The International Monetary System

1
The International Monetary System

• Chapter 3

2
PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS

• I. FIVE MARKET MECHANISMS
• A. Freely Floating (Clean Float)
• 1. Market forces of supply and demand
  determine rates.
• 2. Forces influenced by
• a. price levels
• b. interest rates
• c. economic growth
• 3. Rates fluctuate over time randomly.

3
ALTERNATIVE EXCHANGE RATE SYSTEMS

• B. Managed Float (Dirty Float)
• 1. Market forces set rates unless excess
  volatility occurs.
• 2. Then, central bank determines rate.

4
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.

5
ALTERNATIVE EXCHANGE RATE SYSTEMS

• D. Fixed Rate System
• 1. Rate determination
• a. Government maintains target rates.
• b. If rates are threatened, central banks
  buy/sell currency.
• c. Monetary policies coordinated.

6
ALTERNATIVE EXCHANGE RATE SYSTEMS

• 2. Some Government Controls
• a. On global portfolio investments.
• b. Ceilings on direct foreign direct
  insurance.
• c. Import restrictions.

7
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 fixed-rate systems.

8
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
  short-run changes.
• C. In long run Commodity money insures
  stability.

9
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• II. The Classical Gold Standard
• (1821-1914)
• A. Major currencies on gold standard.
• 1. Involved commitment by nations to fix
  the price of domestic currency in terms of a
  specific amount of gold.

10
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• 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

11
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• a. Price-specie-flow mechanism
• had automatic adjustments
• 1.) When a balance of payments surplus led
  to a gold inflow
• 2.) Gold inflow led to higher prices which
  reduced surplus
• 3.) Gold outflow led to lower prices and
  increased surplus.

12
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• III. The Gold Exchange Standard (1925-1931)
• A. Only U.S. and Britain allowed to hold
  gold reserves.
• B. Other countries could hold both
  gold, dollars or pound reserves.

13
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• C. Currencies devalued in 1931
• - led to trade wars.
• D. Bretton Woods Conference
• - called in order to avoid future
  protectionist and destructive economic
  policies

14
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• 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.

15
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• 3. Exchange rates allowed to fluctuate by 1
  above or below initially set rates.
• B. Collapse, 1971
• 1. Causes
• a. U.S. high inflation rate
• b. U.S. depreciated sharply.

16
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• 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.

17
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• B. OPEC and the Oil Crisis (1973-1974)
• 1. OPEC raised oil prices four fold
• 2. Exchange rate turmoil resulted
• 3. Caused OPEC nations to earn
• large surplus B-O-P.
• 4. Surpluses recycled to debtor nations
  which set up debt crisis of 1980s.

18
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• C. Dollar Crisis (1977-78)
• 1. U.S. B-O-P difficulties
• 2. Result of inconsistent monetary policy in
  U.S.
• 3. Dollar value falls as confidence shrinks.

19
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• 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.
• 3. Result Dollar value rises.

20
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• E. The Sinking Dollar(1985-87)
• 1. Dollar revaluated slowly downward
• 2. Plaza Agreement (1985) G-5 agree to
  depress US further.

21
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
SYSTEM

• 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

22
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.

23
THE EUROPEAN MONETARY SYSTEM

• B. EMS Objective
• to provide exchange rate stability to all
  members by holding exchange rates within
  specified limits.

24
THE EUROPEAN MONETARY SYSTEM

• C. European Currency Unit (ECU)
• A cocktail of European currencies with
  specified weights as the unit of account.
• 1. Exchange rate mechanism (ERM)
• each member determines mutually agreed
  upon central cross rate for its currency.

25
THE EUROPEAN MONETARY SYSTEM

• 2. Member Pledge
• To keep within 15 margin above or below the
  central rate.
• D. EMS ups and downs
• 1. Foreign exchange interventions failed due
  to lack of support by coordinated monetary
  policies.

26
THE EUROPEAN MONETARY SYSTEM

• 2. Currency Crisis of Sept. 1992
• a. System broke down
• b. Britain and Italy forced to
• withdraw from EMS.
• G. Failure of the EMS
• members allowed political priorities
• to dominate exchange rate policies.

27
THE EUROPEAN MONETARY SYSTEM

• H. Maastricht Treaty
• 1. Called for Monetary Union by 1999 (moved
  to 2002).
• 2. Established a single currency the euro
• 3. Calls for creation of a single central EU
  bank.
• 4. Adopts tough fiscal standards.

28
THE EUROPEAN MONETARY SYSTEM

• I. Costs / Benefits of A Single Currency
• A. Benefits
• 1. Reduces cost of doing business.
• 2. Reduces exchange rate risk
• B. Costs
• 1. Lack of national monetary flexibility.