THE INTERNATIONAL MONETARY SYSTEM

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CHAPTER 3

• THE INTERNATIONAL MONETARY SYSTEM

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CHAPTER OVERVIEW

• I. ALTERNATIVE EXCHANGE RATE SYSTEMS
• II. A BRIEF HISTORY OF THE
• INTERNATIONAL MONETARY SYTEM
• III. THE EUROPEAN MONETARY SYSTEM

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PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS

• I. FIVE MARKET MECHANISMS
• A. Freely Floating (Clean Float)
• 1. Market forces of supply and demand
  determine rates.

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ALTERNATIVE EXCHANGE RATE SYSTEMS

• 2. Forces influenced by
• a. price levels
• b. interest rates
• c. economic growth
• 3. Rates fluctuate randomly over time.

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ALTERNATIVE EXCHANGE RATE SYSTEMS

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

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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.

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ALTERNATIVE EXCHANGE RATE SYSTEMS Fixed Rate

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

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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.

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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.

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A BRIEF HISTORY

• II. The Classical Gold Standard
• (1821-1914)
• A. Major currencies on gold standard.
• 1. Nations fix the exchange rate in
  terms of a specific amount of gold.

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A BRIEF HISTORY

• 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

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A BRIEF HISTORY

• a. Price-specie-flow mechanism
• adjustments were automatic
• 1.) When a balance of payments surplus led
  to a gold inflow
• 2.) Gold inflow led to higher prices which
  reduced surplus

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A BRIEF HISTORY

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

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A BRIEF HISTORY

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

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A BRIEF HISTORY

• C. Currencies devalued in 1931
• - led to trade wars.

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A BRIEF HISTORY

• D. Bretton Woods Conference
• - called in order to avoid
• future protectionist and
• destructive economic policies

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A BRIEF HISTORY

• 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.

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A BRIEF HISTORY

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

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A BRIEF HISTORY

• 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.

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A BRIEF HISTORY

• B. OPEC and the Oil Crisis (1973-774)
• 1. OPEC raised oil prices four fold
• 2. Exchange rate turmoil resulted
• 3. Caused OPEC nations to earn large
  surplus
• B-O-P.

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A BRIEF HISTORY

• 4. Surpluses recycled to debtor nations which
  set up debt crisis of 1980s.
• C. Dollar Crisis (1977-78)
• 1. U.S. B-O-P difficulties
• 2. Result of inconsistent monetary policy in
  U.S.

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A BRIEF HISTORY

• 3. Dollar value falls as confidence shrinks.
• 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.

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A BRIEF HISTORY

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

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A BRIEF HISTORY

• 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

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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.

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THE EUROPEAN MONETARY SYSTEM

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

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THE EUROPEAN MONETARY SYSTEM

• C. European Currency Unit (ECU)
• a cocktail of European currencies with
  specified weights as the unit of account.

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THE EUROPEAN MONETARY SYSTEM

• 1. Exchange rate mechanism (ERM)
• - each member determines
• mutually agreed upon central
• cross rate for its currency.

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THE EUROPEAN MONETARY SYSTEM

• 2. Member Pledge
• to keep within 15 margin above or below
  the central rate.

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THE EUROPEAN MONETARY SYSTEM

• D. EMS ups and downs
• 1. Foreign exchange interventions
• failed due to lack of support by
  coordinated monetary policies.

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THE EUROPEAN MONETARY SYSTEM

• 2. Currency Crisis of Sept. 1992
• a. System broke down
• b. Britain and Italy forced towithdraw
  from EMS.

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THE EUROPEAN MONETARY SYSTEM

• G. Failure of the EMS
• members allowed political priorities to
  dominate exchange rate policies.

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THE EUROPEAN MONETARY SYSTEM

• H. Maastricht Treaty
• 1. Called for Monetary Union by 1999 (moved
  to 2002)
• 2. Established a single currency
• the euro

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THE EUROPEAN MONETARY SYSTEM

• 3. Calls for creation of a single
• central EU bank
• 4. Adopts tough fiscal standards

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THE EUROPEAN MONETARY SYSTEM

• I. Costs / Benefits of A Single Currency
• A. Benefits
• 1. Reduces cost of doing business
• 2. Reduces exchange rate risk

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THE EUROPEAN MONETARY SYSTEM

• B. Costs
• 1. Lack of national monetary flexibility.