International Monetary System

1
International Monetary System

• ALTERNATIVE EXCHANGE RATE SYSTEMS
• A BRIEF HISTORY OF THE INTERNATIONAL MONETARY
  SYSTEM
• THE EUROPEAN MONETARY SYSTEM
• Costs and benefits of a single currency

2
Alternative Exchange Rate Systems (Obvious but
important point)

• People trade currencies for two primary reasons
• To buy and sell goods and services
• To buy and sell financial assets

3
There are an enormous number of exchange rate
systems, but generally they can be sorted into
one of these categories

• Freely Floating
• Managed Float
• Target Zone
• Fixed Rate

4
Important Note

• Even though we may call it free float in fact
  the government can still control the exchange
  rate by manipulating the factors that affect the
  exchange rate (i.e., monetary policy)

5
Under a floating rate system, exchange rates are
set by demand and supply.

• price levels
• interest rates
• economic growth

6
Alternate exchange rate systems Managed Float
(Dirty Float)

• Market forces set rates unless excess volatility
  occurs, then, central bank determines rate by
  buying or selling currency. Managed float isnt
  really a single system, but describes a continuum
  of systems
• Smoothing daily fluctuations
• Leaning against the wind slowing the change to
  a different rate
• Unofficial pegging actually fixing the rate
  without saying so.
• Target-Zone Arrangement countries agree to
  maintain exchange rates within a certain bound
  What makes target zone arrangements special is
  the understanding that countries will adjust real
  economic policies to maintain the zone.

7
Fixed Rate System Government maintains target
rates and if rates threatened, central banks
buy/sell currency. A fixed rate system is the
ultimate good news bad news joke. The good is
very good and the bad is very bad.

• Advantage stability and predictability
• Disadvantage the country loses control of
  monetary policy (note that monetary policy can
  always be used to control an exchange rate).
• Disadvantage At some point a fixed rate may
  become unsupportable and one country may devalue.
  (Argentina is the most dramatic recent example.)
  As an alternative to devaluation, the country
  may impose currency controls.

8
A Brief History of the International Monetary
System

• Pre 1875 Bimetalism
• 1875-1914 Classical Gold Standard
• 1915-1944 Interwar Period
• 1945-1972 Bretton Woods System
• 1973-Present Flexible (Hybrid) System

9
The Intrinsic Value of Money and Exchange Rates

• At present the money of most countries has no
  intrinsic value (if you melt a quarter, you dont
  get .25 worth of metal). But historically many
  countries have backed their currency with
  valuable commodities (usually gold or silver)if
  the U.S. treasury were to mint gold coins that
  had 1/35th ounces of gold and sold these for
  1.00, then a dollar bill would have an intrinsic
  value.
• When a countrys currency has some intrinsic
  value, then the exchange rate between the two
  countries is fixed. For example, if the U.S.
  mints 1.00 coins that contain 1/35th ounces of
  gold and Great Britain mints 1.00 coins that
  contain 4/35th ounces of gold, then it must be
  the case that 1 4 (if not, people could make
  an unlimited profit buying gold in one country
  and selling it in another)

10
The Classical Gold Standard(1875-1914) had two
essential features

• Nations fixed the value of the currency in terms
  of
• Gold is freely transferable between countries
• Essentially a fixed rate system (Suppose the US
  announces a willingness to buy gold for 200/oz
  and Great Britain announces a willingness to buy
  gold for 100. Then 12)

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Advantage of Gold System

• Disturbances in Price Levels Would be offset by
  the price-specie-flow mechanism. When a balance
  of payments surplus led to a gold inflow Gold
  inflow (country with surplus) led to higher
  prices which reduced surplus Gold outflow led to
  lower prices and increased surplus.

12
Interwar Period

• Periods of serious chaos such as German
  hyperinflation and the use of exchange rates as a
  way to gain trade advantage.
• Britain and US adopt a kind of gold standard (but
  tried to prevent the species adjustment mechanism
  from working).

13
The Bretton Woods System (1946-1971)

• U.S. was key currency valued at 1 1/35 oz. of
  gold
• All currencies linked to that price in a fixed
  rate system.
• In effect, rather than hold gold as a reserve
  asset, other countries hold US dollars (which are
  backed by gold)

14
Bretton Woods System 1945-1972
U.S. dollar
Pegged at 35/oz.
Gold
15
Collapse of Bretton Woods (1971)

• U.S. high inflation rate
• U.S. depreciated sharply.
• Smithsonian Agreement (1971) US devalued to 1/38
  oz. of gold.
• 1973 The US dollar is under heavy pressure,
  European and Japanese currencies are allowed to
  float
• 1976 Jamaica Agreement
• Flexible exchange rates declared acceptable
• Gold abandoned as an international reserve

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Current Exchange Rate Arrangements

• The largest number of countries, about 49, allow
  market forces to determine their currencys
  value.
• Managed Float. About 25 countries combine
  government intervention with market forces to set
  exchange rates.
• Pegged to another currency such as the U.S.
  dollar or euro (through franc or mark). About 45
  countries.
• No national currency and simply uses another
  currency, such as the dollar or euro as their own.