Chapter 5
The International Monetary System and
Exchange Rate Arrangements
Objectives
• To classify international monetary systems
• To outline the history of exchange rate arrangements
• To outline the pros and cons of fixed and flexible
exchange rates
• To examine the Australian exchange rate
arrangements
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Definition
• The IMS is the framework of rules, regulations and
conventions that govern the financial relations
among countries
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Components of the IMS
• A public component consisting of a series of
agreements
• A private component represented by the banking
and finance industry
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Classification according to reserve assets
• Pure commodity standards (e.g. the gold standard)
• Pure fiat standards
• Mixed standards (e.g. the Bretton Woods system)
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Classification according to flexibility of
exchange rates
• Several systems may arise by restricting, or
otherwise, the exchange rate
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Fixed exchange rates
• The exchange rate is fixed by the central bank and is
not allowed to move
• The FX market is likely to be out of equilibrium
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Perfectly flexible exchange rates
• The exchange rate moves continuously, propelled by
market forces, to maintain equilibrium in the FX
market
• Under this system, currencies appreciate and
depreciate
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Fixed but adjustable exchange rates
• Countries alter the fixed values of their exchange
rates
• Devaluation and revaluation are implemented to
‘correct’ some economic fundamentals such as the
BOP
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Fixed exchange rates and flexible within a
band
• Exchange rates are flexible within upper and lower
limits defined by a band around the par value
• Central bank intervention is required to keep the
exchange rate within the band
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Crawling peg
• The par value of the exchange rate is revised
periodically according to its recent behaviour or
economic indicators such as inflation
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Dual exchange rates
• A commercial (fixed) rate is used for imports and
exports
• A financial (flexible) rate is used for trading in
financial assets
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Managed floating
• The exchange rate is flexible, but the central bank
intervenes to limit the frequency and amplitude of
exchange rate fluctuations
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Target zones
• Major countries establish a set of mutually consistent
targets for real effective exchange rates
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The classical gold standard
• This system operated between approximately 1870
and 1914
• It is remembered with nostalgia because the world
economy prospered during that period
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Pillars of the gold standard
• The monetary authorities fix the price of gold in
terms of their currencies, which produces a fixed
exchange rate
• The market exchange rate can move above or below
the fixed rate by certain limits: the gold points
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The collapse of the gold standard
• The gold standard collapsed in 1914 as the warring
countries suspended the convertibility of their
currencies and prohibited the export of gold
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The inter-war period
• Between the end of World War I and 1926 a system
of flexible exchange rates was adopted
• In 1925, Britain re-established the convertibility of
the pound into gold, signalling the creation of the
gold exchange standard
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The collapse of the gold exchange standard
• In 1931 Britain abolished the convertibility of the
pound, bringing to an end the era of the gold
exchange standard
• This was followed by the decade of the Great
Depression (1931-1939)
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Failure of the inter-war experiment: reasons
• The golden age was a myth
• The world economy experienced significant changes
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The Bretton Woods system
• Forty-four countries signed the BW agreement in
1944
• The creation of the system was accompanied by the
creation of international institutions (the IMF
and IBRD or the World Bank)
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The BW exchange rate system
• Fixed but adjustable exchange rates
• The US dollar was pegged to gold, whereas other
currencies were pegged to the dollar
• Exchange rates could move within a 1% band
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Problems of the BW system
• The adjustment mechanism lacked flexibility and
stability
• Speculation could be destabilising
• There were defects in the liquidity creation
mechanism (Triffin Paradox)
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The collapse of the BW system
• In 1971, the United States suspended the
convertibility of the dollar into gold. As a result, the
system collapsed
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The present system
• In 1971, the Smithsonian Agreement was signed, but
it failed to salvage the BW system
• In 1973, floating became widespread
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The US dollar’s effective exchange rate under
the present system
160
140
120
100
80
60
Jan-80
Jan-84
Jan-88
Jan-92
Jan-96
Jan-00
Jan-04
Jan-08
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Current exchange rate arrangements
• The Jamaica Accord gave countries the freedom of
choosing the arrangements they deemed
appropriate for their economies
• Not all countries opted for floating
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Arrangements with no separate legal tender
• Under this arrangement, the currency of another
country circulates as the sole legal tender
• Alternatively, the country belongs to a monetary or
currency union in which the same legal tender is
shared by members of the union
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Currency boards
• A currency board is an arrangement that is based on
an explicit legislative commitment to exchange the
domestic currency for a specified foreign currency at
a fixed exchange rate, combined with restrictions on
the issuing authority to ensure the fulfillment of its
legal obligation
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Other fixed peg arrangements
• Pegging to a single currency
• Pegging to a basket of currencies
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Pegged exchange rates with horizontal bands
• Under this arrangement the exchange rate is
allowed to fluctuate within a band that is wider than
±1 per cent
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Crawling peg
• Under a crawling peg, the exchange rate is adjusted
periodically at a fixed, pre-announced small rate or in
response to changes in some quantitative indicators
(for example, inflation)
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Crawling bands
• This arrangement requires the exchange rate to be
maintained within a certain band around a central
rate that is adjusted periodically at a fixed, preannounced rate or in response to changes in some
indicators
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Managed floating without a preannounced path
• Under this arrangement, the exchange rate is
determined by market forces but the monetary
authority intervenes actively in the foreign exchange
market without specifying a path for the exchange
rate
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Independent floating
• Under independent floating the exchange rate is
determined by market forces. Any intervention in the
foreign exchange market aims at curbing exchange
rate volatility
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The EMS
• The system started functioning in March 1979 when
the Snake ceased to exist
• It is a system of fixed but adjustable exchange rates
as governed by the exchange rate mechanism
(ERM)
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Realignments
• The first realignment involving all currencies took
place in March 1983
• The period January 1987-September 1992 was
tranquil
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Speculative attacks
• In September 1992, speculative attacks forced the
pound and the lira out of the ERM
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The EMU and the euro
• The EMU was established by the 1991 Maastricht
Treaty
• In January 1999, the euro was introduced
• In January 2002, the euro replaced national
currencies
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The EUR/USD exchange rate
1.20
1.10
1.00
0.90
0.80
0.70
0.60
Jan-99
Jan-01
Jan-03
Jan-05
Jan-07
Jan-09
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Arguments for the euro
•
•
•
•
•
Currency stability reduces inflation
Reduction in transaction and hedging costs
Efficiency gains
Transparency gains
Benefits to trade and capital markets
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Arguments against the euro
• For the system to work well, countries should be
similar
• Individual countries have to give up national interest
and exchange rate policies
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The AUD exchange rate arrangements
• Until December 1971, the AUD was pegged to the
pound
• Until September 1974, the AUD was pegged to the
US dollar
(cont.)
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The AUD exchange rate arrangements (cont.)
• Until December 1983, the AUD was pegged to a
basket
• In December 1983, the AUD was floated
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The USD/AUD exchange rate
1.60
1.40
1.20
1.00
0.80
0.60
0.40
Jul-69
Jul-79
Jul-89
Jul-99
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Arguments for flexible exchange rates
• The BOP adjustment mechanism is smoother and
less painful
• Large and persistent BOP deficits do not arise
• Liquidity problems do not arise or are less acute
(cont.)
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Arguments for flexible exchange rates (cont.)
• Flexible rates are conducive to free trade
• Flexible rates are conducive to policy independence
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Arguments against flexible exchange rates
• They cause uncertainty and inhibit international trade
and investment
• They cause destabilising speculation
• They are not suitable for small countries
• They are unstable
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New international financial architecture
• Linking IMF loans to crisis prevention efforts
• Imposition of holding-period taxes on short-term
capital flows in countries characterised by financial
fragility
(cont.)
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New international financial architecture (cont.)
• Making the private sector partly responsible for the
consequences of sovereign bond issues
• Discouraging fixed but adjustable exchange rates in
favour of either managed floating or currency boards
(cont.)
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New international financial architecture (cont.)
• Directing the IMF to lend less freely and to
distinguish between country crises and systemic
crises
• Removing overlap from the responsibilities of the
IMF and the World Bank
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A global currency?
• Convenience
• Loss of exchange rate policy
• A small open economy has more to gain from the
convenience
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The Tobin tax
• Proposed by James Tobin in 1972, it is a uniform
international tax payable on all spot FX transactions
• Although the idea sounds appealing, there are
serious implementation problems
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