TOPIC 2: THE INTERNATIONAL MONETARY SYSTEM
INTERNATIONAL MONETARY SYSTEM
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Institutional arrangements that govern exchange rates
PEGGED EXCHANGE RATE
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Value of currency – fixed
Relative currency – US dollar (ex)
Determined by reference currency exchange rate – the exchange rate of
currencies
MANAGED-FLOAT SYSTEM / DIRTY-FLOAT SYSTEM
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Value of currency – determined by market forces
A country’s central bank intervenes to change the direction of a country’s
currency value
FIXED EXCHANGE RATE
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Values of a set of currencies – fixed
Mutually agreed-on exchange rate
DOLLARIZATION
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Country is suffering from severe macroeconomic problems
High inflation
Own currency worthless
THE GOLD STANDARD
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The Bretton Woods System
- IMF : maintain order in the IMS
- Wordl Bank : promote development
The Collapse of the Fixed Exchange Rate System
Policies adopted by IMF can have an impact on the economic outlook for a
country – on cost and benefits
THE GOLD STANDARD: MECHANICS OF THE GOLD STANDARD & STRENGTH OF THE GOLD
STANDARD
THE GOLD STANDARD
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Origin – use of gold coins as medium of exchange, unit of account, & store of
value
Gold & silver – payment medium when international trade was limited in volume
More convenient means of financing international trade – when the volume of Int.
Trd expanded during the wake of the Industrial Revolution
MECHANICS FOR GOLD STANDARD
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Pegging currencies to gold
Gold Standard
Guaranteeing convertibility
Adopted the gold standard by 1880:
- Great Britain
- Germany
- Japan
- United States
Easy to determine the value of any currency in units to others (exchange rate)
STRENGTH OF GOLD STANDARD
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Contained a powerful mechanism for achieving balance-of-trade equilibrium by
all countries
BTE : when income earned by residents from exports = money had to pay by
residents for imports. (Current account of its balance of payments – balance)
THE PERIOD BETWEEN THE WARS: 1918-1939
HISTORICAL CONTEXT AND POST-WAR RETURNS
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1870-World War I
- gold standard was effective
- inflation & higher prices by 1918
Reintroduced the GS
- 1919 : US
- 1925 : Great Britain
- 1928 : France
U.S. DEVALUATION
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1933 : left the GS
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1934 : rejoined at a higher price of 35 dollar per ounce, devaluing dollar
Aimed to increase US exports and reduce imports
Altered the pound/dollar exchange rate
END OF THE GOLD STANDARD
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Competitive devaluations
Ensuing lack of confidence in currency values
1939
- World War II
- Gold standard was abandoned
Suspension of
Gold
Convertibility
INTRODUCTION OF THE WOODS AND THE ROLE OF IMF
THE BRETTON WOODS SYSTEM
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Developed 1944 during the United Nations Monetary and Financial Conference
(Bretton Woods, New Hampshire)
A landmark in shaping the post-World War II global economy
44 delegates
Gathered to create an international monetary system
- ensure financial stability
- encourage economic growth
2 MAJOR GOALS
1. To stabilize exchange rates
2. To promote economic development
2 KEY INSTITUTIONS CREATED FOR THIS PURPOSE
1. The International Monetary Fund (IMF)
 To oversee the international monetary system
 To provide financial assistance to countries facing short-term balance-ofpayments problems
 To prevent a repeat of past econ. instability thru 2 key approaches:
 DISCIPLINE : promotes strict financial guidelines and policies
 FLEXIBILITY: recognizes challenges
2. The World Bank
 International Bank for Reconstruction and Development (IBRD)
- Official name for the TWB
 Established by Bretton Woods participants
 Initial mission
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1950
1960
-
To help finance the building of Europe’s economy
Provide low-interest loans
Concentrated on public-sector projects
Began to lend heavily in support of agriculture, education,
population control, and urban development
2 SCHEMES IN LENDING MONEY BY TWB:
1. IBRD
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2. IDA
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Thru bond sales in the international capital market
Market rate of interest (Bank’s cost of funds + Margin for expenses)
Bank offers low-interest loans to risky customers
International Development Association
An arm of the bank
Created 1960
Thru subscriptions from wealthy members:
- United States
- Japan
- Germany
Loans go to only to the poorest countries
50 years to repay (Interest Rate – 1 percent a year)
THE COLLAPSED OF THE FIXED EXCHANGE RATE SYSTEM
FIXED
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Country’s currency is tied to
another currency
Central bank steps in to keep it
stable
Gives businesses predictability
Limites the central bank’s ability
to adjust monetary policy
Requires large foreign exchange
reserves for intervention
Reliable but restrictive
FLOATING
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1960: Fixed rate system work well
1973: collapsed of fixed.
: adopted managed-floating system
Currency’s value changes with
market such as supply/demand
No central bank intervention
More flexible and adapts
economic changes
More volatile
Lead to more ups and downs in
currency value
Allow
freedom
but
more
unpredictable
REASONS FOR LEADING THE COLLAPSE
1. U.S MACROECNOMIC POLICY
 1965-1968
 Increased government spending not financed by an increase in taxes
 President Lyndon Johnson financing both (1) Vietnam conflict and (2)
welfare programs
 Financed by expanding its money supply
 Price inflation from less than 4% in 1966 to close to 9% by 1968
2. ECONOMIC STIMULUS AND TRADE IMBALANCE
 More money in their pockets
 Government spending stimulates the economy
 Increasing consumer spending especially on imports
 Worsened the U.S. trade balance
 Imports > exports
3. SPECULATION IN THE FOREIGN EXCHANGE MARKET
 Dollar would be devalued
 German deutsche marks would be a revalued > dollar
 May 4, 1971
- Bundes Bank (Germany Central Bank) had to buy 1 billion to hold the
dollar/deutsche mark exchange rate as fixed exchange rate
- Great demand for deutsche marks
 May 5
- Purchased another 1 billion during the 1st hour of foreign exchange
trading
 After to float the Deutsche mark – Foreign Exchange Market anticipated a
need to devalue the dollar
 President Dixon : dollar would no longer be convertible
: imposed 10% import tax
 Dec. 1971
- Agreement to devalue the dollar by about 8%
 Feb. 1973
- Foreign exchange market closed
 March 19, 1973
- Reopened
- Japanese yen & European currencies – floating against dollar
THE FLOATING EXCHANGE RATE REGIME: THE JAMAICA AGREEMENT
THE FLOATING EXCHANGE RATE REGIME
Value of a country’s currency – market forces of supply & demand in
foreign exchange market
Rather than being fixed to another currency or commodity like gold
Followed Fixed
Formalized in January 1976
IMF members met in Jamaica and agreed to the rules
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THE JAMAICA AGREEMENT
Revised the IMF rules
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Main Elements of the Agreement:
 Acceptance of Floating Exchange Rates
- Allow currencies to float freely
 Abandonment of Gold as a Reserve Asset
- Redistributed its gold reserves to members
- Used the proceeds to assist poor nations
 Increase in IMF Quotas
- From $41 billion to higher amounts
- Expanded to 188 countries
EXCHANGE RATE SINCE 1973
MARCH 1973
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More volatile
Less predictable
TO BE CONTINUED
FIXED VS. FLOATING: THE CASE FOR FLOATING EXCHANGE RATES
FIXED
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FLOATING
Remain constant over life of a
loan/investment
Predictable monthly payments
Long-term commitments
Adjustable / variable rates
Change periodically
Benchmark index like LIBOR or
prime rate
ADVANTAGES:
 Higher Yield Potential
 Protection Against Rising Rates
 Low Duration
 Low correlation
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THE CASE FOR FIXED EXCHANGE RATES
MONETARY DISCIPLINE
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Country’s commitment
-
Buying & selling of currencies
-
Lack of confidence in the stability and sustainability
SPECULATION
UNCERTAINTY
TRADE BALANCE ADJUSTMENTS & ECONOMIC RECOVERY
FLOATING (FLEXIBLE) EXCHANGE RATE REGIMES
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Market forces
Manipulated by open-market operations
FIXED (PEGGED) EXCHANGE RATE REGIMES
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Sets value of its home country directly proportional to another currency
CHINA’S EXCHANGE RATE REGIMES
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Operates a managed floating exchange rate regime
Renminbi (RMB) – China’s currency
Allowed to fluctuate in value against other currencies
Government intervenes to manage exchange rate
Intervention: fixed
buying or selling RMB
2005 to present
PEGGED EXCHANGE RATES
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Fixed/tied to the value of another currency
MONETARY DISCIPLINE
-
Maintain low inflation rates
INFLATION CONTROL
-
Lower inflation
CHALLENGES:
1. Devaluation Pressure
2. Capital Outflows & Speculation
CURRENCY BOARDS
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A country commits to converting its domestic currency into a foreign
currency at a fixed exchange rate on demand
Foreign currency reserves at least 100% of the domestic currency
FOREIGN RESERVES REQUIREMENT
INFLATION CONTROL
AUTOMATIC INTEREST RATE ADJUSTMENT
DRAWBACKS:
1. Loss of Monetary Control
2. Overvaluation Risk
CRISIS MANAGEMENT BY THE IMF
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Orig function: to provide pool of money which members could
borrow
FINANCIAL CRISIS IN THE POST-BRETTON WOODS ERA
 Currency Crisis
- Attacks on the exchange value of currency result in short
depreciation in the value of int. currency reserves
 Banking Crisis
- List of confidence in banking system
- Indi and companies withdraw their deposits
 Foreign Debt Crisis
- Country cannot service its foreign debt obligation
EVALUATING THE IMF’S POLICY PRESCRIPTIONS
 CURRENCY PEGGING
- Practice of attaching/tying a currency’s exchange rate to another
country’s currency
- Pre-set ratios
- Fixed rate
- Provide stability
- Linking it to an already stable currency
- US Dollars
ASYMMETRIC INFORMATION
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More information about good or service than another in an
economic exchange
ADVERSE SELECTION
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Better-informed part uses an asymmetric balance of information
-
Natural outcome of insurance
MORAL HAZARD
POTENTIAL SOLUTIONS
LACK OF ACCOUNTABILITY & OBSERVATION OF IMF’S
LACK OF ACCOUNTABILITY
-
Jeffrey Sachs – a critic
Small staff & limited expertise, IMF makes poor policy reco
Sachs suggested to involved more external experts and improve
transparency
OBSERVATIONS
FOCUS ON MANAGERIAL IMPLICTIONS: CURRENCY MANAGEMENT, BUSINESS STRATEGY,
AND GOVERNMENT RELATIONS
CURRENCY MANAGEMENT
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Overseeing & optimizing the handling of foreign exchange assets
and liab
Identifying and mitigating risks related to currency fluctuations
Strategic planning to enhance currency conversion processes and
invst. Returns.
BUSINES STRATEGY
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How companies navigate exchange rate risks and opportunities
when conducting global operations
GOVERNMENT RELATIONS
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Create and enforce influence how currencies behave, trade
agreements function, and foreign investment are regulated.