The International
Monetary System:
Chapter 3
Chapter Objectives
& Lecture Notes
FINA 5500
Chapter Objectives: FINA 5500
Chapter 3 / The International Monetary System
1.
To be able to compare and contrast the mechanics of the fixed and floating exchange rate
systems
2.
To be able to explain in your own words, the effects of changes in one country’s inflation
and unemployment rates on the economies of other countries under a fixed exchange rate
system
3.
To be able to explain in your own words, the effects of changes in one country’s inflation
and unemployment rates on the economies of other countries under a floating exchange
rate system
4.
To be able to compare and contrast the strengths and weaknesses of the fixed and floating
exchange rate systems
5.
To be able to relate in your own words, the historical evolution of the European Union
and the events leading to the adoption of a Single European Currency, the Euro
6.
To be able to explain in your own words the pros and cons of having a Single European
Currency
7.
To be able to explain in your own words, how a pegged exchange rate system works
8.
In a three country case when Country A has its currency pegged to the currency of
Country B, while the currency of Country C is floating against the currencies of both
Countries A and B, you should be able to analyze the effects of an appreciation and
depreciation of the floating currencies on the levels of export and import between each
pairs of the countries (AB, BC and AC).
CHAPTER 3: OVERVIEW
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Various Types of Exchange Rate Systems:
» Fixed Rate / Floating Rate / Managed Float /
Pegged Exchange Rate
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Comparing advantages / disadvantages of
fixed and floating rate systems
The European Union and Euro
Implications of pegged exchange rate
systems and its impact on international trade
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Fixed Exchange Rate Systems:
History
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Gold Standard: 1821 - 1914
Gold Exchange Standard: 1925 - 1931
Bretton Woods System: 1946 - 1971
Smithsonian Agreement: 1971 to 1973
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1
Fixed Exchange Rate System:
Mechanics
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The price of a country
country’ss currency is fixed in terms of
gold or other currency
A country’s money supply is constrained by its gold or
other currency reserve
A change in the price level in one country will affect its
balance of payments (BOP)
Th resulting
The
lti change
h
in
i BOP will
ill affect
ff t its
it reserve
The change in reserve will affect its money supply and
price levels
Supposed to provide price stability and promote
international trade
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Floating Exchange Rates
System: History & Mechanics
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1973 to present
Major currencies float (continuous adjustment)
The U.S. actually has a dirty float due to informal
"Exchange Rate Target Zones”
Minor currencies are pegged to major currencies
Exception: European Monetary System has fixed rates
within, but floating outside
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2
Comparison of Fixed and Floating
Exchange Rate Systems
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The Impact of Rise in Inflation (in the US):
» Fixed Exchange Rate System
» Floating Exchange Rate System
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The Impact of a Rise in Unemployment (in the US):
» Fixed Exchange Rate System
» Floating Exchange Rate System
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The Impact of Rise in Inflation (US):
Fixed Exchange Rate System
»
»
»
»
UK goods cheaper in the US
Import from UK increases
Excess demand for goods in UK
Price levels (inflation) in UK also go up Fixed Exchange
Rate System
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3
The Impact of Rise in Inflation (US):
Floating Exchange Rate System
» UK goods cheaper in the US
» Import from UK increases
–increased demand for pounds
» Export to UK decreases
–decreased supply for pounds
» Value of Pound (Dollar) increases (decreases)
» UK goods become more expensive (because of
currency appreciation) only to US buyers
» Domestic inflation in UK is not affected
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Comparison of Fixed & Floating
Exchange Rate Systems: Inflation
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Floating Rate Exchange Rate System:
» Advantage: Inflation in one country does not
necessarily lead to inflation in other countries
» Disadvantage: Since prices of UK goods are high
(due to appreciation of BP), domestic producers
can get away with higher prices in the US (less
international competition)
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4
The Impact of Rise in Unemployment
(US): Fixed Exchange Rate System
» Import from UK decreases
» Reduced demand for goods in UK
» Lower productivity in the UK
» Higher unemployment in UK
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The Impact of Rise in Unemployment
(US): Floating Exchange Rate System
» Import from UK decreases
–decreased demand for pounds
» Value of Pound (Dollar) decreases (increases)
» UK goods now become less expensive (because
of pound depreciation) to US buyers
goods is
» Some of the demand reduction for UK g
offset (because of pound depreciation)
» Unemployment rate in the UK does not rise.
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5
Comparison of Fixed and Floating
Exchange Rate Systems: Unemployment
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Floating Exchange Rate System:
» Advantage: High unemployment in one country
does not necessarily lead to high unemployment
in other countries
» Disadvantage:
–
–
–
–
–
–
–
High unemployment in US
decreased imports from UK
Reduced demand for pounds
pound depreciates
UK goods becomes cheaper in the US
increased imports from UK
Unemployment in US goes up even further
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Comparison of Fixed and Floating
Exchange Rate Systems: A Summary
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Fixed Exchange Rate System:
» Disadvantage: Economic problems (inflation
(inflation,
unemployment) in one country can infect other countries
» Advantages:
– Built in price stability mechanism
– Promotes international trade
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Floating Exchange Rate System:
» Advantage: Economic problems (inflation
(inflation, unemployment)
are generally contained within the country where they
originate.
» Disadvantage: Economic problems can become more
pronounced in the country of origin.
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6
European Union: Historical
Landmarks
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European Economic Community: 1957
» France / West Germanyy / Italy
y / Belgium
g
/ Netherlands /
Luxembourg
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European Union: 1970 - 1990’s
» Enlargement:
– Great Britain / Ireland / Denmark (1973); Greece (1981) ; Spain /
Portugal (1986) ; Austria / Finland / Sweden (1995)
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A Single European Market
» Reduction or elimination of tariffs and duties for trades among
member countries
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Single European Act (1987)
European Currency Unit (1990’s) and its failure
Maastricht Treaty: Establish criteria for euro membership
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The Maastricht Criteria
The Maastricht Treaty stipulated five criteria that
European countries had to meet to become eligible for
Euro:
ƒ Price Stability: A country's inflation rate must not exceed the average
inflation rate of the 3 best performing member states by more than 1.5%.
ƒ The Level of Government Deficit : The government’s budget deficit
must not be more than 3 % of its gross domestic product.
ƒ The Level of Government Debt : The government’s total debt must not
be more than 60 % of its gross domestic product.
ƒ Successful EMS Membership : A country must have participated in
Exchange Rate Mechanism of the European Monetary System for at
least two years, without devaluing against the currency of any other
Member State.
ƒ Interest-Rate Convergence : Its average nominal long-term interest
rate should not be more than 2 % higher than those prevailing in the
three best performing Member States in terms of price stability.
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Why a Single European Currency?
Next Logical Step: A single market concept cannot survive for long
without a single currency
Transaction Costs: Reduce the cost of converting currencies
No Exchange Rate Uncertainty: Eliminates the risks of unforeseen
exchange rate revaluations or devaluations.
Transparency & Competition : Increase direct comparability of prices and
wages across Europe
Strength: The new Euro will be the among the strongest currencies in the
world, along with the US Dollar and the Japanese Yen.
C it l M
Capital
Market:
k t A llarger E
Euro zone will
ill iintegrate
t
t th
the E
European fifinancial
i l
markets
No Competitive Devaluations: Countries can no longer devalue their
currencies against each other to increase their exporters
Fiscal Discipline: Governments with a lack of fiscal discipline can be
brought into line.
European Identity: One currency will strengthen the European identity.
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Euro Introduction: Timetable
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Membership into Euro granted to 11 nations (5/98)
z Conversion
C
i rates
t b
between
t
euro and
d national
ti
l currencies
i
are irrevocably fixed (12/31/98)
z Euro becomes official currency for those 11 nations
(1/1/99)
Austria / Belgium / France / Finland /Germany /
Ireland / Italy /
Luxembourg / Netherlands / Spain
/ Portugal
becomes 12th member (1/1/01)
z Euro banknotes and coins start circulating (1/1/02)
z The circulation of currencies of 12 nations ends
(2/28/02)
z Greece
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Euro Prices
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A Single European Currency:
Possible Disadvantage
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Cost of Introduction: Converting all bills, all wages and prices into
Euro is expensive
Non-Synchronicity of Business Cycles: Business cycles across the
various countries do not move in synchronicity.
Fiscal Policy Spillovers: With a Europe-wide interest rate, individual
countries that increase their debt will raise interest rates in all other
countries
No Competitive Devaluations: In a recession, a country can no longer
stimulate its economy by devaluing its currency and increasing exports.
Central Bank Independence: It will be difficult for the new European
Central Bank (ECB) to maintain its independence, in spite of pressure
from member countries
Excessive Fiscal Discipline: The pressure on a member government to
limit budget deficit could adversely affect that country’s economy
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Pegged Exchange Rates
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Sometimes countries have their currencies
pegged to a major currency (e
(e.g.,
g Argentina
Argentina,
Mexico, South Korea, Hong Kong, have had their
currencies pegged to the US dollar)
» The formal pegging arrangement can vary (ERM,
currency boards, etc)
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These currencies float against other currencies
We examine implications of pegging for the
economies of countries involved
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Pegged Exchange Rates: Three Currency
Case: USA, Mexico, Argentina
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Argentinan Peso (AP):
» Pegged to U.S. dollar at $ 0.75/AP
» Floats against the MP
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Mexican Peso (MP):
» Floats against the dollar at $ 0.125/MP
» Floats against the AP
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Initial AP to MP exchange rate must be:
» 1 AP costs MP 6.00 (0.75 / 0.125)
» 1 MP costs AP 0.167 (0.125 / 0.75)
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Appreciates Against MP
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Dollar appreciates to $ 0
0.100/MP
100/MP (from $0
$0.125/MP)
125/MP)
» AP to dollar is pegged at AP 0.75/$.
» AP to MP floats, new rates are:
– 1 AP now costs MP 7.5 (0.75 / 0.100)
– 1 MP now costs AP 0.133 (0.100 / 0.75)
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The Argentinan
Th
A
ti
P
Peso also
l appreciates
i t against
i t th
the
Mexican Peso
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Appreciates Against MP
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International Trade: USA and Mexico:
» US demand for Mexican goods (US imports) increases
» Mexican demand for US goods (US exports) decreases
» US BOT with Mexico is reduced
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Appreciates Against MP
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International Trade: Argentina and Mexico:
»
»
»
»
The value of AP rises against the MP
Argentinan demand for Mexican goods increases
Mexican demand for Argentinan goods decreases
Argentinan BOT with Mexico is reduced
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Appreciates Against MP
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International Trade: USA and Argentina:
» Since AP has appreciated against MP but is fixed
against $, Argentina will shift imports from US to Mexico.
US exports to Argentina will reduce and Argentinan
imports from Mexico will rise.
» Since the $ has appreciated against MP but is fixed
against AP,
AP USA will shift imports from the Argentina to
Mexico.
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Appreciates Against MP
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International Trade: Overall effects:
» Mexico's ( the country with depreciated floating
currency) economy will be stimulated, because of
increased demand for its goods from USA and Argentina
» Reduced volume of trade between USA and Argentina
(country with pegged currency)
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Depreciates Against MP
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Dollar depreciates to $ 0
0.15/MP
15/MP (from $0
$0.125/MP)
125/MP)
» AP to dollar is pegged at AP 0.75/$.
» AP to MP floats, new rates are:
– 1 AP now costs MP 5.0 (0.75 / 0.15)
– 1 MP now costs AP 0.20 (0.15 / 0.75)
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The Argentinan
Th
A
ti
Peso
P
also
l depreciates
d
i t against
i t the
th
Mexican Peso
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Depreciates Against MP
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International Trade: USA and Mexico:
» US demand for Mexican goods (US imports) decreases
» Mexican demand for US goods (US exports) increases
» US BOT with Mexico is increased
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Depreciates Against MP
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International Trade: Argentina and Mexico:
»
»
»
»
The value of AP falls against the MP
Argentinan demand for Mexican goods decreases
Mexican demand for Argentinan goods increases
Argentinan BOT with Mexico is increased
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Depreciates Against MP
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International Trade: USA and Argentina:
» Since AP has depreciated against MP but is fixed
against $, Argentina will shift imports from Mexico to US.
US exports to Argentina will rise and Argentinan imports
from Mexico will fall.
» Since the $ has depreciated against MP but is fixed
against AP,
AP USA will shift imports from the Mexico to
Argentina.
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Pegged Exchange Rates: USA, Mexico,
Argentina: Dollar Depreciates Against MP
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International Trade: Overall effects:
» Mexico's ( the country with appreciated floating
currency) economy will be hurt, because of reduced
demand for its goods from USA and Argentina
» Increased volume of trade between USA and Argentina
(country with pegged currency). Argentina and US
economies will be stimulated.
stimulated
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