CHAPTER 3
THE INTERNATIONAL
MONETARY SYSTEM
CHAPTER OVERVIEW
I.
ALTERNATIVE EXCHANGE
RATE SYSTEMS
II. A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY
SYTEM
III. THE EUROPEAN MONETARY
SYSTEM
PART I. ALTERNATIVE
EXCHANGE RATE SYSTEMS
I.
FIVE MARKET MECHANISMS
A. Freely Floating
(“Clean Float”)
1. Market forces of
supply and demand
determine rates.
ALTERNATIVE EXCHANGE
RATE SYSTEMS
2.
3.
Forces influenced by
a.
price levels
b.
c.
interest rates
economic growth
Rates fluctuate randomly
over time.
ALTERNATIVE EXCHANGE
RATE SYSTEMS
B. Managed Float
(“Dirty Float”)
1.
Market forces set rates
unless excess volatility
occurs.
2.
Then, central bank
determines rate.
ALTERNATIVE EXCHANGE
RATE SYSTEMS
C. Target-Zone Arrangement
1. Rate Determination
a. Market forces
constrained
to upper and lower
range of rates.
b. Members to the
arrangement adjust
their national
economic policies to
maintain target.
ALTERNATIVE EXCHANGE
RATE SYSTEMS: Fixed Rate
D. Fixed Rate System
1. Rate determination
a. Government
maintains target
rates.
b. If rates threatened,
central banks
buy/sell currency.
c. Monetary policies
coordinated.
ALTERNATIVE EXCHANGE
RATE SYSTEMS
E.
Current System
1. A hybrid system
a. Major currencies:
use freely-floating
method
b. Others move in and
out of various fixedrate systems.
PART II. A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
I. THE USE OF GOLD
A. Desirable properties
B. In short run: High
production costs limit shortrun changes.
C. In long run: Commodity
money insures stability.
A BRIEF HISTORY
II.
The Classical Gold Standard
(1821-1914)
A. Major currencies on gold
standard.
1. Nations fix the
exchange rate in
terms of a specific
amount of gold.
A BRIEF HISTORY
2.
Maintenance involved the
buying and selling of
gold at that price.
3. Disturbances in Price
Levels:
Would be offset by the
price-specie*-flow
mechanism.
* specie refers to gold coins
A BRIEF HISTORY
a. Price-specie-flow mechanism
adjustments were automatic:
1.) When a balance of
payments surplus led to
a gold inflow;
2.) Gold inflow led to higher
prices which reduced
surplus;
A BRIEF HISTORY
3.) Gold outflow led to lower
prices and increased surplus.
A BRIEF HISTORY
III. The Gold Exchange Standard
(1925-1931)
A. Only U.S. and Britain
allowed to hold gold
reserves.
B. Others could hold both
gold, dollars or pound
reserves.
A BRIEF HISTORY
C. Currencies devalued in
1931
- led to trade wars.
A BRIEF HISTORY
D. Bretton Woods
Conference
- called in order to avoid
future protectionist and
destructive economic
policies
A BRIEF HISTORY
V.
The Bretton Woods System
(1946-1971)
1. U.S.$ was key currency;
valued at $1 - 1/35 oz. of
gold.
2. All currencies linked to
that price in a fixed rate
system.
A BRIEF HISTORY
3.
Exchange rates allowed
to fluctuate by 1% above
or below intially set rates.
B. Collapse, 1971
1. Causes:
a. U.S. high inflation
rate
b. U.S.$ depreciated
sharply.
A BRIEF HISTORY
V.
Post-Bretton Woods System
(1971-Present)
A. Smithsonian Agreement,
1971:
US$ devalued to 1/38 oz.
of gold.
By 1973: World on a
freely floating exchange
rate system.
A BRIEF HISTORY
B. OPEC and the Oil Crisis
(1973-774)
1. OPEC raised oil prices
four fold;
2. Exchange rate turmoil
resulted;
3. Caused OPEC nations to
earn large surplus
B-O-P.
A BRIEF HISTORY
4. Surpluses recycled to debtor
nations which set up debt
crisis of 1980’s.
C. Dollar Crisis (1977-78)
1. U.S. B-O-P difficulties
2. Result of inconsistent
monetary policy in U.S.
A BRIEF HISTORY
3.
Dollar value falls as
confidence shrinks.
D. The Rising Dollar (1980-85)
1. U.S. inflation subsides as
the Fed raises interest
rates
2. Rising rates attracts
global capital to U.S.
A BRIEF HISTORY
3. Result: Dollar value
rises.
E. The Sinking Dollar:(1985-87)
1. Dollar revaluated slowly
downward;
2. Plaza Agreement (1985)
G-5 agree to depress US$
further.
A BRIEF HISTORY
3.
Louvre Agreement (1987)
G-7 agree to support the
falling US$.
F. Recent History (1988-Present)
1. 1988 US$ stabilized
2. Post-1991 Confidence
resulted in stronger
dollar
3. 1993-1995 Dollar value
falls
PART III.
THE EUROPEAN MONETARY SYSTEM
I. INTRODUCTION
A. The European Monetary
System (EMS)
1. A target-zone method
(1979)
2. Close macroeconomic
policy coordination
required.
THE EUROPEAN MONETARY
SYSTEM
B. EMS Objective:
to provide exchange rate
stability to all members by
holding exchange rates
within specified limits.
THE EUROPEAN MONETARY
SYSTEM
C. European Currency Unit
(ECU)
a “cocktail” of European currencies
with specified weights as the unit of
account.
THE EUROPEAN MONETARY
SYSTEM
1. Exchange rate mechanism
(ERM)
- each member determines
mutually agreed upon
central
cross rate for its currency.
THE EUROPEAN MONETARY
SYSTEM
2.
Member Pledge:
to keep within 15%
margin above or below
the central rate.
THE EUROPEAN MONETARY
SYSTEM
D. EMS ups and downs
1. Foreign exchange
interventions:
failed due to lack of
support by coordinated
monetary policies.
THE EUROPEAN MONETARY
SYSTEM
2. Currency Crisis of Sept. 1992
a. System broke down
b. Britain and Italy
forced towithdraw
from EMS.
THE EUROPEAN MONETARY
SYSTEM
G. Failure of the EMS:
members allowed political
priorities to dominate
exchange rate policies.
THE EUROPEAN MONETARY
SYSTEM
H. Maastricht Treaty
1. Called for Monetary
Union by 1999 (moved to
2002)
2. Established a single
currency:
the euro
THE EUROPEAN MONETARY
SYSTEM
3.
Calls for creation of a single
central EU bank
4.
Adopts tough fiscal
standards
THE EUROPEAN MONETARY
SYSTEM
I. Costs / Benefits of A Single
Currency
A. Benefits
1. Reduces cost of doing
business
2. Reduces exchange rate
risk
THE EUROPEAN MONETARY
SYSTEM
B. Costs
1. Lack of national
monetary flexibility.