International Monetary
System
Historical monetary standards, gold
standard through currency unification
July 17, 2016
International Monetary System
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Central Banks
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Create money
Mandate reserve ratios
Mandate capital ratios
Control bank rate
Operate in t-bill market
Operate in exchange markets
July 17, 2016
International Monetary System
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Create money
 Central banks order coin and currency
which is stored in the vault
 Money is created when the central bank
buys something with that coin and currency
 Gold and silver
 Foreign exchange
 Foreign denominated cash and currency
 Foreign denominated t-bills
 Domestically denominated t-bills
 Keeps purchases sufficiently high to meet
inflation targets
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International Monetary System
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Mandate reserve ratios
 Commercial banks required to
maintain liquid reserves to meet
demand of deposit holders
demanding redemption
 Inverse of reserve ratio is called the
money multiplier
 How much bank money, base money will
support
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Commercial bank T-account
 Reserve Ratio = 10%
 Money multiplier = 10
Checking deposits
Reserves = $1 billion
Savings Deposits
$9.6 billion
GICs
Loan Portfolio = $9 billion
Bank capital = 400 million
July 17, 2016
International Monetary System
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Commercial bank T-account
 Reserve Ratio = 20%,
 Money multiplier = 5
Checking deposits
Reserves = $1 billion
Savings Deposits
$4.8 billion
GICs
Loan Portfolio = $4 billion
Bank capital = 200 million
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Mandates Bank Capital Ratios
 Leverage
 Measured by the debt/equity ratio or
debt ratio
 Measure of risk
 Manufacturing firms usually D/E = 1 or
D/TA = 0.5
 Banks D/E = .96/.04 = 24 or D/TA = 0.96
 The liabilities (deposits) in a bank are
guaranteed (insured) by the government
 Banks can lever quite a bit because of this
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Determines the bank rate
 Bank rate
 Interest rate charged member banks for
borrowing to increase reserves
 Increase the bank rate decreases system
reserves thereby leading to a decrease in
the money supply
 Decrease the bank rate increases system
reserves thereby leading to an increase in
the money supply
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International Monetary System
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Market operations
 Central bank has large influence in
two markets
 Domestic t-bill market (largest single
entity)
 Exchange market (largest single entity in
domestic currency in exchange markets)
 As a large entity it, unlike other
operators in the market, can affect
price
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International Monetary System
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Historical Monetary Standards
 Bronze
 Silver
 Gold
 U.S. Dollar Standard
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Objective of a monetary standard
 Fix the value of the unit of account
 Something immutable
 Ounce of silver
 Ounce of gold
 Gold standard
 Unit of account – troy ounce
 Medium of exchange
 Coinage
 Gold certificates
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The Bank of Deposit
 Bank of Amsterdam (15th century)
 100% reserves of gold and silver
 Depositors brought gold, silver
 Were given warehousing certificates for the
amount of gold, silver minus a charge
 Depositors would use the warehousing
certificates as money
 Lower transactions costs
 Easier to use
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Bank of Issue
 Queen Elizabeth I 1563 to 1603
 Created the Bank of England
 Held partial reserves of gold and silver
 The rest were in treasury bills
 This was not a strict gold standard, but a
gold exchange standard
 This bank could not refund all claims for
gold with gold
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Fixed Parity? Variable value of the
unit of account?
 Fixed parity price (not fixed value)
 Unit of account varied with the cost of
mining gold
 Often the unit of account appreciated
(increased in value) as gold supplies were
harder to mine
 With new gold discoveries, the unit of
account depreciated (decreased in value)
as the cost of mining gold decreased
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Gold Standard
 Countries fix parity price of gold
 They allow arbitrage between two markets
 parity price of gold at Central Bank
 free market price of gold
 De facto single currency the ounce of gold
 many units of account
 periodic falling off of the gold standard
 Balance of Payments deficits settled with
gold
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Exchange rate – gold standard
 usd parity price = $20.67/ounce
 British parity price = 4.2474/ounce
2067
. usd
eusd , bp 
 4.8665 usd / bp
4.2474 bp
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Arbitrage
S2
Pg
S1
Par
Pg
D2
D1
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International Monetary System
Qg
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The Act of Arbitrage
 Two markets for gold
 official government market
 Legal private markets
 Parity Price greater than market price
 government’s price (parity) the high price
 external markets price the low price
 trader buys low sells high
 buys externally
 sells to government
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The Effects of Arbitrage
 Private market gold supplies decrease
 holders of gold will sell first to the government
 arbitrageurs will buy up stocks and sell to the
government
 excess supply will dry up bringing market price
to equal the parity price
 Government gold supplies will increase
 increases the money supply
 decrease the value of money (inflation)
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Gold Standard
Treasury
Liabilities
Assets
cash
Gold
currency
T-bills
gold increases
due to BOT surplus
July 17, 2016
Money supply
increases
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Gold Standard
monetary effects
 Gold backs all money
 prices move relative to
 excess demand for gold (economic
growth)
 deflation
 excess supply of gold (new gold finds)
 inflation
 Treasuries have no independent
monetary policy
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BOT Surplus
 Mechanism which mitigates BOT
surplus
 gold is paid to pay for excess of exports
to imports
 gold coming into the central bank
increases money supply
 inflation in the economy
 your goods now more expensive in foreign
markets
 foreign goods less expensive to you
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Gold as a unit of account
 If the cost of mining gold increases
 deflation
 Value of gold increases
 Value of other goods remain constant
 Prices decrease
 If the cost of mining gold decreases
 Inflation
 Value of gold decreases
 Value of other goods remain constant
 Prices increase
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Gold Standard
Treasury
Assets
Liabilities
30 – 40%
currency
Gold
T-bills
60 – 70%
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Gold standard & exchange rates
 All currencies fixed to gold
 Gold is the de facto currency
 single world wide currency
 all international trade is denominated in
gold
 No need to hedge exchange rate
volatility since exchange rates are
constant
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Off the Gold standard
 When CBs execute a monetary policy
 discipline of the gold standard is gone
 after WWII governments ran inflationary
policies
 interest rate policies
 employment policies
 inflation sometimes running at 200% or
more
 Exchange rates fluctuate
 creating uncertainty for trade
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Current Exchange rate regimes
 freely floating exchange rate regime
 managed exchange rate
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pegged to another currency
pegged to a basket
joint float
managed float - reduce volatility, but not
change
 Dollarization
 monetary unification
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Floating exchange rates
 Advantages
 Purchasing power parity allowed to hold
 Trend line reflects relative inflation
 International prices adjust automatically
 Prices more transparent
 Allows an independent monetary policy
 Disadvantages
 Exchange rate volatility increases
 Higher costs due to need to hedge volatility
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Bank of Canada
(floating exchange rate)
Liabilities
Assets
Cash, currency
Gold, foreign
exchange
T-bills
July 17, 2016
70 – 80%
Commercial bank
reserves held at
BOC
International Monetary System
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The Spot Exchange rate
 Price for current delivery
 Price of one currency in terms of another
 Delivery no later than four business days
 Price market determined
 fluctuates to reflect new information
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Equilibrium Spot Rate
 Current demand for CD by holders of
foreign currency
 foreigners want to buy something
Canadian
 Current supply from Canadians
holding CD demanding foreign
exchange
 Canadians want to buy something
foreign
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International Monetary System
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Spot rate
 e0 , Can terms = CD/USD = 1.1522
 CD cost of the USD
 e0 , us
terms
= USD/CD = 0.8679
 USD cost of the CD
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Balance of Payments
BOP   X  M   CI  CO 
Balance of Trade
Financial account
Capital account
Reserve account
FI  FO  FXB
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Exchange rate equilibirum
 Demand for the dollar
 all foreigners buying Canadian
 all Canadians selling foreign assets
 Supply of the dollar
 Canadians buying foreign goods and services
 foreigners selling Canadian assets
 Where demand equals supply
 Equilibrium price (Exchange Rate) and Quantity
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Equilibrium spot rate
S1
usd/cd
e 0, usd, cd
D1
Qo, cd
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International Monetary System
Qcd
35
Free Float
 Shift in demand
 US consumers buying more Canadian
 free float allows a new equilibrium
 cd appreciates
 US goods lower in price to Canadians
 usd depreciates
 Canadian goods higher in price to the U.S.
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Free Float
Foreigners increase their demand for Canadian goods
usd/cd
S1
e1, usd, cd
D2
e0, usd, cd
D1
Q0, cd
July 17, 2016
Q1, cd
International Monetary System
Qcd
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Demand for the dollar(Credits)
 Exports (X)
 British buying Canadian goods
 Germans vacationing in Newfoundland
 Capital inflows – real assets (CI)
 Walmart buying out Woolco
 Toyota building a plant in
 Financial inflows – financial assets (FI)
 US investors buying Canadian Imperial, Vulcan
 Germans buying NF CD denominated bonds
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Supply of the dollar (Debits)
 Imports (I)
 Buying Sonys
 Spending a week at Disneyworld
 Canadians spending six months of the year in
Texas
 Capital Outflows – real assets (CO)
 Inco buying a property in Indonesia
 Couple retiring to Florida buying a condo there
 Financial Outflows - financial assets (FO)
 Buying shares in Microsoft
 Buying euro denominated bonds
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Changes in the spot rate
 Positive change
 Costs more CD to buy the USD
 Costs more CD to buy US goods
 CD depreciates
 Negative change
 Costs less CD to buy USD
 Costs less CD to buy US goods
 CD appreciates
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The Forward Exchange rate
 Price for future delivery
 Price of one currency in terms of another
 Delivery date to be determined if
contracted
 Price market determined
 fluctuates to reflect new information
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International Monetary System
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Equilibrium forward rate
S1
usd/cd
e T, usd, cd
D1
QT, cd
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International Monetary System
Qcd
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Equilibrium Forward Rate
 Future demand for CD by holders of foreign
currency expressed in today’s markets
 foreigners contracting to buy something
Canadian today
 But will pay for it at a future date
 Current supply from Canadians holding CD
demanding foreign exchange expressed in
today’s markets
 Canadians contracting to buy something foreign
today
 But expect to pay for it in the future
July 17, 2016
International Monetary System
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Forward rate
 f180 , Can terms = CD/USD = 1.1126
 CD cost of the USD
 f180 , us
terms
= USD/CD = 0.8988
 USD cost of the CD
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Forward premium/discount
f premium ( discount ) 
 fT 


e
 0 
.
 11126

 11522

.
July 17, 2016
365
T
365
180
 1 
 1 
International Monetary System
 0.06846
45
Fixed exchange rates
 Advantages
 reduces short-run exchange rate volatility
 reduce costs of international trade
 Disadvantages
 Externally mandated discipline (loss of
sovereignty
 Monetary policy
 Fiscal policy
 Impede relative price adjustments
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Means to manage exchange
rates
 Currency Boards
 Central Bank Intervention
 devalutaion/revaluation
 Joint Intervention
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China Currency Board
Liabilities
Assets
 gold, silver
 Yuan cash &
currency
 dollar assets
(T-bills) 80%
$400 billion
 some foreign
exchange
July 17, 2016
 Commercial Bank
reserves
International Monetary System
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Dollarization
 Countries adopt a currency not their
own
 Informally
 Black and grey markets exist in which the
medium of exchange is the dollar
 Formally
 Panama, Ecudor
 Lose all sovereignty with regard to
monetary and exchange rate policy
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Euro-Zone (Currency Unification)
 Independent European Central Bank
 convergence criteria
 nominal inflation < 1.5% above
 avg of 3 with lowest in previous year
 long-term interest < 2.0 % above
 avg of 3 with lowest in previous year
 fiscal deficit no more than 3 % of GDP
 debt no more than 60% of GDP
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Countries in the Euro
 Belgium (franc)
 Germany
(deutschemark)
 Spain (peseta)
 France (franc)
 Ireland (punt)
 Luxembourg (franc)
 Italy (lira)
July 17, 2016
 Netherlands
(guilder)
 Austrian (shilling)
 Portugal (escudo)
 Finland (markka)
 Vatican City (lira)
 Greece (drachma)
 Slovenia (tolar)
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EU Countries not in Euro zone
 Bulgaria (Lev)
 Cyprus (Pound)
 Czech Republic
(Koruna)
 Denmark (krone)
 Estonia (Kroon)
 Hungary (Forint)
 Latvia (Lats)
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Lithuania (Litas)
Malta (Lire)
Poland (Zloty)
Romania (Leu)
Slovakia (Koruna)
Sweden (krona)
United Kingdom
(pound)
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Candidate countries for the EU
 Croatia
 Macedonia
 Turkey
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Russian problems
 insecure property rights
 no stable infrastructure
 police
 courts
 taxing by monetary policy
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The Brazilian Fix
 exchange rate policy
 trying to keep the real from depreciating
 convergence of policies a necessary
condition
 monetary policy
 budgetary deficits
 BOP deficits
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The impact of a devaluation
 Brazilian Stock market take a hit
 Government borrowing in dollars
 have to pay back in higher valued
currency
 often leading to re-negotiation of terms
 operating exposure
 (change in real exchange rate)
 on exporters
 on importers
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