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					    The International                              2
    Monetary System                          Chapter Two

Chapter Objective:
 This chapter serves to introduce the student to the
  institutional framework within which: (1) International
  payments are made, (2) The movement of capital is
  accommodated, (3) Exchange rates are determined.

Chapter Outline
 Evolution of the International Monetary System
 Current Exchange Rate Arrangements
 European Monetary System
 Euro and the European Monetary Union
 Fixed versus Flexible Exchange Rate Regimes

                                                            1
                Evolution of the
        International Monetary System

 Definition: IMS is institutional framework within which
  international payments are made, movements of capital are
  accommodated, and exchange rates among currencies are
  determined
   Bimetallism: Before 1875
   Classical Gold Standard: 1875-1914
   Interwar Period: 1915-1944
   Bretton Woods System: 1945-1972
   The Flexible Exchange Rate Regime: 1973-Present

                                                              2
       Evolution of the International
            Monetary System

Bimetallism (prior to 1875)
      Gold and Silver used as international means of payment
       and the exchange rate among currencies was determined
       by either their gold or silver content.

      Gresham’s law - exchange ratio between two metals
       was officially fixed, therefore only more abundant metal
       was used, driving the more scarce metal out of
       circulation


                                                                  3
          Evolution of the International
           Monetary System (contd.)
Classic Gold Standard (1876 - 1913)
   During this period in most major countries:
    1. gold alone is assured of unrestricted coinage
    2. two-way convertibility between gold and national currencies at a
       stable ratio
    3. gold is freely exported or imported
   The exchange rate between two country’s currencies would
    be determined by their relative gold contents
   Highly stable exchange rates under the classical gold
    standard provided an environment that was conducive to
    international trade and investment.
   Price-specie-flow mechanism corrected misalignment of
    exchange rates and international imbalances of payment
   Might lead to deflationary pressures
                                                                          4
        Evolution of the International
         Monetary System (contd.)

Interwar period (1915 – 1944)
 characterized by:
       Economic nationalism
       Attempts and failure to restore gold standard
       Economic and political instability
 These factors highlighted some of the shortcomings
  of the gold standard
   The result for international trade and investment was
    profoundly detrimental.
                                                            5
       Evolution of the International
        Monetary System (contd.)

Bretton Woods System (1944 – 1973)
 Creation of the International Monetary Fund (IMF) and the
  World Bank
 Under the Bretton Woods system, the U.S. dollar was
  pegged to gold at $35 per ounce and other currencies were
  pegged to the U.S. dollar.
 Each country was responsible for maintaining its exchange
  rate within ±1% of the adopted par value by buying or
  selling foreign reserves as necessary.
 US dollar based gold exchange standard
                                                              6
   Evolution of the International
    Monetary System (contd.)

 Bretton Woods System (1944 – 1973)
                      German
          British      mark               French
          pound                            franc
                         Par
                        Value

                     U.S. dollar

                                Pegged at $35/oz.
                       Gold
                                                    7
         Evolution of the International
          Monetary System (contd.)

Bretton Woods System (1944 – 1973)
 Problem with the system is that U.S. constantly incurred
  trade deficits as other countries wanted to maintain US$
  reserves (Triffin Paradox)
 Special Drawing Rights (SDR) – new reserve asset,
  (US$, FF, DM, BP, JY)
 Smithsonian Agreement (1971) – US$ devalued to
  $38/oz.
 European, Japanese currencies allowed to float–Mar 1973
                                                       8
       Evolution of the International
        Monetary System (contd.)

Flexible Exchange Rate Regime (1973–present)
 Jamaica Agreement (1976)
 Flexible exchange rates were declared acceptable to the IMF
  members.
      Central banks were allowed to intervene in the exchange rate
       markets to iron out unwarranted volatilities.
 Gold was abandoned as an international reserve asset.
 Non-oil-exporting countries and less-developed countries
  were given greater access to IMF funds.

                                                                      9
       Contemporary Currency Regimes

 Free Float
      The largest number of countries, about 36, allow market forces to
       determine their currency’s value.
 Managed Float
      About 50 countries combine government intervention with market
       forces to set exchange rates.
 Pegged to (or horizontal band around) another currency
      Such as the U.S. dollar or euro
 No national currency
      About 40 countries do not bother printing their own, they just use the
       U.S. dollar. For example, Ecuador, Panama, and El Salvador have
       dollarized.

                                                                           10
          Fixed vs. Flexible
        Exchange Rate Regimes
 Arguments in favor of flexible exchange rates:
      Easier external adjustments.
      National policy autonomy.
 Arguments against flexible exchange rates:
      Exchange rate uncertainty may hamper international trade.
      No safeguards to prevent crises.
 Currencies depreciate (or appreciate) to reflect the
  equilibrium value in flexible exchange rates
 Governments must adjust monetary or fiscal policies to return
  exchange rates to equilibrium value in fixed exchange rate
  regimes

                                                                   11
        Fixed versus Flexible
       Exchange Rate Regimes

 Suppose the exchange rate is $1.40/£ today.
 In the next slide, we see that demand for British
  pounds far exceed supply at this exchange rate.
 The U.S. experiences trade deficits.
 Under a flexible ER regime, the dollar will
  simply depreciate to $1.60/£, the price at which
  supply equals demand and the trade deficit
  disappears.

                                                      12
                       Fixed versus Flexible
                      Exchange Rate Regimes
 Dollar price per £




                                                     Supply
 (exchange rate)




                                                       (S)




                                                      Demand
$1.40                                                   (D)


                                 Trade deficit

                             S                   D      Q of £   13
                 Fixed versus Flexible
                 Exchange Rate Regimes
 Dollar price per £



                                                   Supply
 (exchange rate)



                                                     (S)




$1.60
                      Dollar depreciates            Demand
$1.40                 (flexible regime)               (D)

                                                 Demand (D*)


                                           D=S        Q of £   14
            Fixed versus Flexible
           Exchange Rate Regimes
 Instead, suppose the exchange rate is “fixed” at $1.40/£,
  and thus the imbalance between supply and demand
  cannot be eliminated by a price change.
 The US Federal Reserve Bank may initially draw on its
  foreign exchange reserve holdings to satisfy the excess
  demand for British pounds.
 If the excess demand persists the government would
  have to shift the demand curve from D to D*
      In this example this corresponds to contractionary monetary
       and fiscal policies.
                                                                 15
                       Fixed versus Flexible
                      Exchange Rate Regimes
 Dollar price per £



                      Contractionary
                                                  Supply
 (exchange rate)



                            policies                (S)
                      (fixed regime)




                                                   Demand
$1.40                                                (D)

                                                Demand (D*)


                                       D* = S        Q of £   16
        European Monetary System (EMS)

 EMS was created in 1979 by EEC countries to maintain
  exchange rates among their currencies within narrow bands,
  and jointly float against outside currencies.
 Objectives:
      Establish zone of monetary stability
      Coordinate exchange rate policies vis-à-vis non-EMS countries
      Develop plan for eventual European monetary union
 Exchange rate management instruments:
      European Currency Unit (ECU)
           Weighted average of participating currencies
           Accounting unit of the EMS
      Exchange Rate Mechanism (ERM)
           Procedures by which countries collectively manage exchange rates

                                                                               17
              What Is the Euro (€)?
 The euro is the single currency of the
  EMU which was adopted by 11                 Euro Conversion Rates
  Member States on 1 January 1999.         1 Euro is Equal to:
 These original member states were:       40.3399 BEF       Belgian franc
  Belgium, Germany, Spain, France,         1.95583 DEM       German mark
  Ireland, Italy, Luxemburg, Finland,      166.386 ESP       Spanish peseta
  Austria, Portugal and the Netherlands.   6.55957 FRF       French franc
 Prominent countries initially missing    .787564 IEP       Irish punt
  from Euro :                              1936.27 ITL       Italian lira
    Denmark, Greece, Sweden, UK           40.3399 LUF       Luxembourg
    Greece: did not meet convergence      2.20371 NLG       franc guilder
                                                             Dutch
      criteria, was approved for           13.7603 ATS       Austrian
      inclusion on June 19, 2000           200.482 PTE       schilling
                                                             Portuguese
      (effective Jan. 2001)                5.94573 FIM       escudo markka
                                                             Finnish
                                                                          18
         Benefits and Costs of the
            Monetary Union
 Transaction costs reduced    Loss of national monetary
  and FX risk eliminated        and exchange rate policy
 Creates a Eurozone – goods,   independence
  people and capital can move  Country-specific asymmetric
  without restriction           shocks can lead to extended
 Compete with the U.S.         recessions
      Approximately equal in terms
       of population and GDP
 Price transparency and
  competition


                                                        19
      The Long-Term Impact
           of the Euro
 If the euro proves successful, it will advance the
  political integration of Europe in a major way,
  eventually making a “United States of Europe”
  feasible.
 It is likely that the U.S. dollar will lose its place as
  the dominant world currency.
 The euro and the U.S. dollar will be the two major
  currencies.

                                                             20

				
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