International Monetary System
Organization of Lecture
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ALTERNATIVE EXCHANGE RATE SYSTEMS
A BRIEF HISTORY OF THE INTERNATIONAL
MONETARY SYSTEM
THE EUROPEAN MONETARY SYSTEM
Costs and benefits of a single currency
Alternative Exchange Rate Systems
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Overview : If people who don’t ordinarily use the
same currency are going to trade, there must be some
way of exchanging currency. (If you want a Porsche,
you’ve got to get German marks, or now the euro).
There are an enormous number of exchange rate
systems, but generally they can be sorted into one of
these categories
– Freely Floating
– Managed Float
– Target Zone
– Fixed Rate
– Hybrid
Under a floating rate system, exchange rates are
set by demand and supply.
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The model of demand and supply is extremely
useful in explaining exchange rates under a
floating system (just make sure you keep track
of what currency is purchased and what is
sold).
Any number of factors might influence exchange
rates, including
– price levels
– interest rates
– economic growth
Important Note:
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Even though we may call it “free float” in fact the
government can still control the exchange rate by
manipulating the factors that affect the exchange rate
(i.e., monetary policy)
Alternate exchange rate systems: Managed Float
(“Dirty Float”)
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Market forces set rates unless excess volatility occurs, then,
central bank determines rate by buying or selling currency.
Managed float isn’t really a single system, but describes a
continuum of systems
– Smoothing daily fluctuations
– “Leaning against the wind” slowing the change to a different
rate
– Unofficial pegging: actually fixing the rate without
saying so.
– Target-Zone Arrangement: countries agree to maintain
exchange rates within a certain bound What makes target
zone arrangements special is the understanding that
countries will adjust real economic policies to maintain the
zone.
Alternate exchange rate systems: Fixed Rate System
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One way to do this is to dictate an exchange rate and
shoot people who try to trade currency at anything
other than the official exchange rate. Price controls
are hard to enforce (and even if they could be
enforced lead to a misallocation of resources).
An alternative is to simply instruct the monetary
authority to buy stand willing to buy or sell currency
at the desired rate.
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A fixed rate system is the ultimate good news bad news joke.
The good is very good and the bad is very bad.
– Advantage: stability and predictability
– Disadvantage: the country loses control of monetary policy
(note that monetary policy can always be used to control an
exchange rate).
At some point a fixed rate may become unsupportable
and one country may devalue. (Argentina is the most
dramatic recent example.) As an alternative to
devaluation, the country may impose currency controls.
Final note
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Not every exchange relationship has to be the same
A Brief History of the International Monetary
System
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Overview
– Pre 1875 Bimetalism
– 1875-1914: Classical Gold Standard
– 1915-1944: Interwar Period
– 1945-1972: Bretton Woods System
– 1973-Present: Flexible (Hybrid) System
The Intrinsic Value of Money
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At present the money of most countries has no intrinsic value (if
you melt a quarter, you don’t get $.25 worth of metal). But
historically many countries have backed their currency with
valuable commodities (usually gold or silver)—if the U.S.
treasury were to mint gold coins that had 1/35th ounces of gold
and sold these for $1.00, then a dollar bill would have an
intrinsic value.
When a country’s currency has some intrinsic value, then the
exchange rate between the two countries is fixed. For example,
if the U.S. mints $1.00 coins that contain 1/35th ounces of gold
and Great Britain mints £1.00 coins that contain 4/35th ounces
of gold, then it must be the case that £1 = $4 (if not, people could
make an unlimited profit buying gold in one country and selling
it in another)
At various times some countries have minted coins in
both gold and silver (referred to as bimetallism) The
U.S., for example, has circulated gold and silver coins
at the same time.
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In principle such a system can function effectively in an environment
where different countries back their currency with different metal. For
example, during part of the 19th Century, Great Britain was on a gold
standard, Germany was on a silver standard, and France minted both
gold and silver coins. The franc/pound exchange rate was set by the
relative gold values of the currencies while the franc/mark rate was set
by the relative silver values of the currency. (Think about how such a
system implicitly sets the pound/mark rate.)
Gresham’s Law, however, creates a potential problem. People will tend
to horde the currency that is relatively valuable and spend the currency
that has less value. Following discoveries of gold in the U.S and
Australia in the mid 19th Century, the intrinsic value of gold fell
relative to the value of silver. The French people, quite sensibly, held on
to their silver coins (or melted them down) and spent their gold.
The Classical Gold Standard (1875-1914)
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The Classical Gold Standard had two essential
features
– Nations fixed the value of the currency in terms of
– Gold is freely transferable between countries
Essentially a fixed rate system (Suppose the US
announces a willingness to buy gold for $200/oz
and Great Britain announces a willingness to
buy gold for £100. Then £1=$2)
Advantage of Gold System
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Disturbances in Price Levels Would be offset by the
price-specie-flow mechanism. When a balance of
payments surplus led to a gold inflow Gold inflow
(country with surplus) led to higher prices which
reduced surplus Gold outflow led to lower prices and
increased surplus
Interwar Period
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Periods of serious chaos such as German
hyperinflation and the use of exchange rates as a way
to gain trade advantage.
Britain and US adopt a kind of gold standard
(but tried to prevent the species adjustment
mechanism from working).
Bretton Woods System:
1945-1972
British
pound
German
mark
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
The Bretton Woods System (1946-1971)
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U.S.$ was key currency valued at $1 = 1/35 oz. of gold
All currencies linked to that price in a fixed rate
system.
In effect, rather than hold gold as a reserve
asset, other countries hold US dollars (which
are backed by gold)
Real GDP in German During B-W Period
Collapse of Bretton Woods (1971)
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U.S. high inflation rate
U.S.$ depreciated sharply.
Smithsonian Agreement (1971) US$ devalued to 1/38
oz. of gold.
1973 The US dollar is under heavy pressure,
European and Japanese currencies are allowed to
float
1976 Jamaica Agreement
– Flexible exchange rates declared acceptable
– Gold abandoned as an international reserve
Current Exchange Rate Arrangements (IMF
Classification
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No national currency (e.g., dollars in Panama and Euros
in Italy)
Currency Board: Explicit commitment to fix exchange
rates to some foreign currency (Hong Kong fixed to
dollar)
Other fixed rate systems fixing the countries currency to
a single currency or some basket of currencies (allowing
some narrow fluctuations of less than 1%)
Current Exchange Rate Arrangements (IMF
Classification
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Crawling pegs: exchange rate adjusted at a
preannounced rate, usually in response to some objective
qualitative indicator (e.g., Costa Rica).
Floating within crawling bands
Managed float: authorities manipulate the exchange rate
but do not announce their intentions
Independent float.
The Mexican Peso Crisis
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On 20 December, 1994, the Mexican government
announced a plan to devalue the peso against the dollar
by 14 percent.
This decision changed currency trader’s expectations
about the future value of the peso.
They stampeded for the exits.
In their rush to get out the peso fell by as much as 40
percent.
The Mexican Peso Crisis
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The Mexican Peso crisis is unique in that it represents
the first serious international financial crisis touched off
by cross-border flight of portfolio capital.
Two lessons emerge:
– It is essential to have a multinational safety net in
place to safeguard the world financial system from
such crises.
– An influx of foreign capital can lead to an
overvaluation in the first place.
The Asian Currency Crisis (1997)
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In 1996 several Asian countries experienced an inflow
of nearly $100 billion in foreign capital.
This explosion of credit led to a kind of speculative
bubble in some sectors (e.g., real estate).
In mid-1997 the Thai bhat came under much pressure.
The Thai Central Bank tried to defend the bhat by
drawing down foreign exchange reserves. In the end,
however, they had to devalue and the bhat lost about
40% of its
The Asian Currency Crisis
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The Asian currency crisis turned out to be far more
serious than the Mexican peso crisis in terms of the
extent of the contagion and the severity of the resultant
economic and social costs.
Many firms with foreign currency bonds were forced
into bankruptcy.
The region experienced a deep, widespread recession.
The Argentinean Peso Crisis
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In 1991 the Argentine government passed a convertibility
law that linked the peso to the U.S. dollar at parity.
The initial economic effects were positive:
– Argentina’s chronic inflation was curtailed
– Foreign investment poured in
As the U.S. dollar appreciated on the world market the
Argentine peso became stronger as well.
The Argentinean Peso Crisis
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The strong peso hurt exports from Argentina and caused
a protracted economic downturn that led to the
abandonment of peso–dollar parity in January 2002.
– The unemployment rate rose above 20 percent
– The inflation rate reached a monthly rate of 20 percent
The Argentinean Peso Crisis
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There are at least three factors that are related to the
collapse of the currency board arrangement and the
ensuing economic crisis:
– Lack of fiscal discipline
– Labor market inflexibility
– Contagion from the financial crises in Brazil and
Russia
Currency Crisis Explanations
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In theory, a currency’s value mirrors the fundamental strength of its
underlying economy, relative to other economies. In the long run.
In the short run, currency trader’s expectations play a much more
important role.
In today’s environment, traders and lenders, using the most modern
communications, act by fight-or-flight instincts. For example, if
they expect others are about to sell Brazilian reals for U.S. dollars,
they want to “get to the exits first”.
Thus, fears of depreciation become self-fulfilling prophecies.
The European Experience
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THE EUROPEAN MONETARY SYSTEM (1979) established to provide
exchange rate stability to all members by holding exchange rates within
specified limits by establishing a kind of target-zone method
– Close macroeconomic policy coordination required.
– Currency Crisis of Sept. 1992: System brakes down. Britain and
Italy forced to withdraw from EMS and finally collapses in 1993.
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Maastricht Treaty
– Called for Monetary Union by 1999 (moved to 2002)
– Established a single currency (the euro)
– Called for creation of a single central EU bank (ECB)
– Adopts tough fiscal standards for entering countries For example,
countries could not carry a total debt of more than 60% of GDP,
and inflation rates had to be no more than 1.5% than the average
inflation of the three lowest inflation nations.
Benefits of a single currency
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Reduces exchange rate risk
Allows for larger capital markets which may provide
greater liquidity
May promote a sense of political unity among nations
sharing the currency.
Costs of a Single Currency
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Lack of national monetary flexibility.
Leaving countries vulnerable to “asymmetric shocks”
(problems in one country not common to all)