The International Monetary System

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• The International Monetary System
• (Shapiro Chapters 2 and 3)

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The International Monetary System

• International Monetary System is a set of
• Agreements, Rules and Institutions
• Relating 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
• Evolution of the international monetary systems
• How do differing monetary systems affect currency
  values?

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Evolution of the International Monetary System

• Bimetallism Before 1875
• Classical Gold Standard 1875-1914
• Interwar Period 1915-1944
• Bretton Woods System 1945-1973
• The Post-Bretton Woods System (The Flexible
  Exchange Rate Regime) 1973-Present

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Bimetallism Before 1875

• A double standard in the sense that both gold
  and silver were used as money.
• Some countries were on the gold standard, some on
  the silver standard, some on both.
• Both gold and silver were used as international
  means of payment and the exchange rates among
  currencies were determined by either their gold
  or silver contents.

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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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Interwar Period 1915-1944

• Exchange rates fluctuated as countries widely
  used beggar-thy-neighbor or predatory
  depreciations as a means of gaining advantage in
  the world export market.
• Nations cheapened their currencies to increase
  their exports at others expense and to reduce
  imports, led to a trade war.
• 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.

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Bretton Woods Agreement 1945-1973

• 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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Bretton Woods System 1945-1973
U.S. dollar
Pegged at 35/oz.
Gold
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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
  worlds 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
• Even this agreement collapsed a year later

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The Flexible Exchange Rate Regime 1973--Present

• Flexible exchange rates were declared acceptable
  to the IMF members.
• Central banks were allowed to intervene in the
  exchange rate markets to iron out unwarranted
  volatilities.
• Gold was abandoned as an international reserve
  asset.
• Non-oil-exporting countries and less-developed
  countries were given greater access to IMF funds.

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Current Exchange Rate Arrangements

• Free Float
• The largest number of countries, about 48, allow
  market forces to determine their currencys
  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 e.g. HK7.80
  US1
• 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.

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1973- 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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• Others like Japan allowed oil prices to increase
  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)
• Sinking dollar 85-87 and the Plaza-Louvre
  Intervention Accord
• 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

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• 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
• 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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• 1988- Present
• Fell in 1993-95 against the yen and DM
• Rally in 1996
• Recent decline in value of dollar

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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.
• Individual currencies are determined based on the
  ECU
• Monetary union - EMU (European monetary union)
  and the Euro
• Conditions for entry

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EMU and The Euro

• EMU single currency area within Europe where
  people, goods, services and capital can move
  without restrictions.
• The euro is the single currency of the European
  Monetary Union which was adopted by 11 Member
  States on 1 January 1999.
• Idea was that a single currency would promote
  stability in the region.
• A single currency unit removes exchange rate
  instability, reduces transactions costs and make
  firms more competitive.
• These original member states were Belgium,
  Germany, Spain, France, Ireland, Italy,
  Luxembourg, Finland, Austria, Portugal and the
  Netherlands.

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• Currently member countries that participate in
  the Euro
• 1 Euro 40.3399 BEF (Belgian Frank)
• 1.9558 DEM (German DM)
• 340.750 GRD (Greek Drachma)
• 166.386 ESP (Spanish pesets)
• 6.5595 FRF (French Frank)
• 0.7875 IEP (Irish punt)
• 1936.27 ITL (Italian lira)
• 40.3399 LUF ( Luxembourg franks)
• 2.2037 NLG (Netherlands guilder)
• 13.7603 ATS (Austrian schilling)
• 200.482 PTE (Portuguese escudos)
• 5.9457 FIM (Finnish markkaa)

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Euro Bank Notes
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Euro Coins
Ireland
Austria
common side
national side