
fluctuate, “speculation” is likely to play havoc with the
exchange rate.”
Ragnar Nurske (1944) of the League of Nations
16
Currencies
devalued in
1931- led to
trade wars.
17
Bretton Woods
Conference
- called in order to
avoid future
protectionist and
destructive economic
policies
18
THE BRETTON WOODS SYSTEM
The Bretton Woods
System (1946-1971)
 U.S.$ was key
currency;
valued at $1 - 1/35 oz. of
gold.
 All currencies linked
to that price in a fixed
rate system.
19
A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
Exchange rates
allowed to fluctuate
by 1% above or
below initially set
rates.
 Collapse, 1971
Causes:

U.S. high inflation
rate
 U.S.$ depreciated
sharply.

20
BREAKDOWN OF BRETTON WOODS
By late 1960’s: US liabilities abroad exceeded their
gold reserves.
US: expansionary monetary policy during Vietnam
wars
Current account and trade balance teriorated.
No possibility to back its commitment to its
currency with gold.
On August 15, 1971, Nixon officially took the US
off the gold standard. (see IMF site)
www.imf.org/external/about/histend.htm
21
POST-BRETTON WOODS SYSTEM (1971- PRESENT)

Smithsonian Agreement, 1971
US$ devalued to 1/38 oz. of gold.
 By 1973: World on a freely
floating exchange rate system.

22
OPEC AND THE OIL CRISIS (1973-1974)
1.
2.
3.
4.
OPEC raised oil prices four fold;
Exchange rate turmoil resulted;
Caused OPEC nations to earn large surplus
Surpluses recycled to debtor nations which
set up debt crisis of 1980’s.
23
DOLLAR CRISIS (1977-78)
1.
2.
3.
U.S. B-O-P difficulties
Result of inconsistent monetary
policy in U.S.
Dollar value falls as confidence
shrinks.
24
THE RISING DOLLAR (1980-85)
1.
2.
3.
U.S. inflation subsides as the Fed
raises interest rates
Rising rates attracts global capital to
U.S.
Result: Dollar value rises.
25
THE SINKING DOLLAR:(1985-87)
1.
2.
3.
Dollar revaluated slowly downward;
Plaza Agreement (1985) G-5 agree
to depress US$ further.
Louvre Agreement (1987) G-7
agree to support the falling US$.
26
RECENT HISTORY
1.
2.
3.
4.
1988 US$ stabilized
Post-1991 Confidence resulted in
stronger dollar
1993-1995 Dollar value falls
Now?
27
Thanks
for your attention!
28
THE EUROPEAN MONETARY SYSTEM
I. INTRODUCTION
A. The European Monetary System (EMS)
1.
A target-zone method
(1979)
2.
Close macroeconomic policy
coordination required.
29
THE EUROPEAN MONETARY
SYSTEM
B. EMS Objective:
to provide exchange rate stability to all
members by holding exchange rates
within specified limits.
30
THE EUROPEAN MONETARY
SYSTEM
C.
European Currency Unit (ECU)
A “cocktail” of European currencies
with
specified weights as the unit of
account.
1. Exchange rate mechanism (ERM)
each member determines mutually
agreed
upon central cross rate for its
currency.
31
THE EUROPEAN MONETARY
SYSTEM
2.
Member Pledge:
To keep within 15% margin above or
below
the central rate.
D.
EMS ups and downs
1. Foreign exchange interventions failed
due to
lack of support by coordinated
monetary
policies.
32
THE EUROPEAN MONETARY
SYSTEM
2.
G.
Currency Crisis of Sept. 1992
a.
System broke down
b.
Britain and Italy forced to
withdraw from EMS.
Failure of the EMS
members allowed political priorities
to dominate exchange rate policies.
33
THE EUROPEAN MONETARY
SYSTEM
H. Maastricht Treaty
1.
Called for Monetary Union by
1999
(moved to 2002).
2.
Established a single currency: the
euro
3.
Calls for creation of a single
central EU
bank.
4.
Adopts tough fiscal standards.
34
THE EUROPEAN MONETARY
SYSTEM
I. Costs / Benefits of A Single Currency
A. Benefits
1.
Reduces cost of doing business.
2.
Reduces exchange rate risk
B. Costs
1.
Lack of national monetary
flexibility.
35