International monetary system Ulvi Vaarja 2015. Monetary history First trade was barter Goods used as money Precious metals – weight was measured First.

International monetary system

Ulvi Vaarja2015

Monetary history

• First trade was barter• Goods used as money• Precious metals – weight was measured• First coins from 7 century B.C. in Lydia. Early

coins also found in Greece, Middle East (Egypt and Mesopotamia) and China– Value according to the weight of the coin

• Decreased value problem with the early coins – less gold and more silver

Monetary history• Contemporary money from 15-16th century

Florence• i-o-u system in 15th century England• 1694 – first “exchangeable” money in England• Historically money can be divided into:

– Full-value – e.g. gold coin where the value of the coin reflects its whole value in gold

– Token – does not reflect the full value of the precious metal in it

• Seigniorage – profit from the difference between the value of the coin as an asset and as a coin

Some powerful currencies

• Persian daric• Roman currency. • Thaler.• Spanish American pesos. • British pound. • US dollar. • Euro.

What is money?

• Narrow definition:– Cash– Demand deposits

• Broader definitions include:– Time deposits– Deposit certificates– Foreign exchange deposits

Why money is money?

• Money is an asset that general public accepts as a means of payment.

• Economic functions of money:– Medium of exchange– Unit of account– Store of value– Standard of deferred payment

Why money is money?

• When is barter better than money?– Fixed prices

• Price higher than market price (left graph)• Price lower than market price (right graph)

– hyperinflation

Why money is money?• Money as a store of value

– Price changes, but so does the price of other assets• Standard of deferred payment• Alternative cost for liquidity

– you get no interest on cash– You lose money when its price changes

• Money is issued usually by government– Some cases in history that banks or companies have

issued their own money

Exchange rate regimes chronology

Gold standard

• Advantages– reduced exchange rate risk - established fixed

exchange rates between currencies– Countries forced to observe strict monetary

policies. – gold standard helps a country correct its trade

imbalance.

Gold standard• The gold standard eventually collapsed from the impact of World

War I. • In the 1920s, most countries returned to the gold standard• However, the revival of the gold standard was short-lived due to

the Great Depression, which began in the late 1920s. – The gold standard limited the flexibility of the monetary policy of each

country’s central banks by limiting their ability to expand the money supply.

• By 1931, the United Kingdom had to officially abandon its commitment to maintain the value of the British pound.

• In 1934, the United States devalued its currency from $20.67 per ounce of gold to $35 per ounce.

• By 1939, the gold standard was dead

Inter world wars period

• Prior and after the short-lived return to gold standard floating exchange rates were used

• beggar thy neighbour policies – trying to cure domestic depression and unemployment by shifting effective demand away from imports onto domestically produced goods

• The various policies worked inconsistently and self-defeatingly.

Bretton Woods • In the early 1940s, the United States and the United Kingdom began

discussions to formulate a new international monetary system. • In July 1944, representatives from 44 countries met in Bretton Woods,

New Hampshire, to establish a new international monetary system.• The Bretton Woods system fixed the value of the US dollar to gold at $35

to one ounce of gold. – All other countries then set the value of their currencies to the US dollar.

• Member countries had to maintain the value of their currencies within 1 percent of the fixed exchange rate.

• only governments, rather than anyone who demanded it, could convert their US dollar holdings into gold

• the Bretton Woods Agreement provided for a devaluation of a currency– more than 10 percent if needed.

Bretton Woods

• The agreement established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group.

– These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement.

• the IMF’s initial primary purpose was to help manage the fixed rate exchange system

• The World Bank’s purpose was to help with post–World War II European reconstruction.

• Triffin Paradox in the late 1960s - concern that the US did not have enough gold reserves to exchange all of the US dollars in global circulation.

Bretton Woods• The expense of the Vietnam War and an increase in domestic spending

worsened the Triffin Paradox• The Nixon Shock was a series of economic decisions made by the US

President Richard Nixon in 1971 that led to the demise of the Bretton Woods system.

• Later that same year, the member countries reached the Smithsonian Agreement

– devalued the US dollar to $38 per ounce of gold– increased the value of other countries’ currencies to the dollar,– increased the band within which a currency was allowed to float from 1 percent to 2.25

percent.

• This agreement still relied on the US dollar• Countries gradually dropped out of system• By 1973 the idea of fixed exchange rates was over.

Exchange rate volatility

Inflation

Income growth

Exchange rate regimes

IMF classification• Exchange arrangement with no separate legal tender• Currency board arrangement • Conventional pegged arrangement • Pegged exchange rate within horizontal bands• Crawling peg• Crawling band• Managed floating with no pre-announced path for

the exchange rate• Independently floating

Rogoff and Reinhart system

Rogoff and Reinhart system

Choice of the exchange rate system

• A system is chosen that sets the exchange rate at which foreign currency operations are carried out

• Institutional and economic policy choices have to be in accordance with the chosen system

• Choice depends on:– Initial conditions– Structural status

• Stability of fiscal policy• Openness• flexibility of labour market

• Type of shocks affecting the country• Credibility of the institutions and economic policy goals

Exchange rate systems

• All fixed rates can be chosen unilaterally. • the responsibility for maintaining the fix lies on

the fixing country only– E.g Austria, Estonia, Slovenia, Latvia, Lithuania (all

before the adoption of euro)• Bi- and multilateral agreements involve sharing

responsibilities• Multilateral fixes might face the Nth country

problem

Nth country problem

Due to one independent institution in the system, all the participants end up being worse off

Anchor currencies for the fixed regimes

Rates used in advanced countries

Emerging markets

Developing countries

Pros of fixed rates

• Decreased exchange rate volatility and instability that arises from it

• Anchor for nominal prices• Increased prudence and credibility

Cons of fixed rates

• Sets limits to economic policy• Tendency for the real exchange rate to rise• Level of the rate• Appropriate level of reserves• Fear of indirect exchange rate guarantee

Pros of the flexible rates

• Isolates domestic monetary system from foreign shocks

• Gives economic policy flexibility• No “political costs” are involved in changing

the rate• Instability of the rate

Cons of flexible rates

• Possibility of high volatility of the rate• No nominal price anchor• Devaluation-inflation cycles possible• Need for skilful monetary policy

Theoretical models for setting the exchange rate

• Keynes – Mundell – Fleming• Purchasing power parity (PPP) • Interest parity• Overshooting• Portfolio theory• Asset price theory• Bubbles theory• None of them can perfectly explain the movement of

the exchange rates

Regime choices

• Theories– The impossible trinity – trilemma– Optimal currency area

• Empirical situation– Fear of floating– Bipolar view– De jure vs de facto

Choice of the peg

• Both the pegging system and currency for interventions have to be chosen– Whether to peg to 1 currency or a basket

• Low inflation trade partner• Trade weighted basket

• Level of the rate• Form of the rate

Empirical information

• Actively trading countries have less flexible regimes

• Dollarization is wider in fear of floating countries

Exchange rate and monetary policy

• Flexible regime– Independent monetary policy

• Fixed regime– Strict monetary policy– Control on domestic loan growth– Interest parity

Interest parity

• i = i* - (ERe – ER)/ER– Fixed rate – presumed devaluation is zero– Periodically changing rates – presumed

devaluation is the change of the crawl• If the parity is not followed, then:

– Volatile capital flows occur– Pressure on money supply occurs

Exchange rate policy

• Real exchange rate shows:– purchasing power of the domestic currency– price competitiveness of the domestic industry

• RER = ERP*/P = (Pt/Pn)/(P*t/P *n) or RER = Pt/Pn

• Balassa – Samuelson effect• Rate can rise in the unified currency area too

Exchange rate and monetary policy

Tripolar world

• The most important currencies – USD, EUR and JPY

• There is increasing demand for stability of nominal exchange rates of these currencies– Volatility is expensive– Speculations are “unfair and unjust” by decreasing

international trade– Risk aversion or reduction is costly

• Discussion of target bands

Central bank interventions

• Mean that the central bank gets involved in the trade in the exchange market

• Take mostly place in the fixed exchange rate regimes in order to keep the peg.

• Sometimes take place in partly flexible regimes

• Should not take place in freely floating regimes.

Interventions

• Economic agents can be involved in all types of transactions in the liberalized exchange rate regimes

• Restrictions and limits on positions• Number of participants

– More is better– Less is easier for the central bank

Principles of interventions

• Try to change the market situation• Try to change behaviour and expectations of

the market participants• Central bank should not be the price setter• Central bank should guarantee

competitiveness in the market

Intervention instruments

• Central banks intervene in one currency– It is not efficient to use more– If the customers have interest in other currencies,

conversion will take place• Interventions are usually made in spot-market

– Sometimes forward-deals are used

Currency board arrangements (CBA)

• A currency board arrangement – monetary regime based on commitment to exchange domestic currency against a specific foreign currency at a specific fixed rate.– The whole amount of domestic currency has to be

backed by foreign assets.• The level of backing domestic currency with foreign

assets depends on the foreign reserves level of the country introducing the CBA at the moment of its introduction.

CBA• The rate of the peg should be set taking into

account the probability of continuous inflation, possibility of devaluation and the effect of price liberalization

• Theoretically the peg could be made to a basket of currencies, but in reality usually 1 anchor is chosen to enhance ease and clarity of the exchange rate system

• Money is emitted according to the same principles as in the gold standard

Pros and cons of the CBA• Pros:

– Ease of administration and operation• If enough information is distributed, the CBA framework is easily understood even by

people not involved in finance– Credibility– Stability of the currency, interest rates and financial interventions

• Cons:– Rigidity of the nominal exchange rate– Vulnerability of the financial system– No other possible monetary policy instruments– Limits on fiscal policy

• Duration of the CBA depends on the economic goals of the country in question