Chapter 24: Learning Objectives

1
Chapter 24Learning Objectives

• The Bank for International Settlements History
  Operations
• The International Monetary Fund World Bank
  History and Operations
• European Institutions EBRD, EMS EMU
• The Workings of the EMS Target Zone

2
Why did International Financial Institutions
Emerge?

• Began as a way of reducing the dangers associated
  with beggar thy neighbour policies
• Also, institutions were needed to coordinate
  post-war recovery and management of reparations
• The growth of international trade and capital
  movements also necessitated some international
  institutions

3
Bank for International Settlements

• Originally formed to deal with Germans
  reparations after WW I
• Became a forum for central bankers to discuss
  common issues
• Members include industrialized as well as other
  central banks representatives (25 countries and
  growing)
• Managed by a Board which includes members from
  central banks and member countries Treasuries

4
BIS contd

• Activities include
• Buying/selling of gold
• lending to member countries
• issuance and marketing of securities
• negotiate international financial agreements
  (e.g., BIS capital standards CHAPTER 10)
• forum for discussion of international monetary
  issues

5
International Monetary Fund

• Outcome of post-war plans by the US and UK mainly
• Major goal was to improve financial coordination
  and avoid problems with the gold standard, namely
  deflation and lack of independence in monetary
  policy
• Member countries have voting rights roughly a
  function of the volume of trade in the world
• Created at Bretton Woods, NH, where the founders
  agreed to an adjustable peg system of exchange
  rates

6
IMF contd

• The BW system permitted a /- 1 fluctuation in
  exchange rates around the par rate
• Devaluations permitted only if chronic BOP
  difficulties arose
• The US and UK , along with gold, were the
  reserve currencies at first
• The par exchange rate was vis-à-vis the US
  and members could convert into gold _at_ 35/oz.

7
IMF contd

• BW was flawed because the system assumed the US
  would not inflate and that it would run a BOP
  deficit in perpetuity
• Germany, in particular, eventually had to revalue
  its currency continuously until it was no longer
  willing to do so
• The IMF is no stranger to controversy especially
  because of its conditionality programs
• Nixon took the US of the gold standard
  effectively ending BW

8
The Future of the IMF

• Most countries are adopting flexible exchange
  rates and full capital mobility, putting in
  question IMFs mission
• International expectations for the IMF to ensure
  financial stability has increased, especially
  since the 1994-95 Mexican crisis and the Asian
  crisis of 1997-98
• Should the IMF become an international lender of
  last resort? An international credit rating
  agency?

9
World Bank

• Created at the same time as the IMF to facilitate
  reconstruction and development through access to
  liquidity
• Borrows on the open market and makes different
  types of loans to developing countries
• Coordination with sister institution - the IMF -
  to monitor and assist in meeting conditionality
  requirements

10
The European Monetary System

• Organized with the ending of BW in 1972
• Originally called the snake and consisted
  essentially of the Benelux, Germany, and France
• In 1979 renamed the EMS or ERM
• Member countries grew as the EC grew and
  eventually led to the Maastricht Treaty of
  Monetary Union in 1991
• The EMS has essentially the same flaws as BW but
  is currently far more flexible (i.e., wider
  bands, more realignments)

11
Real Effective Exchange Rates in 5 EMS Countries
12
The Target Zone Model Hypothetical Illustration
Exchange rate
Actual exchange rate
Central parity
Target Zone
lt realignment
TIME
13
Franc/Deutschmark Exchange Rates
14
The EMS contd

• With Maastricht comes EMU or European Monetary
  Union
• In 1998, the members of EMU were announced (11
  countries)
• EMU participants were thought to have satisfied
  the convergence requirements (inflation,
  interest rates, govt debt)
• The Euro was launched in 1999 while the
  European Central Bank was launched in 1998

15
European Central Bank

• Considered perhaps the most independent central
  bank in the world
• Its principal objective is price stability
  defined as inflation in Euroland lt 2
• To achieve its objective the ECB also monitors
  money growth and the exchange rate (two of the
  three pillars of monetary policy)
• The creation of the ECB has raised interest in
  currency unions, especially in Canada

16
Currency Unions

• What are the ideal determinants of a currency
  area? What is an optimum currency area?
• Labour mobility allow movement to regions with
  greater labour demand
• Capital mobility funds should be able to seek
  out highest available return for given risk
• Openness and regional interdependence close
  trading relationship reduces need for separate
  currency
• Industrial and portfolio diversification eases
  impact of shocks
• Wage and price flexibility replaces the primary
  function of the exchange rate

17
Point Counterpoint Should Canada drop its
currency?

• POINT
• Lower transactions costs
• Connection between fundamentals and exchange rate
  unclear
• Facilitates trade between countries
• More price competition
• Encourages labor mobility

• COUNTERPOINT
• Transactions costs savings small
• BOC equation suggests that exchange rate is an
  important shock absorber
• Canadas monetary policy pretty good
• Since NAFTA scope for price competition is small

18
Summary

• This chapter surveys international financial
  institutions
• The principal institutions are BIS, IMF, World
  Bank
• The history of exchange rate arrangements since
  WW II is dominated by Bretton Woods and the EMS
• The 1990s see the ratification of the Maastricht
  Treaty of European Monetary Union
• The new ECB is created in 1998 with the Euro to
  be introduced in 1999
• EMU has rekindled interest in currency unions