Management 3460
Institutions and Practices in
International Finance
Fall 2003
Greg Flanagan
Chapter 2
International Monetary System
Chapter Objectives:
This chapter serves to introduce the student
to the institutional framework within which:
international payments are made;
 movement of capital is accommodated;
 exchange rates are determined.
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September 16-22, 2003
Outline
Money
The evolution of the International Monetary
System
Current Exchange Rate Arrangements
Euro and the European Monetary Union
Currency Crisis
 Mexican Peso Crisis
 Asian Currency Crisis
Fixed versus Flexible Exchange Rate Regimes
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September 16-22, 2003
Money
Means of exchange
Unit of account
Store of value
Commodity money
Fiat money
Characteristics of good money:
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September 16-22, 2003
Bimetallism: Before 1875
 A “double standard” in the sense that both gold
and silver were used as money.
 Some countries were on the gold standard, some
on the silver standard, some on both.
 Both gold and silver were used as international
means of payment and the exchange rates among
currencies were determined by either their gold or
silver contents.
 Gresham’s Law: ‘bad money drives out good
money’
 implied that it would be the least valuable metal that
would tend to circulate.
 Not ‘systematic’-- many disruptions in trade.
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September 16-22, 2003
Classical Gold Standard:
1875-1914
Gold standard est. 1821 Bank of England
pound notes redeemable for gold.
Full gold standard 100%
 partial: more notes than gold.
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September 16-22, 2003
Classical Gold Standard:
1875-1914
Conditions
 Gold alone was assured of unrestricted coinage;
 There was two-way convertibility between gold
and national currencies at a stable ratio.
 Gold could be freely exported or imported.
The exchange rate between two country’s
currencies would be determined by their relative
gold contents.
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September 16-22, 2003
Classical Gold Standard:
1875-1914
Highly stable exchange rates under the
classical gold standard provided an
environment that was conducive to
international trade and investment.
Misalignment of exchange rates and
international imbalances of payment were
automatically corrected by the price-specieflow mechanism.
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September 16-22, 2003
Price-specie-flow mechanism.
 Arbitrage will keep the exchange rates equal.
 Trade flows will adjust to exchange rates by the
flow of gold.
 Money Supply X Velocity =Prices X Quantities.
MsV=PQ
 M = f (Gold)
 If V and Q constant a G ha Ms h a Ph
a eXportsi iMportsh a Gi until X=M (trade
balance)
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September 16-22, 2003
Price-specie-flow mechanism.
Problems:
Limited supply of new gold restricts the
growth of world trade and investment due to
insufficient medium of exchange.
National economies respond to the
exchange rate (gold reserves) rather than
real production possibilities.
any national government could abandon the
standard.
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September 16-22, 2003
Interwar Period: 1915-1944.
 Gold flow ceased due to WW1
 Exchange rates fluctuated as countries widely used
“predatory” depreciations of their currencies as a
means of gaining advantage in the world export
market.
 Attempts were made in the 1920s to restore the gold
standard, however, major countries (i.e.USA, GB)
‘sterilized’ gold in order to pursue domestic interests.
 Hyperinflation in Germany, the stock market crash, and
the great depression result gold standard abandoned.
 international trade and investment was profoundly
diminished.
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September 16-22, 2003
Bretton Woods System:
1945-1972
Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
The purpose was to design a postwar
international monetary system.
The goal was exchange rate stability
without the gold standard.
The result was the creation of the
International Monetary Fund (IMF) and the
World Bank.
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September 16-22, 2003
Bretton Woods System:
1945-1972
US$ based Gold exchange Standard: the
U.S. dollar was pegged to gold at $35 per
ounce and other currencies were pegged
to the U.S. dollar.
Each country was responsible for
maintaining its exchange rate within ±1% of
the adopted par value by buying or selling
foreign reserves as necessary.
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September 16-22, 2003
Bretton Woods System:
1945-1972
 Increasing U.S. trade deficits occurred in the late
1950s and 1960s.
 Triffin Paradox: h need for reserves a M > X a $
outflow a more $ than gold at $35 per ounce.
 France wants Gold for $ a pressure on reserves
 a Interest Equalization Tax (1963) and the Foreign
Credit Restraint Program (1965-68)
 Special Drawing Rights (SDR) established by IMF
 Smithsonian agreement: US$38/ounce; band h
2.25% 1973 US$42/ounce
 1973 the US$ is released from the gold standard.
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September 16-22, 2003
Special Drawing Rights
 Weighted average of currencies
Currency
1981-85
1986-90
1991-95
19962000
20012005
US$
42
42
40
39
45
Euro
29
German
Mark
19
19
21
21
Japanese
Yen
13
15
17
18
15
British
pound
13
12
11
11
11
French
Franc
13
12
11
11
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September 16-22, 2003
Supply and Demand Review
A digression
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September 16-22, 2003
The Market Model
Demand and Supply
Shows how the price and output of a
commodity are determined in a
competitive market.
When relevant variables change it shows
how these changes affect the price and
output.
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September 16-22, 2003
Demand (coffee)
Price. We expect that as the price goes up, the
quantity demanded goes down and vice versa.
Income. Changes in income modify people’s
consumption opportunities. It is hard to say a
priori, however, what effect such changes have
on consumption of a given good.
normal good: as incomes go up, people
use some of their additional income to
purchase more coffee.
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September 16-22, 2003
Demand
inferior good: it may be that as incomes
increase, people consume less coffee,
perhaps spending their money on cognac
instead.
We expect that changes in income affect
demand one way or the other, but in some
cases it is hard to predict the direction of the
change. Px
Inferior good: I h a Dh & v. v.
Normal good: I h a Di & v. v.
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September 16-22, 2003
Demand
 Prices of related goods.
 substitutes: if the price of tea goes up people can
substitute coffee for tea, this increase in the price of
tea increases the amount of coffee people wish to
consume.
 complements: if the price of cream goes up and if
people consume coffee and cream together, this
tends to decrease the amount of coffee consumed.
 Tastes. The extent to which people “like” a good
affects the amount they demand.
 Expectations
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September 16-22, 2003
Demand
 A demand schedule (or demand curve) is the
relation between the market price of a good and
the quantity demanded of that good during a given
time period, other things being the same.
(Economists often use the Latin for “other things
being the same,” ceteris paribus.)
Dx = F(Px, I, Psub, Pcomp, T, Ex, etc.)
Dx =f(Px)c.p.
 A hypothetical demand schedule for coffee is
represented graphically by curve Dc=f(Pc)
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September 16-22, 2003
Demand Curve
Change in ‘Quantity Demanded’
due to a change in Price
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September 16-22, 2003
Increase in Demand due some variable other than Price
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September 16-22, 2003
Supply
Price. We expect that as the price goes up, the
quantity supplied goes up and vice versa. It is
reasonable to assume that the higher the price
per pound of coffee, the greater the quantity
profit-maximizing firms are willing to supply.
Costs, or Prices of inputs. Coffee producers
employ inputs to produce coffee—labour, land,
and fertilizer. If their input costs go up, the
amount of coffee that they can profitably supply
at any given price goes down.
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September 16-22, 2003
Supply
Conditions of production. The most important
factor here is the state of technology. If there is a
technological improvement in coffee production,
the supply increases.
Other variables. also affect production
conditions. For agricultural goods, weather is
important. Several years ago, for example,
flooding in Latin America seriously reduced the
coffee crop.
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September 16-22, 2003
Supply
 A supply schedule (or supply curve) is the
relation between the market price of a good and
the quantity demanded of that good during a given
time period, other things being the same.
(Economists often use the Latin for “other things
being the same,” ceteris paribus.)
Sx = F(Px, Costs, Tech, etc.)
Sx =f(Px)c.p.
 A hypothetical supply schedule for coffee is
represented graphically by curve Sc=f(Pc)
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September 16-22, 2003
Supply Curve
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September 16-22, 2003
Decrease in Supply due some variable other than Price
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September 16-22, 2003
Equilibrium
The demand and supply curves provide
answers to a set of hypothetical questions:
If the price of coffee is $2 per pound, how
much are consumers willing to purchase? If
the price is $1.75 per pound, how much are
firms willing to supply? Neither schedule by
itself tells us the actual price and quantity.
But taken together, the schedules determine
price and quantity.
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September 16-22, 2003
Equilibrium
equilibrium—a situation that tends to be
maintained unless there is an underlying
change in the system.
Quantity demanded equals quantity
supplied.
In the next Figure the demand schedule Dc
is superimposed on the supply schedule Sc.
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September 16-22, 2003
Market Equilibrium
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September 16-22, 2003
i.e. suppose the price is P1 dollars per pound. At this
price, the quantity demanded is Q1 and the quantity
supplied is Q1
Price P1 cannot be maintained,
because firms want to supply more
coffee than consumers are willing to
purchase. This excess supply tends
to push the price down, as suggested
by the arrows.
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September 16-22, 2003
Decrease in Supply due to
some variable other than
price changing. i.e. Costs of
production increase.
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September 16-22, 2003
Arbitrage
Market A
Market B
P
P
S
S
S*
Pe
PB
D
D*
D
QY
Sell in the high market a Sh
QY
Buy in the low market a Dh
Arbitrage brings markets together over space,
bringing a common price (except transaction costs).
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September 16-22, 2003
Back to the Main History
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September 16-22, 2003
The Flexible Exchange Rate
System 1973—
The Jamaica Agreement 1976
Flexible exchange rates were declared
acceptable to the IMF members.
Central banks were allowed to intervene in
the exchange rate markets to iron out
unwarranted volatilities.
Gold was abandoned as an international
reserve asset.
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September 16-22, 2003
The Flexible Exchange
Rate System 1973—
The IMF continued assistance to countries
experiencing Balance of Payments and
foreign exchange problems.
And non-oil-exporting countries and lessdeveloped countries were given greater
access to IMF funds.
However, assistance was conditional on
practicing IMF proscribed economic policy
a resentment and dissent.
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September 16-22, 2003
1973—The Flexible Exchange
Rates:
The Plaza Accord 1985
G5 Agreed to let the $US slide
The Louvre Accord 1987
G7 cooperate for greater exchange
rate stability
More closely coordinate economic
policies
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September 16-22, 2003
Current Exchange Rate
Arrangements
Independent Float
Market determined
Some management (intervention) to
moderate the rate of fluctuations.
The largest about 41 countries,
(including Canada).
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September 16-22, 2003
Current Exchange Rate
Arrangements
Managed Float
Active government intervention in
market forces to set exchange rates.
With no preannounced path for the
exchange rate
About 42 countries
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September 16-22, 2003
Current Exchange Rate
Arrangements
Exchange rates with crawling
bands
Central rate with +/- margins
Adjusted periodically on set dates or
due to set quantitative indicators.
 ~6 countries
i.e. Venezuela
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September 16-22, 2003
Current Exchange Rate
Arrangements
Crawling Pegs
Adjusted periodically on set dates or
due to set quantitative indicators.
 ~4 countries
i.e. Bolivia
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September 16-22, 2003
Current Exchange Rate
Arrangements
Pegged with horizontal bands
Formal or de facto fixed rate with
margins greater than +/- 1%
5 countries
i.e. Denmark
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September 16-22, 2003
Current Exchange Rate
Arrangements
Conventional Pegged rate
pegged to a major currency ($) or
basket of currencies (SDR)
Narrow band fluctuation <1%
~40 countries
i.e. China
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September 16-22, 2003
Current Exchange Rate
Arrangements
Currency Board arrangements
Legislated commitment to exchange
domestic currency for a specified
currency at a fixed exchange rate
Combined with restrictions on the
issuing authority 9bioard) to ensure its
legal obligations.
i.e. Hong Kong a US$; Estonia a €
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September 16-22, 2003
Current Exchange Rate
Arrangements
No separate Currency (legal
tender)
Another country’s currency circulate
or the country belongs to a currency
union
i.e. Ecuador a US$
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September 16-22, 2003
European Monetary System
The euro € is the single currency of the
European Monetary Union which was
adopted by 12 Member States on 11 on
January 1st 1999. and Greece in 2000.
Marks, Francs, Lira, etc. are no longer
independent currencies.
Fixed exchange rates:
European Central Bank
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September 16-22, 2003
1 Euro is Equal to:
40.3399 BEF
Belgian franc
1.95583 DEM
German mark
166.386 ESP
Spanish peseta
6.55957 FRF
French franc
.787564 IEP
Irish punt
1936.27 ITL
Italian lira
40.3399 LUF
Luxembourg franc
2.20371 NLG
Dutch gilder
13.7603 ATS
Austrian schilling
200.482 PTE
Portuguese escudo
5.94573 FIM
Finnish markka
40.750 GRD
48
Greek Drachma
September 16-22, 2003
European Monetary System
Benefits
Reduced transaction costs
elimination of exchange rate uncertainty
No hedging costs
Promote cross border investments and
trade
Increased competition a prices i
Integration of financial markets
Continental capital markets
Political cooperation and peace
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September 16-22, 2003
European Monetary System
Costs
Loss of sovereignty over national
monetary and exchange rate policies.
Mundell: Theory of optimal common
currency area.
currency common a factor resource
mobility: differing economic conditions
mean resources move.
Immobility of resources a different
currencies adjust to differing economic
conditions.
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September 16-22, 2003
The ‘Trilemma’
1. Fixed Exchange rate.
2. Free international flows of capital
3. An independent monetary policy
a Can choose only two
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September 16-22, 2003
The ‘Trilemma’
Fixed rates
reduce uncertainty a h foreign
trade
tie monetary and fiscal policies to
exchange rate maintenance
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September 16-22, 2003
The ‘Trilemma’
Flexible exchange rates
increase uncertainty.
• however, hedging can be used
monetary and fiscal policies can be
independent and used to achieve
other goals.
No safeguards to prevent currency
crises.
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September 16-22, 2003
Fixed versus Flexible
Exchange Rate Regimes
Suppose the exchange rate is US$1.40/£
today.
In the next slide, we see that the quantity
demanded for British pounds far exceed
the quantity supplied at this exchange rate.
The U.S. experiences trade deficits.
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September 16-22, 2003
Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Demand
(D)
$1.40
Trade deficit
55
QS
QD
Q of £
September 16-22, 2003
Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
$1.60
Demand
(D)
Dollar depreciates
(flexible regime)
$1.40
Demand (D*)
56
Q D = QS
Q of £
September 16-22, 2003
Under a flexible exchange rate regime,
the dollar will simply depreciate to
$1.60/£, the price at which supply equals
demand and the trade deficit disappears.
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September 16-22, 2003
Under a flexible exchange rate regime,
the dollar will simply depreciate to
$1.60/£, the price at which supply equals
demand and the trade deficit disappears.
58
September 16-22, 2003
Fixed versus Flexible
Exchange Rate Regimes
If the exchange rate is “fixed” at
US$1.40/£, and thus the imbalance
between supply and demand cannot be
eliminated by a price change.
The US government would have to
intervene in order to demand or supply
i.e. a shift of demand from D to D* through
contractionary monetary and fiscal policies.
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September 16-22, 2003
Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Contractionary
policies (T h)
Demand
(D)
(fixed regime)
$1.40
Demand (D*)
60
QD* = QS
Q of £
September 16-22, 2003
Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S) Supply
Contractionary
(S*)
policies i h
(fixed regime)
$1.40
61
Demand
(D)
Q of
£
QD = QS*September
16-22, 2003