The International Monetary
System (IMS)
• Official Part of the International Financial
System
• Presents a Structure within which
 Exchange rates are determined
 Trade and capital flows are accommodated
 Balance of payments adjustments are made
• Includes instruments, institutions, and
agreement which link together the world’s
financial and commodity markets
• Exchange Rate Systems
 Exchange rate systems can be classified
according to the degree by which exchange
rates are controlled by the government.
•
•
•
•
Fixed
Freely Floating
Managed Float
Pegged
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World Trade and the
International Monetary System
• Integration of the world’s markets
for goods and services
 Creation of the World Trade Organization (WTO)
 Emergence of China as a major trading partner
 Global trend toward free-market economies
 Industrialization of the Far East and Pacific Rim
 Emergence of central and eastern Europe
 Reunification of East and West Germany
 Hong Kong’s 1997 return to China
 Introduction of the euro
• Integration of financial markets
 An increase in cross-border financing
 Increasingly interdependent national financial
markets
 An increasing number of cross-border mergers,
acquisitions, and joint ventures
 An increasing number of cooperative linkages
among securities exchanges
2
History of the international
monetary system
•
1971 - Exchange rate turmoil
 Dollar falls off the gold standard
 Most currencies float on world markets
•
1971 - Smithsonian Agreement (G-10)
 dollar devalued to $38/oz of gold
 other currencies revalued against the dollar
 4.5% band adopted
•
1972 - European Joint Float Agreement
 “The snake” adopted by EEC
1976 - Jamaica Agreement
 Floating rates are declared “acceptable”
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•
•
•
•
1979 - European Monetary System (EMS)
 European Exchange Rate Mechanism (ERM) established to maintain EEC
currencies within a 2.25% band around central rates
 European currency unit (ECU) created
1985 - Plaza Accord (G-10)
 The Group of Ten agree to cooperate in controlling exchange rate volatility
and bringing down the value of the dollar
1987 - Louvre Accord (G-5)
 The Group of Five agree to maintain current exchange rate levels
1991 - Treaty of Maastricht
 EC members agree to a broad agenda of economic, financial and monetary
reforms
 A single European currency is proposed as the ultimate goal of monetary
union
•
1999 - Introduction of the euro
 Emu-zone currencies pegged to the euro
 European bonds convert to the euro
•
2002 - Euro begins public circulation
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Gold Standard (1821-1914)
• Gold is the dominant international money
• Currencies are valued in terms of a gold
equivalent
• All players had to adhere to the rules of the game
• Government intervention
• International reserves
• Limited growth of the money supply
• Automatic balance of payment adjustments
• Gold Exchange Standard
(1925-1931)
 Each currency is freely convertible into gold at a
fixed rate but also into other currencies at relatively
stable prices.
 Greater convenience for international traders and
investors.
4
Bretton Woods System (1944-1971)
Fixed Rates with Narrow Bands
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•
•
•
•
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A dollar based system
Maintain a fixed, or pegged, exchange rate in terms of gold or the U.S.
dollar
Dollar per gold value of $35.00
Allow currencies to fluctuate within a narrow band of ±1%.
Government intervention
International reserves
•
World Bank which now includes





•
International Bank for Reconstruction and Development
International Development Association
International Finance Corporation
Multilateral Investment Guarantee Agency
International Centre for Settlement of Investment Disputes
International Monetary Fund (IMF)
 Responsible for ensuring the stability of the international financial system
 Compiles balance-of-payments statistics
•
•
Exchange rate systems
Pegged or fixed exchange rate systems
 Forges a direct link between inflation differentials and employment levels
 Can result in large adjustments
•
Floating exchange rate systems
 Allows exchange rates to adjust for inflation differences
 Allows employment levels and wages to equalize through the exchange rate
mechanism
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Smithsonian Agreement (1971-1973)
Fixed Rates with Wider Bands
• Dollar per gold value was changed to $38.02
• Allow currencies to fluctuate within a wider band
of ±2.25%.
• Eclectic Currency Arrangement
 Free or Clean Float (March 1973)
 Managed or Dirty Float (January 1976)
 Joint Float - European Monetary System (March
1979)
• Freely Floating Exchange Rate System






Market forces determine the exchange rate
No government intervention
No need for international reserves
Independent monetary and fiscal policies
No capital flow restrictions
Price instability
• Contemporary Currency Regimes
 IMS (national currencies, artificial currencies,
composite currency)
 Exchange Rate Regimes (8)
• Rigidly fixed system (euro area)
• Independently floating (developed and emerging
market countries)
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Recent exchange rate
arrangements
FX
regime
Africa
Asia/Pa
cific
No
separate
legal
tender
WAEM
U
CAEM
C
Marshall Euro
Is,
Area
Micrones
ia
Ecuador,
Panama
China,
HK,
Malaysia
Taiwan,
Argentina
Bahamas,
Suriname
Currency Libya,
board or Sudan,
fixed peg Zimbab
we
Crawling
peg or
horiz
band
Egypt
Europe/
Mid
East
Iran,
Kuwait,
Saudi
Arabia,
Syria
Americas
Denmark Bolivia,
Israel
Venezuel
a
Source: International Financial Statistics, April
2003 (as of Dec 2001)
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Recent exchange rate
arrangements
FX
regime
Africa
Asia/Pac Europe/ Americas
ific
Mid
East
Manage
d float
Algeria,
Ethiopi
a
Kenya,
Nigeria
India,
Indonesia
Singapor
e,
Thailand
Croatia,
Iraq,
Russian
Fed.,
Yugosla
via
Dom. Rep,
Guatemal
a,
Jamaica,
Trinidad
Indepen
dent
float
Mozam
bique,
S.
Africa,
Uganda
Afghanist
an,
Australia,
Japan, S.
Korea
Czech
Rep,
Norway
Poland,
Sweden
Turkey,
Switzerl
and, UK
Brazil,
Canada,
Chile,
Colombia
Mexico,
Peru,
United
States
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Major exchange rate agreements
1946
1971
1972
1976
1979
1985
1987
1991
1999
2002
Bretton Woods Conference
Smithsonian Agreement
European Joint Float Agreement
Jamaica Agreement
European Monetary System (EMS)
created
Plaza Accord
Louvre Accord
Treaty of Maastricht
Introduction of the euro
Euro begins public circulation
• History of the international monetary system
• 1946Bretton Woods Conference
 The U.S. dollar is convertible into gold at $35/ounce
 Other currencies are pegged to the dollar
 Created the IMF and the World Bank
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Fixed versus Flexible
Exchange Rates
•
Preference for Fixed Exchange Rates


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Price stability
Anti-inflationary
Large international reserves
Inconsistency with economic fundamentals
Attributes of the Ideal Currency
 Fixed value
 Convertibility
 Independent monetary policy
•
Emerging Markets and Regime Choices
 A currency board is a system for maintaining the value of
the local currency with respect to some other specified
currency.
 Dollarization refers to the replacement of a local currency
with U.S. dollars
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•
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Currency Board System
Argentina (1991)
Fixed Rate System
100% Reserve System
Monetary Policy and Money Supply
Dollar-Denominated Accounts (interest differential)
End of Argentine Currency Board (2002)
10
Currency Board System
• Characteristics
 No Central Bank
 No Discretionary Monetary Policy
• Advantages
 Promotes price stability
 Responsible fiscal policy
• Disadvantages
 Sharp contraction in money supply
 High interest rates
• Dollarization
 Use of U.S. dollar as the official currency
• Panama, Ecuador, Liberia
 Requires change in structure and responsibilities of
monetary policy authorities
 Arguments for:
• Removes currency volatility against dollar
• Expectations of greater economic integration
 Argument against:
• Loss of sovereignty over monetary policy
• Loss of power of seignorage
• Loss of role of lender of last resort
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The Birth of a European
Currency: The Euro
• European Monetary System
 Target Zone Arrangement
 Pegged Exchange Rate System
 Joint Float Agreement
• European Monetary Union
 Why Monetary Unification
 Launch of the Euro
 How to Achieve Monetary Unification
• Target Zone Arrangement
 Member countries maintain fixed exchange rates
within a flexible range, called target zone, among
themselves.
 Each member’s currency is pegged to all the other
members’ currencies.
 The group as a whole floats jointly against the rest
of the world.
• The EMS:
A Joint Float Agreement
 EMS members peg their currencies to each other.
 Exchange outside the EMS is subject to a managed
float.
 Objective: Exchange rate stability
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Maastricht Treaty
(December 1991)
•
Common European Currency - Euro
 Fixed rate system
 Replaces individual national currencies
•
European Central Bank (ECB)
 Issues common currency
 Conducts monetary policy
•
The Maastricht Treaty Criteria
 Inflation not to exceed that in three EU states with the lowest rate
by more than 1.5%.
 Long-term interest rates not to exceed that in three EU states with
the lowest inflation rates by more than 2%.
 The annual fiscal deficit not to exceed 3% of GDP.
 Cumulative public debt not to exceed 60% of GDP.
 A country must have maintained its membership in the EMS for
two years without having initiated a devaluation.
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Monetary Unification
 Why Monetary Unification?
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•
A single currency area called euro zone
Competing globally
 How to Achieve Monetary Unification
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•
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Fiscal policy
Monetary policy
Fixing the value of the euro
 Performance of The Euro
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Currency crises
•
Recent currency crises
 Mexican peso crisis of 1995
 Asian contagion of 1997
 Russian ruble crisis in 1998
 Argentinian peso crisis of 1998
•
Contributing factors in each crisis
 A fixed or pegged exchange rate system that
overvalued the local currency
 A large amount of foreign currency debt
• Transmission Mechanisms
 Trade Links
 Financial System
• Emerging Market Currency Crises
 Origins
• Moral Hazard
• Fundamental Policy Conflict
 Policy Proposals
• Currency Controls
• Free Float
• Fixed Exchange Rates
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The debate over IMF lending
• Proponents of IMF lending policies believe
 Short term loans help countries overcome
temporary crises
• Critics of IMF lending believe
 Belt-tightening is counterproductive
 Capital market liberalizations increase risks
 Loans are often spent supporting unsustainable
exchange rates
 IMF loans last for decades
 IMF remedies benefit developed countries
• IMF lending and moral hazard
• Moral hazard
 The existence of a contract can change the
behaviors of parties to the contract
• The IMF’s challenge
 develop policies that promote economic stability
 and ensure that the consequences of poor
investment decisions are borne by investors and
not taxpayers
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