009_The International Monetary System

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        What Is The International
                                                                                  What Was The Gold Standard?
          Monetary System?
• The international monetary system refers to the institutional                  • The gold standard refers to a system in which
  arrangements that countries adopt to govern exchange rates                       countries peg currencies to gold and guarantee their
• A floating exchange rate system exists when a country allows                     convertibility
  the foreign exchange market to determine the relative value                       – the gold standard dates back to ancient times when gold
  of a currency                                                                       coins were a medium of exchange, unit of account, and
   – a dirty float exists when a country tries to hold the value of its               store of value
     currency within some range of a reference currency
                                                                                       • payment for imports was made in gold or silver
• A fixed exchange rate system exists when countries fix their
  currencies against each other                                                     – later, payment was made in paper currency which was
   – European Monetary System (EMS)                                                   linked to gold at a fixed rate
• A pegged exchange rate system exists when a country fixes                         – in the 1880s, most nations followed the gold standard
  the value of its currency relative to a reference currency                           • $1 = 23.22 grains of “fine” (pure) gold
                                                                                    – the gold par value refers to the amount of a currency
                                                                                      needed to purchase one ounce of gold

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             Why Did The                                                                      What Was The
      Gold Standard Make Sense?                                                           Bretton Woods System?
• The great strength of the gold standard was that it contained                  • In 1944, representatives from 44 countries met at
  a powerful mechanism for achieving balance-of-trade                              Bretton Woods, New Hampshire, to design a new
  equilibrium - when the income a country’s residents earn                         international monetary system that would facilitate
  from its exports is equal to the money its residents pay for                     postwar economic growth
  imports                                                                        • Under the new agreement
• The gold standard worked well from the 1870s until 1914                           – a fixed exchange rate system was established
   – but, many governments financed their World War I expenditures by
     printing money and so, created inflation
                                                                                    – all currencies were fixed to gold, but only the U.S. dollar
                                                                                      was directly convertible to gold
• People lost confidence in the system                                              – devaluations could not to be used for competitive
   – demanded gold for their currency putting pressure on countries' gold             purposes
     reserves, and forcing them to suspend gold convertibility
                                                                                    – a country could not devalue its currency by more than 10%
• By 1939, the gold standard was dead                                                 without IMF approval

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         What Institutions Were                                                          What Institutions Were
     Established At Bretton Woods?                                                   Established At Bretton Woods?
•        The Bretton Woods agreement also established two                         2. The World Bank to promote general economic
         multinational institutions                                                  development - also called the International Bank
1.       The International Monetary Fund (IMF) to maintain order                     for Reconstruction and Development (IBRD)
         in the international monetary system through a                              – Countries can borrow from the World Bank in two ways
         combination of discipline and flexibility                                   1. under the IBRD scheme, money is raised through bond
     –     requiring fixed exchange rates stopped competitive devaluations              sales in the international capital market
           and brought stability to the world trade environment                         •   borrowers pay a market rate of interest - the bank's cost of
     –     fixed exchange rates imposed monetary discipline on countries,                   funds plus a margin for expenses.
           limiting price inflation                                                  2. through the International Development Agency, an arm
     –     in cases of fundamental disequilibrium, devaluations were                    of the bank created in 1960
           permitted                                                                    •   IDA loans go only to the poorest countries
     –     the IMF lent foreign currencies to members during short periods of
           balance-of-payments deficit, when a rapid tightening of monetary
           or fiscal policy would hurt domestic employment

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Why Did The Fixed Exchange Rate                                                                  What Was The
       System Collapse?                                                                       Jamaica Agreement?
• Bretton Woods worked well until the late 1960s                                  • A new exchange rate system was established in 1976
• It collapsed when huge increases in welfare programs and the                      at a meeting in Jamaica
  Vietnam War were financed by increasing the money supply
  and causing significant inflation                                               • The rules that were agreed on then, are still in place
• Other countries increased the value of their currencies                           today
  relative to the U.S. dollar in response to speculation the dollar
  would be devalued
                                                                                  • Under the Jamaican agreement
• However, because the system relied on an economically well                         – floating rates were declared acceptable
  managed U.S., when the U.S. began to print money, run high                         – gold was abandoned as a reserve asset
  trade deficits, and experience high inflation, the system was                      – total annual IMF quotas - the amount member countries
  strained to the breaking point – the U.S. dollar came under                          contribute to the IMF - were increased to $41 billion –
  speculative attack
                                                                                       today they are about $300 billion

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 What Has Happened To Exchange                                      What Has Happened To Exchange
       Rates Since 1973?                                                  Rates Since 1973?
• Since 1973, exchange rates have been more                                        Major Currencies Dollar Index, 1973-2008

  volatile and less predictable than they were
  between 1945 and 1973 because of
  – the 1971 oil crisis
  – the loss of confidence in the dollar after U.S.
    inflation in 1977-78
  – the 1979 oil crisis
  – the rise in the dollar between 1980 and 1985
  – the partial collapse of the European Monetary
    System in 1992
  – the 1997 Asian currency crisis
                                                             10-9                                                             10-10

 Which Is Better – Fixed Rates Or                                    Which Is Better – Fixed Rates Or
         Floating Rates?                                                     Floating Rates?
• Floating exchange rates provide                                   • But, a fixed exchange rate system
1. Monetary policy autonomy                                         1. Provides monetary discipline
  –   removing the obligation to maintain exchange rate parity        – ensures that governments do not expand their
      restores monetary control to a government                         money supplies at inflationary rates
2. Automatic trade balance adjustments                              2. Minimizes speculation
  –   under Bretton Woods, if a country developed a                   – causes uncertainty
      permanent deficit in its balance of trade that could not
      be corrected by domestic policy, the IMF would have to        3. Reduces uncertainty
      agree to a currency devaluation                                 – promotes growth of international trade and

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                                                                      What Type of Exchange Rate
               Who Is Right?
                                                                      System Is In Practice Today?
• There is no real agreement as to which system is                  • Various exchange rate regimes are followed
  better                                                              today
• A fixed exchange rate regime modeled along the lines                – 14% of IMF members follow a free float policy
  of the Bretton Woods system will not work                           – 26% of IMF members follow a managed float
• But a different kind of fixed exchange rate system                    system
  might be more enduring and might foster the kind of                 – 28% of IMF members have no legal tender of their
  stability that would facilitate more rapid growth in                  own
  international trade and investment                                  – the remaining countries use less flexible systems
                                                                        such as pegged arrangements, or adjustable pegs

                                                            10-13                                                      10-14

  What Type of Exchange Rate
                                                                    What Is A Pegged Rate System?
  System Is In Practice Today?
                                                                    • A country following a pegged exchange rate
                Exchange Rate Policies, IMF Members, 2006

                                                                      system, pegs the value of its currency to that
                                                                      of another major currency
                                                                      – popular among the world’s smaller nations
                                                                      – adopting a pegged exchange rate regime can
                                                                        moderate inflationary pressures in a country

                                                            10-15                                                      10-16


                                                                                What Is The Role
   What Is A Currency Board?
                                                                                Of The IMF Today?
• Countries using a currency board commit to                  • Today, the IMF focuses on lending money to countries in
                                                                financial crisis
  converting their domestic currency on                           – A currency crisis occurs when a speculative attack on the exchange
  demand into another currency at a fixed                           value of a currency results in a sharp depreciation in the value of the
                                                                    currency, or forces authorities to expend large volumes of
  exchange rate                                                     international currency reserves and sharply increase interest rates in
  – the currency board holds reserves of foreign                    order to defend prevailing exchange rates
                                                                  – A banking crisis refers to a situation in which a loss of confidence in
    currency equal at the fixed exchange rate to at                 the banking system leads to a run on the banks, as individuals and
    least 100% of the domestic currency issued                      companies withdraw their deposits
                                                                  – A foreign debt crisis is a situation in which a country cannot service its
  – the currency board can issue additional domestic                foreign debt obligations, whether private sector or government debt
    notes and coins only when there are foreign
    exchange reserves to back them

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 What Was The Mexican Currency                                                 What Was The
        Crisis Of 1995?                                                    Asian Currency Crisis?
• The Mexican currency crisis of 1995 was a                   •    The 1997 Southeast Asian financial crisis was
  result of                                                        caused by events that took place in the previous
  – high Mexican debts                                             decade including
  – a pegged exchange rate that did not allow for a               1. An investment boom - fueled by huge increases in
    natural adjustment of prices                                     exports
                                                                  2. Excess capacity - investments were based on projections
• To keep Mexico from defaulting on its debt,                        of future demand conditions
  the IMF created a $50 billion aid package                       3. High debt - investments were supported by dollar-based
  – required tight monetary policy and cuts in public                debts
    spending                                                      4. Expanding imports – caused current account deficits

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                What Was The                                                                     What Was The
            Asian Currency Crisis?                                                           Asian Currency Crisis?
• By mid-1997, several key Thai financial institutions                        • Speculation caused other Asian currencies including the
                                                                                Malaysian Ringgit, the Indonesian Rupaih and the Singapore
  were on the verge of default                                                  Dollar to fall
   – speculation against the baht                                             • These devaluations were mainly driven by
• Thailand abandoned the baht peg and allowed the                                  – excess investment, high borrowings, much of it in dollar denominated
                                                                                     debt, and a deteriorating balance of payments position
  currency to float
                                                                              • The IMF provided a $37 billion aid package for Indonesia
• The IMF provided a $17 billion bailout loan package                              – required public spending cuts, closure of troubled banks, a balanced
                                                                                     budget, and an end to crony capitalism
   – required higher taxes, public spending cuts, privatization of
     state-owned businesses, and higher interest rates                        • The IMF provided a $55 billion aid package to South Korea
                                                                                   – required a more open banking system and economy, and restraint by

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                                                                                  What Does The Monetary System
       How Has The IMF Done?
                                                                                       Mean For Managers?
• By 2008, the IMF was committing loans to 65 countries in                    •        Managers need to understand how the international
  economic and currency crisis                                                         monetary system affects
• All IMF loan packages require a combination of tight                        1.       Currency management - the current system is a managed
  macroeconomic policy and tight monetary policy                                       float - government intervention can influence exchange
• However, critics worry                                                           –     speculation can also create volatile movements in exchange rates
   – the “one-size-fits-all” approach to macroeconomic policy is              2.       Business strategy - exchange rate movements can have a
     inappropriate for many countries                                                  major impact on the competitive position of businesses
   – the IMF is exacerbating moral hazard - when people behave recklessly          –     need strategic flexibility
     because they know they will be saved if things go wrong
                                                                              3.       Corporate-government relations - businesses can influence
   – the IMF has become too powerful for an institution without any real               government policy towards the international monetary
     mechanism for accountability
• But, as with many debates about international economics, it                      –     companies should promote a system that facilitates international
  is not clear who is right                                                              growth and development

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