H YSTORY OF EXCHANGE RATE SYSTEMS Lecture 8 1. L EARNING GOALS Features and Mechanism of Gold Standard Features and Mechanism of Dollar Standard The Credit.

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HYSTORY OF EXCHANGE RATE SYSTEMS Lecture 8

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LEARNING GOALS

Features and Mechanism of Gold Standard

Features and Mechanism of Dollar Standard

The Credit Money System

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INTERNATIONAL MONETARY SYSTEMS

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HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

Desirable properties Raire, durable,

divisible, fungible

New phenomena in crises: speculative!

Representative money:Coins, notes represented real

commodities strored elsewhere

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THE USE OF GOLD

In short run: High production costs limit short-run changes.

In long run: Commodity money insures stability.

Silver: the main circulating medium (Gresham)

Gold: medium of reserve

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THE CLASSICAL GOLD STANDARD

Major currencies on gold standard.

Involved commitment by nations to fix the price of domestic currency in terms of a specific amount of gold.

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EXCHANGE RATE PARITY

The relationship between the value of one currency and another

1 uncia gold = 86,58 RM 1 uncia gold = 20,67 USD 1 USD = ? RM 1 USD = 4,19 RM

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THE CLASSICAL GOLD STANDARD (1875-1914)

1844 Britain: Bank Charter Act Establishment of Bank of England notes backed

by gold 1871 Germany:

After unified, and Franco-Prussian war Mark defined its value in gold

By 1879 only gold coins were accepted in Latin Monetary Union (France, Italy, Belgium, Switzerland, Greece)

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ARBITRAGE

Attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.

The ideal version is riskless arbitrage. A risk-free transaction consisting of purchasing

an asset at one price and simultaneously selling that same asset at a higher price, generating a profit on the difference.

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THE CLASSICAL GOLD STANDARD 2

Maintenance involved: the buying and selling of gold at that price.

Besides the free flow of capital free exchange rate market

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THE CLASSICAL GOLD STANDARD 3

Operating conditions:

1. All national currency is backed by gold, and growth in money supply is linked to gold reserves.

Growing world economies

Growing money demand

Growing gold reserves (colonies)

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THE CLASSICAL GOLD STANDARD 4

Conditions:

2. Each currency convertible into gold at a fixed price - the exchange rate between the two currencies automatically fixed.

3. No fluctuation in the exchange rate unless either country changes the local price of gold.

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HOW???

From 4.19 the dollar rises to 5 Mark Over or undervaluation of USD? Cause: arbitrage

Example: 1 uncia gold = 86,58 RM 1 uncia gold = 20,67 USD 1 USD = 4,19 RM

Buy USD directly from 1000RM or make an arbitrage?

11.55 uncia gold sold at the fixed rate Result: 238.74USD Dollar surplus push down the exchange rate: rise in

dollar volume, decrease in mark volume

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PRICE-SPECIE-FLOW MECHANISM: AUTOMATIC ADJUSTMENTS

Gold outflow led to lower prices and increased surplus.

Gold inflow led to higher prices which reduced surplus

When a balance of payments surplus led to a gold inflow

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THE GOLD EXCHANGE STANDARD (1925-1931)

Only U.S. and Britain allowed to hold gold reserves

Other countries could hold both gold, dollars or pound reserves.

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BETWEEN WW1 AND WW2

Countries experimented with floating rates in the

1920’s and ’30

“If there is anything that the inter-war experience

has clearly demonstrated, it is that currency exchanges cannot be left free to fluctuate from day to-day under the influence of demand and supply. If currencies are left to fluctuate, “speculation” is likely to play havoc with the exchange rate.”

Ragnar Nurske (1944) of the League of Nations

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Currencies devalued in 1931- led to trade wars.

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Bretton Woods Conference

- called in order to avoid future protectionist and destructive economic policies

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THE BRETTON WOODS SYSTEM

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.

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A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

Exchange rates allowed to fluctuate

by 1% above or below initially set rates.

Collapse, 1971Causes: U.S. high inflation

rate U.S.$ depreciated

sharply.

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BREAKDOWN OF BRETTON WOODS

By late 1960’s: US liabilities abroad exceeded their gold reserves.

US: expansionary monetary policy during Vietnam wars

Current account and trade balance teriorated. No possibility to back its commitment to its

currency with gold.On August 15, 1971, Nixon officially took the

US off the gold standard. (see IMF site)www.imf.org/external/about/histend.htm

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POST-BRETTON WOODS SYSTEM (1971- PRESENT)

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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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

surplus4. Surpluses recycled to debtor nations

which set up debt crisis of 1980’s.

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DOLLAR CRISIS (1977-78)

1. U.S. B-O-P difficulties2. Result of inconsistent

monetary policy in U.S.3. Dollar value falls as

confidence shrinks.

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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.

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THE SINKING DOLLAR:(1985-87)

1. Dollar revaluated slowly downward;

2. Plaza Agreement (1985) G-5 agree to depress US$ further.

3. Louvre Agreement (1987) G-7 agree to support the falling

US$.

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RECENT HISTORY

1. 1988 US$ stabilized2. Post-1991 Confidence resulted in

stronger dollar3. 1993-1995 Dollar value falls

4. Now?

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Thanks for your attention!

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THE EUROPEAN MONETARY SYSTEM

I. INTRODUCTIONA. 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.

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.

D. EMS ups and downs1. 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. 1992a. System broke downb. Britain and Italy forced to

withdraw from EMS.G. Failure of the EMS

members allowed political prioritiesto dominate exchange rate policies.

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THE EUROPEAN MONETARY SYSTEM

H. Maastricht Treaty1. Called for Monetary Union by

1999 (moved to 2002).2. Established a single currency:

the euro3. 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 CurrencyA. Benefits

1. Reduces cost of doing business.

2. Reduces exchange rate riskB. Costs

1. Lack of national monetary flexibility.