chapter 3 the international monetary system. chapter overview i. alternative exchange rate systems...

CHAPTER 3CHAPTER 3

THE INTERNATIONAL THE INTERNATIONAL MONETARY SYSTEMMONETARY SYSTEM

CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. ALTERNATIVE EXCHANGE ALTERNATIVE EXCHANGE RATE SYSTEMSRATE SYSTEMS

II.II. A BRIEF HISTORY OF THE A BRIEF HISTORY OF THE

INTERNATIONAL INTERNATIONAL MONETARY MONETARY SYTEMSYTEM

III.III. THE EUROPEAN THE EUROPEAN MONETARY MONETARY SYSTEMSYSTEM

PART I. ALTERNATIVE PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS EXCHANGE RATE SYSTEMS

I.I. FIVE MARKET FIVE MARKET MECHANISMSMECHANISMS

A.A. Freely Floating Freely Floating (“Clean Float”) (“Clean Float”)

1.1. Market forces of Market forces of supply and supply and

demand demand determine rates.determine rates.

ALTERNATIVE EXCHANGE ALTERNATIVE EXCHANGE RATE SYSTEMSRATE SYSTEMS

2.2. Forces influenced byForces influenced by

a. a. price levelsprice levels

b.b. interest ratesinterest rates

c.c. economic growtheconomic growth

3.3. Rates fluctuate randomly Rates fluctuate randomly

over time.over time.


B.B. Managed Float Managed Float (“Dirty (“Dirty Float”)Float”)

1.1. Market forces set rates Market forces set rates

unless excess volatility unless excess volatility

occurs.occurs.

2.2. Then, central bank Then, central bank

determines rate. determines rate.


C.C. Target-Zone ArrangementTarget-Zone Arrangement1.1. Rate DeterminationRate Determination

a.a. Market forces Market forces constrainedconstrained

to upper and lower to upper and lower range of rates.range of rates.b.b. Members to the Members to the arrangement adjustarrangement adjust

their national their national economic policies to economic policies to

maintain target.maintain target.

ALTERNATIVE EXCHANGE ALTERNATIVE EXCHANGE RATE SYSTEMS: Fixed RateRATE SYSTEMS: Fixed Rate

D.D. Fixed Rate SystemFixed Rate System

1.1. Rate determinationRate determinationa.a. Government Government maintains target maintains target rates.rates.

b.b. If rates threatened, If rates threatened, central banks central banks buy/sell buy/sell

currency.currency.

c.c. Monetary policies Monetary policies coordinated.coordinated.


E.E. Current SystemCurrent System

1.1. A hybrid systemA hybrid systema.a. Major currencies:Major currencies:

useuse freely-floating freely-floating methodmethod

b.b. Others move in and Others move in and outout of various fixed-of various fixed-rate systems.rate systems.

PART II. A BRIEF HISTORY OF THE PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEMINTERNATIONAL MONETARY SYSTEM

I.I. THE USE OF GOLDTHE USE OF GOLD

A.A. Desirable propertiesDesirable properties

B.B. In short run: High In short run: High production costs limit short-production costs limit short- run run changes.changes.

C.C. In long run: Commodity In long run: Commodity money insures stability.money insures stability.

A BRIEF HISTORYA BRIEF HISTORY

II.II. The Classical Gold Standard The Classical Gold Standard (1821-1914)(1821-1914)A.A. Major currencies on gold Major currencies on gold

standard.standard.

1.1. Nations fix the Nations fix the exchange rate in exchange rate in terms of a specific terms of a specific amount of gold.amount of gold.


2.2. Maintenance involved the Maintenance involved the

buying and selling of buying and selling of gold at that price.gold at that price.

3.3. Disturbances in Price Disturbances in Price Levels:Levels:

Would be offset by the Would be offset by the price-specie*-flow price-specie*-flow

mechanism.mechanism.

* specie refers to gold coins* specie refers to gold coins


a.a. Price-specie-flow mechanismPrice-specie-flow mechanismadjustments were automatic:adjustments were automatic:

1.)1.) When a balance of When a balance of payments surplus led to payments surplus led to

a gold inflow;a gold inflow;2.)2.) Gold inflow led to higher Gold inflow led to higher

prices which reduced prices which reduced surplus;surplus;


3.)3.) Gold outflow led to lower Gold outflow led to lower prices and increased prices and increased

surplus.surplus.


III.III. The Gold Exchange Standard The Gold Exchange Standard (1925-1931)(1925-1931)

A.A. Only U.S. and Britain Only U.S. and Britain allowedallowed to hold gold to hold gold reserves.reserves.

B.B. Others could hold both Others could hold both gold, dollars or pound gold, dollars or pound reserves.reserves.


C.C. Currencies devalued in Currencies devalued in 19311931

- led to trade wars.- led to trade wars.


D.D. Bretton Woods Bretton Woods ConferenceConference

- called in order to avoid - called in order to avoid

future protectionist and future protectionist and

destructive economic destructive economic policies policies


V.V. The Bretton Woods SystemThe Bretton Woods System

(1946-1971)(1946-1971)

1.1. U.S.$ was key currency;U.S.$ was key currency;

valued at $1 - 1/35 oz. of valued at $1 - 1/35 oz. of gold.gold.

2.2. All currencies linked to All currencies linked to that price in a fixed rate that price in a fixed rate system.system.


3.3. Exchange rates allowed Exchange rates allowed to to fluctuate by 1% above fluctuate by 1% above or below or below intially set rates.intially set rates.

B.B. Collapse, 1971Collapse, 1971

1.1. Causes:Causes:a.a. U.S. high inflation U.S. high inflation raterate

b.b. U.S.$ depreciated U.S.$ depreciated sharply.sharply.


V.V. Post-Bretton Woods SystemPost-Bretton Woods System

(1971-Present)(1971-Present)

A.A. Smithsonian Agreement, Smithsonian Agreement, 1971:1971:

US$ devalued to 1/38 oz. US$ devalued to 1/38 oz. of of gold.gold.

By 1973: World on a By 1973: World on a freely floating freely floating exchange exchange rate system.rate system.


B.B. OPEC and the Oil Crisis (1973-774)OPEC and the Oil Crisis (1973-774)

1. OPEC raised oil prices 1. OPEC raised oil prices four fold;four fold;

2. Exchange rate turmoil 2. Exchange rate turmoil resulted;resulted;

3. Caused OPEC nations to 3. Caused OPEC nations to earn large surplus earn large surplus

B-O-P.B-O-P.


4. Surpluses recycled to debtor 4. Surpluses recycled to debtor nations which set up debt nations which set up debt crisis of 1980’s.crisis of 1980’s.

C.C. Dollar Crisis (1977-78)Dollar Crisis (1977-78)

1.1. U.S. B-O-P difficultiesU.S. B-O-P difficulties

2.2. Result of inconsistent Result of inconsistent monetary policy in U.S.monetary policy in U.S.


3.3. Dollar value falls as Dollar value falls as confidence shrinks.confidence shrinks.

D.D. The Rising Dollar (1980-85)The Rising Dollar (1980-85)

1.1. U.S. inflation subsides as U.S. inflation subsides as thethe Fed raises interest Fed raises interest

ratesrates

2.2. Rising rates attracts Rising rates attracts global capital to U.S.global capital to U.S.


3.3. Result: Dollar value Result: Dollar value rises.rises.

E.E. The Sinking Dollar:(1985-87)The Sinking Dollar:(1985-87)

1.1. Dollar revaluated slowly Dollar revaluated slowly downward;downward;

2.2. Plaza Agreement (1985)Plaza Agreement (1985)

G-5 agree to depress US$G-5 agree to depress US$

further.further.


3.3. Louvre Agreement (1987)Louvre Agreement (1987)G-7 agree to support the G-7 agree to support the falling US$.falling US$.

F.F. Recent History (1988-Present)Recent History (1988-Present)1.1. 1988 US$ stabilized1988 US$ stabilized2.2. Post-1991 Confidence Post-1991 Confidence

resulted in stronger resulted in stronger dollardollar

3.3. 1993-1995 Dollar value 1993-1995 Dollar value fallsfalls

PART III.PART III.THE EUROPEAN MONETARY SYSTEMTHE EUROPEAN MONETARY SYSTEM

I.I. INTRODUCTIONINTRODUCTION

A.A. The European Monetary The European Monetary System System (EMS)(EMS)

1.1. A target-zone method A target-zone method (1979)(1979)

2.2. Close macroeconomic Close macroeconomic policy coordination policy coordination required.required.

THE EUROPEAN MONETARY THE EUROPEAN MONETARY SYSTEMSYSTEM

B.B. EMS Objective:EMS Objective:

to provide exchange rate to provide exchange rate

stability to all members stability to all members

by by holding exchange rates holding exchange rates

within specified within specified

limits.limits.


C.C. European Currency Unit European Currency Unit (ECU)(ECU)

a “cocktail” of European currencies a “cocktail” of European currencies with specified weights as the unit of with specified weights as the unit of account.account.


1. Exchange rate mechanism 1. Exchange rate mechanism (ERM)(ERM)

- each member determines - each member determines

mutually agreed upon mutually agreed upon centralcentral

cross rate for its currency.cross rate for its currency.


2.2. Member Pledge:Member Pledge:

to keep within 15% to keep within 15% margin above or margin above or

below below the central rate.the central rate.


D.D. EMS ups and downsEMS ups and downs

1. Foreign exchange 1. Foreign exchange interventions:interventions:

failed due to lack of failed due to lack of support by support by

coordinated coordinated monetary monetary policies.policies.


2.2. Currency Crisis of Sept. 1992Currency Crisis of Sept. 1992

a. a. System broke downSystem broke down

b.b. Britain and Italy Britain and Italy forced towithdraw forced towithdraw from EMS.from EMS.


G.G. Failure of the EMS:Failure of the EMS:

members allowed political members allowed political

priorities to dominate priorities to dominate

exchange rate exchange rate

policies.policies.


H.H. Maastricht TreatyMaastricht Treaty

1.1. Called for Monetary Called for Monetary Union by 1999 Union by 1999

(moved to (moved to 2002)2002)2.2. Established a single Established a single

currency:currency:the eurothe euro


3.3. Calls for creation of a singleCalls for creation of a singlecentral EU bankcentral EU bank

4.4. Adopts tough fiscal Adopts tough fiscal standardsstandards


I.I. Costs / Benefits of A Single Costs / Benefits of A Single CurrencyCurrency

A. BenefitsA. Benefits

1.1. Reduces cost of doing Reduces cost of doing businessbusiness

2.2. Reduces exchange rate Reduces exchange rate riskrisk


B.B. CostsCosts1.1. Lack of national Lack of national

monetary flexibility.monetary flexibility.

chapter 3 the international monetary system. chapter overview i. alternative exchange rate systems...

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