Chapter 19
Alternative
International
Monetary
Standards
Topics to be Covered
• The Gold Standard 1880–1914
• The Interwar Period 1918–1939
• The Gold Exchange Standard 1944–1970
• The Transition Years 1971–1973
• Floating Exchange Rates Since 1973
• Types of Exchange Rate Arrangements
• Choosing an Exchange Rate System
• Optimum Currency Area
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Topics to be Covered (cont.)
• European Monetary System and the Euro
• Target Zones
• Currency Boards
• International Reserve Currencies
• Multiple Exchange Rates
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History of
International Monetary Systems
• The Gold Standard: 1880–1914
• The Interwar Period: 1918–1939
• The Gold Exchange Standard: 1944–
1970
• Transition to Floating Exchange Rates:
1971–1973
• Floating Exchange Rates: Since 1973
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The Gold Standard: 1880–1914
• Under a gold standard, currencies are
valued in terms of a gold equivalent, or mint
parity price. An ounce of gold was worth
$20.67.
• Since each currency is defined in terms of its
gold value, all currencies are linked in a fixed
exchange rate system.
• Each participating country must be willing and
ready to buy and sell gold to anyone at the
fixed price.
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Gold Standard (cont.)
• Gold is used as a monetary standard
because it is a homogenous good,
easily storable, portable, and divisible
into standardized units, such as ounces.
Another important feature of gold is that
governments cannot easily increase
its supply.
• A gold standard is a commodity money
standard.
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Gold Standard (cont.)
• A money standard based on a
commodity such as gold with a relatively
fixed supply will lead to long run price
stability. This is because a country’s
supply of money is limited by its
supply of gold.
• Refer to Figure 19.1
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Solutions to BOP Disequilibria under
a Gold Standard
• A country with a balance of payments deficit would
experience net outflows of gold, thus reducing its
money supply and, in turn, its prices.
• A country with a balance of payments surplus would
have gold flowing in, raising its money supply and
hence its prices.
• Falling prices in the deficit country would lead to
increasing net exports, while the rising prices in the
surplus country would reduce its net exports,
eventually restoring BOP equilibrium.
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Interwar Period: 1918–1939
• World War I effectively ended the gold standard.
• Europe experienced inflation during and after the war
so restoration of the gold standard at the old
exchange values was not possible.
• The U.S. experienced little inflation and returned to
the gold standard in 1919 at the old parity.
• In 1925, England returned to the gold standard
despite inflation. Money supply fell as gold purchases
soared, and by 1931 the British pound was
declared inconvertible.
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Interwar Period (cont.)
• Demand for gold focused on the U.S.
market. A “run” on U.S. gold lead to
the U.S. raising the official gold price to
$35 an ounce.
• The depression years of the 1930s
were characterized by international
monetary warfare in the form of
competitive devaluations and foreign
exchange controls.
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Gold Exchange Standard: 1944–
1970
• An international conference in Bretton Woods, New
Hampshire, in 1944 led to an agreement among
participating countries to fix the values of their
currencies to gold.
• The U.S. dollar was the key currency, and $1 was
defined as equal in value to 1/35 ounce of gold. All
currencies were linked to the dollar and each other
in a fixed exchange rate system.
• If a country had difficulty maintaining its parity value, it
could turn to the International Monetary Fund (IMF)
for short-term loans (see Item 19.1).
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Gold Exchange Standard (cont.)
• In the case of more fundamental BOP
problems, a country was allowed to devalue
its currency (refer to Table 19.1).
• The gold exchange standard is also called an
adjustable peg system.
• Large U.S. balance of payments deficits and
the consequent gold outflows as well as the
unwillingness of major trading partners to
realign currency values led to suspension of
U.S. gold sales in 1971 and the end of fixed
exchange rates.
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Transition Years: 1971–1973
• In 1971, an international conference in
Washington led to the Smithsonian
agreement which raised the gold exchange
value from $35 to $38 and also revalued the
currencies of surplus countries.
• In 1972 and early 1973, currency speculators
sold large amounts of dollars leading to
further dollar devaluation.
• By March 1973, all major currencies
were floating.
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Floating Exchange Rates:
Since 1973
• Although exchange rates since 1973 are
described as floating (i.e., determined by
market forces of demand and supply), the
rates are effectively “managed float”, wherein
central banks reserve the right to intervene at
any time to obtain desirable rate levels.
• Today, different countries follow different
exchange rate arrangements. See Table
19.2 for examples.
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Types of
Exchange Rate Arrangements
• Crawling peg—the rate is adjusted
periodically in small amounts.
• Crawling band—the rate is maintained within
fluctuation margins around a central rate
which is adjusted periodically.
• Managed floating—the central bank
intervenes in the foreign exchange market
with no pre-announced path for the exchange
rate.
• Independently floating—the rate is
market-determined.
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Types of XR Arrangements (cont.)
• No separate legal tender—either another
country’s currency circulates as legal tender,
or the country belongs to a monetary union
with a shred legal tender.
• Currency board—a fixed rate is established
by legislative commitment to exchange
domestic currency for foreign currency at a
fixed rate.
• Fixed peg—the rate is fixed against a major
currency or market basket of currencies.
• Horizontal band—the rate fluctuates around
a fixed central target rate.
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Floating vs. Fixed Exchange Rates
• An argument in favor of flexible exchange rates is that
a country can follow domestic macroeconomic
policies independent from other countries.
• An argument in favor of fixed exchange rates is that
fixed rates impose international discipline on the
inflationary policies of countries.
• An argument against flexible rates is that such rates
are subject to destabilizing speculation wherein
speculators increase the variability or fluctuations of
exchange rates.
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Country Factors and
Choice of Exchange Rate System
• Country size—Large countries tend to be less willing
to subjugate own domestic policies to maintain a fixed
rate system.
• Openness—More open economies tend to follow a
pegged exchange rate to minimize foreign shocks,
while closed economies prefer the floating rate.
• Trade pattern—A country that trades largely with one
foreign country tends to peg its exchange rate to the
other’s currency. A country with more diversified trade
patterns might peg to a market basket of currencies.
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Country Factors (cont.)
• Inflation rate—Countries with more
harmonious or stable inflation rates will prefer
fixed exchange rates.
• Money supply—The greater a country’s
money supply fluctuations, the more likely the
country will peg its exchange rate.
See Table 19.3
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Optimum Currency Area
• Currency Area—an area where
exchange rates are fixed within the area
and floating exchange rates exist
against currencies outside the area.
• The “optimum” currency area is the
best grouping of countries to achieve
some objective, such as ease of
adjustment to real or nominal shocks.
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Optimum Currency Area (cont.)
• The optimum currency area is the
region characterized by free and
relatively costless mobility of resources
such as labor and capital.
• When factors are immobile, so that
equilibrium is restored via changes in
goods prices, then there is an
advantage to flexible exchange rates.
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European Monetary System
and the Euro
• The European Monetary System (EMS) was
established in 1979 to maintain exchange rate
stability in Western Europe.
• The Exchange Rate Mechanism (ERM)
required that each country maintain the value
of its currency within a 2.25 percent band.
• The ERM broke down in 1992 as a result
of the removal of capital controls and
countries pursuing different domestic
macroeconomic goals.
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Maastricht Treaty of 1991
• Called for a single European central bank and
a single currency via the following:

Removal of restrictions on European capital
flows and greater coordination of monetary and
fiscal policies.

Creation of a European Monetary Institute (EMI)
to prepare for a single monetary policy.

Irrevocable fixing of exchange rates among
member nations with a single currency (euro).
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The Euro
• The euro made its debut on January 1, 1999.
• In the transition years of 1999–2001, the euro
was used as a unit of account.
• Euro notes and coins began to circulate on
January 1, 2002.
• Currently, the United Kingdom, Denmark, and
Sweden have not adopted the euro.
• See Table 19.4 for exchange rates of old
European currencies.
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European Central Bank
• The European Central Bank (ECB)
began operations in 1998 in
Frankfurt, Germany.
• The Governing Council of the ECB
determines the monetary policy for the
euro-area.
• The network of national central banks
and the ECB is called the European
System of Central Banks.
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Target Zones
• Target zones allow a country’s exchange
rate to fluctuate within a limited range or
band around some central fixed value.
• The closer the exchange rate gets to the
upper or lower limit, the greater the
probability of central bank intervention (refer
to Figure 19.2).
• A target zone backed by a credible
government creates stability & confidence.
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Currency Board
• Currency Board—a government institution
that exchanges domestic currency for foreign
currency at a fixed rate of exchange.
• A currency board achieves a credible
fixed exchange rate by holding a stock of
foreign currency equal to 100 percent of the
outstanding currency supply of the country.
For example, Hong Kong.
• If government policy is inconsistent with the
fixed exchange rate, the currency board
cannot last. For example, Argentina.
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International Reserve Currencies
• A reserve currency is a currency
which serves the role of money in the
international economy.
• As with any money, the reserve
currency must serve as a unit of
account, medium of exchange, and
store of value.
• Refer to Table 19.5 Roles of a
Reserve Currency
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Reserve Currencies (cont.)
• Although the U.S. dollar is not the only
reserve currency, it is the dominant
reserve currency.
• Refer to Table 19.6
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Seigniorage
• Seigniorage is the difference between
the cost to the reserve country of
creating new balances and the real
resources the reserve country is able to
acquire with the new balances.
• It is a financial reward accruing to the
reserve currency as a result of its being
used as a world money.
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Multiple Exchange Rates
• Some countries maintain multiple
exchange rates.
• Arguments against multiple rates include:

Multiple rates harm both the countries imposing
them and other countries.

They are costly in that people spend scarce
resources to find ways to profit from the tiered
exchange rates.

Maintenance of multiple exchange rate system
requires a costly administrative structure.
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