International Monetary System

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International Monetary System

• International Corporate Finance
• P.V. Viswanath

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Learning Objectives

• Alternative Exchange Rate Systems
• Equilibrium under different exchange rate systems
• Categories of Central Bank Intervention

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Alternative Exchange Rate Systems Free Float

• In a free market, exchange rates are determined
  by the interaction of currency supplies and
  demands.
• Supply and demand schedules are influenced by
  price level changes, interest differentials and
  economic growth.
• In a free float, as these economic parameters
  change, market participants will adjust their
  current and expected future currency needs.
  These adjustments will lead to changing exchange
  rates.

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Free Float
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Managed/Dirty Float

• Three types of central bank intervention
• Smoothing out daily fluctuations something akin
  to a specialist on the NYSE.
• Leaning against the wind maintaining an
  exchange rate against temporary irrational
  values.
• Unofficial pegging attempt to manipulate
  fundamental exchange rates without public
  announcements

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Other Exchange Rate Systems

• Target Zone Arrangement countries adjust their
  national economic policies to maintain their
  exchange rates within a specific margin around
  agreed-upon, fixed central exchange rates.
  Example European Monetary System.
• Fixed-Rate System Governments are committed to
  maintaining target exchange rates. All
  participants must, effectively, have the same
  monetary policy else, equilibrium rates would
  shift. Example Bretton Woods.

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Classical Gold Standard

• Countries on the Gold Standard agree to maintain
  convertibility of their currency into gold.
• This ensures predictability of exchange rates
• Gold is a durable, storable, portable, easily
  recognized, divisible commodity. Short-run
  changes in its stock are limited by high
  production costs hence it is difficult for
  governments to manipulate its value.
• Its value as a commodity, relative to other
  commodities taken as a whole is relative stable.

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Gold Standard

• Great Britain maintained a fixed price of gold
  from 1821 to 1914 at 4.2474 an ounce.
• The US maintained the price of gold at 20.67 an
  ounce from 1834-1933 (except 1861-1878).
• This led to long-run price stability as well as
  international trade, facilitated by exchange rate
  stability.
• However, governments monetary policy is forced
  by changes in the supply of gold e.g., greater
  exports lead to greater inflows of gold, which,
  in turn, imply a larger money supply and ensuing
  inflation.

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How the Gold Standard Works
Suppose higher productivity in the non-gold
producing sector of the US lowers the prices of
other goods relative to gold and the US price
level declines.
Prices are equal again, but probably at a lower
level than before.
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Post-Gold Standard

• The Gold-Exchange Standard operated from
  1925-1931 the US and England could hold only
  gold reserves, but other nations could hold both
  gold and dollars or pounds as reserves. In 1931,
  England suffered due to massive capital flows and
  devalued the pound.
• Other countries devalued competitively. This led
  to a trade war. Protectionist exchange rate
  policies fueled the global depression of the
  1930s.

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Bretton Woods

• The Bretton Woods Agreement was implemented in
  1946. Each government agreed to maintain a
  pegged exchange rate for its currency vis-à-vis
  the dollar or gold (35/oz.). The exchange rate
  could fluctuate only within 1 of its stated par
  value.
• The fixed rates were maintained by official
  intervention in foreign exchange markets.
• However, in practice, governments were unwilling
  to suffer the political costs of such
  intervention.
• The lack of US monetary discipline due to the
  Vietnam war made it difficult for the US to
  maintain the official 35/oz. gold price.
• W. Germany, Japan and Switzerland refused to
  accept the inflation that a fixed exchange rate
  would have forced on them.
• The dollar therefore depreciated rapidly.
  Subsequently, rates have, more or less, floated.

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Assessment of Floating-Rate System

• Currency Volatility has increased this is partly
  due to real shocks, such as changing oil prices
  and shifting competitiveness among countries.
• However, not only nominal exchange rate
  volatility, but also real exchange rate
  volatility has increased. Hence there have been
  calls for a return to fixed rates.
• Currency stability with fixed rates requires that
  markets believe that countries will act to keep
  the currency stable this requires a willingness
  to accept coordinated monetary policies.
• Countries are not willing to accept the political
  price of such subordination. A monetary union is
  an alternative to fixed rates.
• Under monetary union, individual countries
  replace their local currencies with a common
  currency. For example, in the United States, all
  50 states share the same dollar.

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Europe and the EMS

• Europe started out in March 1979 with the
  European Monetary System (EMS), which is an
  example of a target zone arrangement.
• The heart of the EMS was an exchange rate
  mechanism. Each member of the EMS agreed on a
  central exchange rate for its currency in terms
  of the ECU (European Currency Unit). Members
  were required to support the agreed upon exchange
  rates.
• However, due to widely differing economic
  policies, the EMS did not last. The EMS was
  abandoned in 1993.

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European Monetary Union

• On January 1, 1999, the 11 founding members of
  the EMU surrendered their monetary autonomy to
  the new European Central Bank and gave up their
  right to create money. Only the ECB can create
  money.
• However, governments can issue their own
  euro-denominated bonds, just as individual
  American states can issue bonds.
• Individual countries in the EMU can attract
  investors only by convincing them that they have
  the financial ability through taxes and other
  revenues to generate the euros to repay the debt.
• An important advantage of the EMU was the ability
  of member countries to use the requirements of
  the monetary union to rein in the expensive
  welfare state and its costly regulations.

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Advantages of a Common Currency

• Greater convenience for travelers from one part
  of the common currency area to another
• Eliminates the risk of currency fluctuations and
  facilitates cross-border price comparisons
• Lower risk and improved price transparency
  encourages the flow of trade and investments
  among member countries.
• This allows greater integration of the regions
  capital, labor and commodity markets and a more
  efficient allocation of resources within the
  region.
• Increased trade and price transparency will spur
  area-wide competition in goods and services and
  encourage corporate restructurings and mergers
  and acquisitions.

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Disadvantages of a Common Currency

• Monetary policy could not be used to affect
  relative prices of domestic goods versus foreign
  goods.
• For example, if there were a decrease in demand
  for French goods, France could increase local
  money and allow the franc to depreciate. This
  would increase demand for French goods.
• However, in a monetary union, this is not
  possible. This would only be achieved through
  reduced demand for French goods leading to
  unemployment, which would then enable French
  manufacturers to reduce wages, allowing French
  goods to be once again competitive.
• The social and economic costs of this process
  could be high.

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Emerging Market Crises

• In the 1990s, there were several emerging market
  currency crises in fixed exchange rate countries
  the Mexican crisis in 1994/5, the Asian crisis
  in 1997, the Russian crisis in 1998, and the
  Brazilian crisis in 1998/9.
• There are two different transmission mechanisms
  for currency crises
• Trade links from one emerging market to another
  through their trade links e.g. when Argentina is
  in crisis, it imports less from Brazil, its
  principal trading partner. As Brazil contracts,
  its currency will likely weaken.
• Financial system trouble in one market leads to
  investors seeking to exit other countries with
  similar risky characteristics. Investors may
  become more risk averse and rebalance their
  portfolios by selling off other risky assets.

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Dealing with Emerging Market Crises

• Currency Controls abandoning free capital
  movement, as in the case of Malaysia.
• Freely Floating Currency Australia and New
  Zealand were protected against the Asian crises
  because they had floating exchange rates.
• Permanently fixed exchange rates dollarization,
  currency boards or monetary union.