1 The International Monetary System International Monetary System is a set of: Agreements, Rules and Institutions Relating to Exchange rates, International.

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The International Monetary System

International Monetary System is a set of:Agreements, Rules and InstitutionsRelating to Exchange rates, International Payments

and the flow of capital across national borders Current system is based on a system of floating

exchange rates - came about after the decline of the Bretton Woods system

Historical review of the international monetary systems How do differing monetary systems affect currency

values?

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Historical overview of the systems of payment

Classical gold standard (1875-1914)

Rules under the gold standard: Fix an official gold price of the local currency e.g.

$20.67 = one ounce of gold in 1879

Money supply should be backed by gold

Prices worldwide would depend on the demand and supply of gold

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Exchange rate between 2 countries was determined by the gold content of the respective currencies

E.g. 1 ounce of gold sold for DM 20 in Germany 1 ounce of gold sold for £ 10 in U.K.

This implied that DM 20 = £ 10 i.e. DM 1 = £ 0.5 (=10/20)

£ 1 = DM 2 (=20/10) Domestic price level in a country was linked to the

supply of gold through money supplies Money was fully backed by gold Governments need to find more gold to increase money

supply

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One motivation of the gold standard is price stability

Since currencies are tied to gold, prices depend on the cost of producing gold

Hence the long-run cost of gold production would determine price levels

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How exactly does the gold standard work?

Starting from equilibrium assume that productivity increases in the U.S.

The cost of production declines The price level declines (since prices are set based on how

much gold is needed to produce a bundle of goods) Prices of exports from the U.S. decline relative to imports Demand for U.S. exports increases Gold flows into the U.S. hence increasing money supply and

prices Relative to the initial equilibrium prices everywhere will be

slightly lower than before since the cost of production has declined everywhere

Converse is true if prices increase in the U.S.

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Imbalances in exports and imports was self-correcting E.g. Consider a situation where Germany exported more

to the U.K. than what it imported: Net payment from U.K. To Germany Gold flows from U.K. To Germany Supply of gold declines in the U.K. Price level in the U.K. Declines Imports from the U.K. Are relatively more attractive The imbalance changes

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Period of 1821-1914 was indeed characterized by price stability, stable exchange rates, expansion of international trade and economic growth worldwide

While the average inflation rate during the gold standard was lower than in the post-World war era, the variability of inflation in the U.S. was higher under the gold standard

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Problems with the gold standard

World trade was hampered by the availability of gold

Inflation rates across countries would have to be equalized

Required co-ordination of domestic monetary policies with international policies

This is especially true during periods of inflation

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Bretton Woods Agreement 1945-1972

Most countries abandoned the gold standard after the Great Depression

Bretton Woods Agreement: Articles of agreement led to the birth of the

International Monetary Fund (IMF)Rules of conduct of international monetary policy

Birth of the International Bank for Reconstruction and Development (IBRD)Financing development projects

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Each country established a par value of its currency vis-a-vis the U.S. Dollar

The exchange rate was allowed to fluctuate within 1% 1 ounce of gold = (set) $35 Countries had the option to change the parity rate in response

to “fundamental disequilibrium” Countries were allowed to pursue their own domestic

macroeconomic goals Temporary imbalances in balance of payments would be

covered using a buffer stock of reserves and borrowing from the IMF

If the demand for the £ increases versus the $, the Bank of England must be willing to supply extra pounds so that the exchange parity is maintained

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Problem: Requires official intervention in the foreign exchange

markets Assume inflation in the U.K.

This would lead to an increase in prices of their exports Hence exports would decline and imports increase Supply of pounds would have to increase on the world’s

foreign exchange markets This supply would reduce the value of the pound To reduce the excess supply the U.K. would have to

“buy” back using its reserves This would reduce domestic money supply and prices Problems arise if governments are not willing to do this

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In reality most countries kept their exchange rates pegged to the dollar and kept changes to a minimum

Hence the exchange rate of the dollar was also fixed in this process

As the war ravaged economies outside the U.S. rebuilt , the stability of fixed rates helped

Soon however, the U.S. liabilities held by foreigners was more than that could be supported by the gold reserves held in the U.S. (using the fact that $35 = one ounce of gold

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U.S. Had to supply dollars continuously to finance world trade

Dollars were moving from the U.S. To other countries U.S. Had to be willing to run Balance of Payments

deficits continuously Gradually this led to loss of confidence in the dollar The basis of the system (confidence in the dollar)

collapsed

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1963: President Kennedy levied the Interest Equalization Tax (IET) Tax on U.S. purchases of foreign securities Dollars would less likely leave the U.S.

1965: Foreign Credit Restraint Program Regulated the amount of U.S. Dollars that banks

could lend to multinational corporations

1970: IMF introduced Special Drawing Rights (SDR) SDR: is a basket of currencies allotted to IMF

members Could be used to finance transactions (in lieu of the $)

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During the late 1960s with the Vietnam wars, inflation in the U.S. increased to 3.5% based on producer prices (compared to 1% from 1951-67) -

Dollar lost credibility

All these factors strained the system 1971: President Nixon suspended the dollar to gold

convertibility Smithsonian Agreement:

1 ounce of gold = $38 (dollar devalued) Currencies revalued Flexible exchange rates - band of 1 - 2.5%

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Even this agreement collapsed a year later 1973 - 1.Flexible, free floating exchange rate system: Advantages and disadvantages of the freely floating

system of exchange rates: E.g. Inflation in the U.S.:

U.S. Consumers shift to imports (say from U.K.)Demand for imports increasesDemand for foreign currency (£) increasesUnder fixed exchange rates:

Value of (£) does not changePrice of imports increases (given unchanged

value of the pound) Inflation in U.K. also

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With flexible exchange rates, Increased demand for imports Increased demand for pounds Value of the pound would increase Hence imports would become more expensive to the

U.S. Consumer (even if the prices of the goods in pounds are unchanged)

Inflation in the U.S. Does not lead to inflation abroad However, if inflation in the U.S. Continues, this would

lead to increase in the price of U.S. Materials which will increase the price of U.S. Goods and hence further reduce demand for them abroad

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2. Managed float exchange rate system:

Exchange rates float freely However governments sometimes intervene Managed or “dirty” float Government manipulation

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3. Pegged exchange rate system: Some currencies are pegged to other currencies or a

basket of currenciesHome currency’s value is fixed in terms of the

foreign currency to which it is peggedMoves in line with the foreign currency against

other currenciesSo the exchange rate is fixed vis-a vis the currency

to which it is pegged but floats with other currencies

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E.g. Argentinian currency is pegged to the US dollar - so a unit of Argentinian currency = $0.2

If $1 = £0.5 this would imply for instance that a unit of Argentinian currency = £0.10

If the U.S. Dollar moves then the Argentinian currency moves with it, however it is fixed in terms of the U.S. Dollar

So if the dollar pound exchange rate changes to $1 = £0.15 then one unit of Argentininan currency is now worth:

$0.200.20 x 0.15 = £ 0.03

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E.g. Consider a world with 3 countries: 1. The U.S. 2. A country called FLOAT whose currency fluctuates

against the U.S. Dollar and 3. A country called PEG whose currency is pegged to

the U.S. Dollar , 1 PEG = $1.20 The current exchange rate for FLOAT is 1 FLOAT =

$0.50 Hence 1 FLOAT = ?? PEGs

1 FLOAT = $0.50 and hence $1 = 2 FLOATS1 PEG = $1.20 and hence $1 = 0.83 PEGS2 FLOATS = 0.83 PEGS,1 FLOAT = 0.83/2 = 0.42 PEGS1 PEG = 1/ 0.42 = 2.38 FLOATS

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Assume now that in the next 6 months, FLOAT depreciates against the dollar and 1 FLOAT = $0.40

How will trade between these countries be affected? Since FLOAT depreciates against the dollar, it also

depreciates against PEG 1 FLOAT = ?? PEGS $1 = 1/0.4 = 2.5 FLOATS $1 = 0.83 PEGS Hence 2.5 FLOATS = 0.83 PEGS Or 1 FLOAT = 0.83/2.5 = 0.332 PEGS Or 1 PEG = 3 FLOATS

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Effect on trade

Hence consumers in FLOAT reduce their demand for PEG’s goods (more expensive now)

Consumers in PEG will substitute goods made in FLOAT for goods made in the U.S.

Similarly consumers in the U.S. Will substitute goods made in FLOAT for goods made in PEG

Overall FLOAT’s economy gets a boost Korean won is pegged to the dollar, while the

Japanese yen floats against the dollar. Following the dollar’s decline in 1986, Japanese products became more expensive in the US. Hence some US importers switched to Korean products

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1971- Present (Post Bretton Woods)

OPEC Crisis 1973-74 Some nations like the U.S. tried to counter increasing oil

prices through expansionary monetary policies and trying to control the price of oil leading to BOP deficits

Others like Japan allowed oil prices to increase Dollar crisis 1977-78

Enter Paul Volcker who announced a major change in monetary policy

The Fed would concentrate on controlling money supply Rising dollar 1980-85

1981-84- inflation declined and the dollar appreciated

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Sinking dollar 1985-87 Dollar peaked in March 85 September 85, Group of Five or G-5 nations met and

drafted the Plaza Agreement to bring down the value of the dollar to keep it competitive

Feb 87- G-7 nations (G-5 + Canada and Italy) met to stop the decline in the dollar - Louvre Accord

Dollar however, continued to fall despite this

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Plaza-Louvre Intervention Accord

1981: Expansive fiscal policy and tight monetary policy in the U.S.

Led to prolonged appreciation in the dollar (appreciated by almost 50% in 1985 relative to 1980)

On Sept. 22, 1985, officials from the G-5 countries - Britain, France, West Germany, Japan and the U.S. met at the Plaza Hotel in NY Pledged to support a depreciation of the dollar Dollar fell sharply and kept declining till 1986

Dollar kept declining till 1987 so much so that it prompted the Louvre Accord on Feb. 22, 1987

Countries pledged to keep exchange rates around target zones

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Target zones were never publicly announced but it is believed that the zones were bands of +/- 5% around the value of 1.825 DM / $ and 153.50 ¥ / $ (these were the rates that prevailed on the Friday before the meeting)

At the same time the European community was getting together to limit exchange rate fluctuations

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European Economic Community (EEC) 1972Currencies were to be set within a band of each

other (Snake system)Problems when all countries do not abide by itEuropean Monetary System (EMS) 1979

Countries’ exchange rates are tied together within specified limits

Also linked to the European Currency Unit (ECU)

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The European Monetary System (EMS)

EMS was established in 1979 to foster monetary stability in the EC (European community

ECU (European currency unit) is a weighted average of different currencies in the EC (exhibit 3.9)

Individual currencies are determined based on the ECU Problems of political enforcement

Monetary union - EMU (European monetary union) and the Euro Conditions for entry Pros and cons e.g. a tourist in Paris that left with 1,000 francs and traveled to 11

EC countries without spending anything came back with 500 francs

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1988- Present Fell in 1993-95 against the yen and DM Rally in 1996