The European Monetary System

Chapter 11
The International
Monetary System:
Past, Present, and
Learning Objectives
 Identify the key characteristics of an
effective monetary system.
 Describe the historical evolution of the
international monetary system from Bretton
Woods to the present time.
 Explain the purpose of the IMF and
understand its strengths and weaknesses.
 Differentiate among existing alternative
monetary arrangements.
 Compare and contrast several proposals for
reform of the current international monetary
International monetary systems
facilitate movements of goods,
services, and assets.
Historically, international monetary
systems have differed greatly.
The gold standard (1880 – 1914).
1920s: considerable exchange rate
1930s: global economic downturn;
competitive devaluations and high
tariffs limited trade.
Bretton Woods: Goals of the
To seek stability in exchange rates
Reconciliation of country
adjustments to payments
imbalances with national autonomy
in macroeconomic policy
To help preserve relatively free trade
and payments in the world economy
Bretton Woods: IMF Loans
When a country joins the IMF, it
agrees to pay a quota based on the
size of its economy.
Member countries can borrow foreign
exchange from the IMF in tranches to
help with BOP deficits.
Additional loans may come with
“strings attached” – conditions
requiring policy reform or currency
valuation changes.
Bretton Woods in Retrospect:
3 Problems
The Bretton Woods system
worked well until the 1960s, when
problems began to emerge.
1. Adequacy of reserves (or
 As volume of global trade grows,
BOP imbalances will also grow.
 This demands increases in reserves.
 The supply of gold was not keeping
Bretton Woods in Retrospect:
3 Problems
 Slow growth of gold supplies meant
countries increasingly held foreign
currency reserves (mainly $s and £s).
 Dollar holdings by foreign countries grew
well above U.S. gold holdings, so concern
grew over convertibility.
3. Adjustment
 Certain countries had prolonged BOP
deficits or surpluses.
 These countries were using monetary
and fiscal policies in ways that prevented
BOP adjustments.
Gradual Evolution of a New
International Monetary System
Early disruptions
 1967: U.K. devalued the pound by 14%.
 Since the pound was a “key currency”,
this raised serious doubts about the IMFs
exchange rate pegs.
1968: Central banks stopped gold
transactions with private individuals
and firms.
 Gold now a “two-tier” market – a private
gold market now emerged.
 This reduced the importance of gold in
the international monetary system.
Special Drawing Rights (SDRs)
In 1970, IMF created a new paper asset
called special drawing rights.
Countries were allocated SDRs and
could use them as international
reserves to settle BOP deficits.
If a country holds SDRs, it receives
interest on excess holdings.
Originally 1 SDR = $1.
Today SDRs are a weighted average of
the values of dollars, euros, yen, and
Breaking the Gold-Dollar Link:
the Smithsonian Agreement
1971: U.S. stopped trading gold with foreign
central banks.
This effectively ended the Bretton Woods
Later in 1971, the major countries met to
work out a new exchange rate arrangement:
the Smithsonian Agreement.
Initially, countries were optimistic.
However, continued currency speculation
caused some countries to devalue or
even float their currencies.
The Jamaica Accords
1976: IMF makes several changes.
 Each member country can choose its
own exchange rate system.
 Official gold price was abolished;
IMF sold off one-third of its holdings.
 SDRs were to become a more
important reserve asset.
 IMF was to maintain surveillance of
global exchange rate behavior and
advise members.
The European Monetary
1979: European countries begin to
move towards a monetary union.
A European currency unit (ecu) was
created, functioning only as a unit of
Exchange rates were to be kept within
a narrow band of each other.
The European Monetary Cooperation
Fund was set up as a proto-European
central bank.
The European Monetary
System: Maastricht
1991: European countries agree to
take steps toward the creation of a
monetary union in 1999.
The European Central Bank (ECB)
would serve as the supra-national
central bank for member countries.
In 1999, the 11 member countries fixed
their exchange rates in relation to the
In 2002, euro notes and coins were
The European Monetary
System: Maastricht
“Euroland”: Austria, Belgium, Finland,
France, Germany, Ireland, Italy,
Luxembourg, the Netherlands, Portugal,
and Spain
This system required convergence
 Inflation rates could not be too high.
 Long-term government bond interest rates
could not be too high.
 Government budget deficits could not be
too high.
 Government debt must be kept in check.
The European Monetary
System: Maastricht
Convergence requirements
presented major challenges.
In the end only Greece was
denied admission to the EMU (it
later was admitted).
Denmark, Sweden, and the U.K.
elected not to join the EMU.
 Giving up sovereignty over monetary
policy and giving up their domestic
currencies were too great a step for
these countries.
The European Monetary
System: Early Results
The transition to the euro went
smoothly and was popular with citizens.
Elimination of exchange rate and lower
transactions costs has created new
opportunities and has enhanced
The euro has helped further financial
The euro is the world’s second-most
widely used currency.
The European Monetary
System: New Entrants
European Union has added many
new countries in the past decades.
Once they meet convergence
criteria, countries can apply to
join the EMU.
Slovenia was admitted in 2007.
Slovak Republic was admitted in
Since Bretton Woods: A
Fluctuations in the
exchange rates among
the major currencies
have been very large
since the Bretton
Woods system fell
Since Bretton Woods: A
As a result, international
competitiveness has
varied considerably, with
substantial dislocations in
export and importcompeting sectors of
Current Exchange Rate
As of 1978, IMF member countries
have the right to have whatever
exchange rate systems they wish.
A number of distinct exchange rate
arrangements now exist, ranging
from no flexibility to total flexibility.
Sometimes this non-uniform
collection of arrangements is called
a “non-system.”
Current Exchange Rate
Arrangements with no separate legal
tender (a country uses the dollar or
some other currency as its own)
 Complete absence of exchange rate
 10 countries have adopted this, e.g.
Micronesia and Panama.
Currency Boards (currency is fixed in
value against an anchor currency)
 Ms can only increase if anchor currency
holdings increase.
 13 countries, e.g. Bulgaria and Dominica
Current Exchange Rate
Conventional Pegs (minimal variation
is allowed around a parity value set
against a foreign currency)
 Pegs against the dollar: 36 countries, e.g.
Argentina, Malawi
 Pegs against the euro: 20 countries, e.g.
Denmark, Niger
 Pegs against other currencies: 5
countries, e.g. Lesotho, Bhutan
 Pegs against a composite basket of
currencies: 7 countries, e.g. Libya,
Russian Federation
Current Exchange Rate
Other pegs, including crawling pegs
(greater variation is allowed around a
parity value set against a foreign
 Horizontal bands: 3 countries, e.g. Syria
 Crawling pegs/crawling bands: 10
countries, e.g. China, Iran
Managed floats (currency floats with
occasional intervention)
 44 countries, e.g. Egypt, Uruguay
Current Exchange Rate
Floats (the value of currency
is determined by markets with
only rare intervention)
40 countries, e.g. the EU,
Mexico, the U.S.
Experience Under the Current
International Monetary System
The international monetary system
for industrialized countries can be
characterized as a managed float.
What is the consensus about the
operation of that system?
Experience Under the Current
International Monetary System
1. The international monetary
system has been characterized by
substantial exchange rate
2. Exchange rate overshooting
(discussed in Chapter 22) has
3. Exchange rate variability has
had real effects: nominal rate
fluctuations have not matched
PPP exchange rate variations, so
real exchange rates have
4. The system hasn’t insulated
countries from foreign shocks as
well as was hoped; perhaps
because of intervention.
5. Countries have increased their
holdings of international reserves;
a flexible exchange rate system
was supposed to allow reduction.
 Particular concern: some central
banks (esp. China’s) now have
enormous dollar reserves – selling
these would cause a dramatic
decrease in the dollar’s value.
6. There has not been an increase
in inflation because of greater
flexibility of exchange rates (the
“vicious circle” hypothesis of
Chapter 28 hasn’t come to pass).
7. More flexible exchange rates do
not seem to have caused the
volume of trade to shrink.
8. The Asian financial crisis of
1997 was fueled by
speculative overinvestment
inadequate institutional
development and oversight
ease of capital flight from one
country to another
The Global Financial Crisis and
Recession of 2007-?
The world’s worst recession since
WWII began in 2007 with the onset of
the collapse of the U.S. subprime
The downturn quickly spread to
other countries.
In response, governments have used
expansionary fiscal and monetary
policy; IMF has attempted to help
developing countries.
The Global Financial Crisis and
Recession of 2007-?
Who’s to blame? Fingers have been
pointed variously at:
 Financial institutions that took
dangerous risks.
 Regulatory agencies that allowed
reckless behavior.
 Large global imbalances, such as the
U.S.’s large and persistent current
account deficits and China’s surpluses.
At present, the severity and duration
of this recession are unclear.
Suggestions for Reform of the
International Monetary System
A return to the gold standard
 Long-standing BOP imbalances would
not occur, and exchange rate risks
would be reduced.
 However, this system emphasizes BOP
equilibrium over internal goals such as
full employment.
A world central bank
 Extreme form: something like the EMU
 Which country would give up its
Suggestions for Reform of the
International Monetary System
The target zone proposal
 Major countries would negotiate
targets for real effective exchange
rates; each country would commit to
maintaining this value within a range
around the target.
 It can be difficult to manage real
exchange rates, and some argue that
such a system would interfere with
efficient resource allocation.
Suggestions for Reform of the
International Monetary System
Controls on capital flows
If speculative capital flows
cause instability, minimize them
perhaps by a “Tobin tax.”
But capital flows can increase
economic efficiency, and so
economists typically oppose
capital controls.
Suggestions for Reform of the
International Monetary System
Greater stability and coordination of
Macroeconomic Policies Across Countries
Macro policies for a particular country can be
unstable over time, and countries’ macro policies
are sometimes at cross-purposes.
It might therefore be sensible to make a greater
effort to coordinate policies.
Such coordination
might be difficult
to operationalize.
The International Monetary
System and the Developing
Less developed countries (LDCs)
generally prefer fixed exchange rate
systems, and they wish to avoid the
exchange rate volatility of the postBretton Woods world.
However, fixed exchange rate systems
require adequate international
reserves, so LDCs want any reform to
address this.
The International Monetary System
and the Developing Countries
LDCs are also concerned about IMF
“conditionality” – the strings that are
attached to any LDC use of IMF
LDCs want an international monetary
system that will generate more
LDCs would like a greater voice in
organizations such as the IMF and
the World Bank.
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