International Monetary Arrangements in Theory and Practice

International Monetary Arrangementsin Theory and Practice

The international monetary system is the institutional framework within which:

International payments are made. Movements of capital are accommodated. Exchange rates among currencies are

determined.

The International Gold Standard, 1879-1913

Countries unilaterally elected to follow the rules of the gold standard system, which lasted until the outbreak of World War I in 1914, when European governments ceased to allow their currencies to be convertible either into gold or other currencies.

Fix an official gold price or “mint parity” and allow free convertibility between domestic money and gold at that price.

For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents:

The International Gold Standard, 1879-1913

$30 = £6

$5 = £1

Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment.

Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

The International Gold Standard, 1879-1913

Price-Specie-Flow Mechanism

Suppose Great Britain exported more to France than France imported from Great Britain.

This cannot persist under a gold standard.– Net export of goods from Great Britain to France will be

accompanied by a net flow of gold from France to Great Britain.

– This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain.

The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

The International Gold Standard, 1879-1913

With stable exchange rates and a common monetary policy, prices of tradable commodities were much equalized across countries.

Real rates of interest also tended toward equality across a broad range of countries.

On the other hand, the workings of the internal economy were subservient to balance in the external economy.

There are shortcomings:– The supply of newly minted gold is so restricted

that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves.

– Even if the world returned to a gold standard, any national government could abandon the standard.

The International Gold Standard, 1879-1913

The Relationship between Money and Growth

Money is needed to facilitate economic transactions. MV=PY →The equation of exchange. Assuming velocity (V) is relatively stable, the quantity

of money (M) determines the level of spending (PY) in the economy.

If sufficient money is not available, say because gold supplies are fixed, it may restrain the level of economic transactions.

If income (Y) grows but money (M) is constant, either velocity (V) must increase or prices (P) must fall. If the latter occurs it creates a deflationary trap.

Deflationary episodes were common in the U.S. during the Gold Standard.

Interwar Period: 1918-1941

Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market.

Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”.

The result for international trade and investment was profoundly detrimental.

Smoot-Hawley tariffs Great Depression

Economic Performance and Economic Performance and Degree of Exchange Rate Degree of Exchange Rate

Depreciation During the Great Depreciation During the Great DepressionDepression

The Spirit of the Bretton Woods Agreement, 1945

In essence, the Agreement removed countries from the tyranny of the gold standard and permitted greater autonomy for national monetary policies

Fix an official par value for domestic currency in terms of gold or a currency tied to gold as a numeraire. In the short run, keep the exchange rate pegged within 1% of its par value, but in the long-run leave open the option to adjust the par value unilaterally if the IMF concurs.

Bretton Woods System: 1945-1972

Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire.

The purpose was to design a postwar international monetary system.

The goal was exchange rate stability without the gold standard.

The result was the creation of the IMF and the World Bank.

Bretton Woods System: 1945-1972

Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar.

Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary.

The U.S. was only responsible for maintaining the gold parity.

This created strong demand for $ reserves and allowed the U.S. to run trade deficits.

The Bretton Woods system was a dollar-based gold exchange standard.

The Fixed-Rate Dollar Standard, 1945-1972

Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, and keep the exchange rate within 1% of this par value indefinitely. United States : Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target.

In practice, the Bretton Woods system evolved into a fixed-rate dollar standard.

Bretton Woods System: 1945-1972

German markBritish

poundFrench franc

U.S. dollar

Gold

Pegged at $35/oz.

Par Value

Par ValuePar

Value

Purpose of the IMF

The IMF was created to facilitate the orderly adjustment of Balance of Payments among member countries by:

encouraging stability of exchange rates, avoidance of competitive devaluations, and providing short-term liquidity through loan

facilities to member countries

Composition of SDR(Special Drawing Right)

Collapse of Bretton Woods

Triffin paradox – world demand for $ requires U.S. to run persistent balance-of-payments deficits that ultimately leads to loss of confidence in the $.

SDR was created to relieve the $ shortage. Throughout the 1960s countries with large $ reserves began

buying gold from the U.S. in increasing quantities threatening the gold reserves of the U.S.

Large U.S. budget deficits and high money growth created exchange rate imbalances that could not be sustained, i.e. the $ was overvalued and the DM and £ were undervalued.

Several attempts were made at re-alignment but eventually the run on U.S. gold supplies prompted the suspension of convertibility in September 1971.

Smithsonian Agreement – December 1971

The Floating-Rate Dollar Standard, 1973-1984

Without an agreement on who would set the common monetary policy and how it would be set, a floating exchange rate system provided the only alternative to the Bretton Woods system.

The Floating-Rate Dollar Standard, 1973-1984

Industrial countries other than the United States : Smooth short-term variability in the dollar exchange rate, but do not commit to an official par value or to long-term exchange rate stability. United States : Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target. No need for sizable official foreign exchange reserves.

The Floating-Rate Dollar Standard, 1973-1984

Essentially, the foreign exchange rate was left to play the role of a residual variable that did a great deal of the adjusting to offset the macroeconomic policy differences across countries.

Germany, Japan, and the United States (G-3) : Set broad target zones for the $/DM and $/¥ exchange rates. Do not announce the agreed-upon central rates, and allow for flexible zonal boundaries. Allow the implicit central rates to adjust when economic fundamentals among the G-3 countries change substantially. Other industrial countries : Support or do not oppose interventions by the G-3 to keep the dollar within its target zone limits.

The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999

The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999

An episode started by an expansive U.S. fiscal policy introduced in 1981 combined with tight monetary control convinced policymakers that …

exchange rates were too important to be left to market forces

– intervention was deemed appropriate exchange rates were too important to be the residual from

uncoordinated economic policies– better policy coordination was required.

Value of $ since 1965

Current Exchange Rate Arrangements

Free Float – The largest number of countries, about 48, allow market forces

to determine their currency’s 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).

No national currency– Some countries do not bother printing their own, they just use

the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.