Evolution of the International Monetary System

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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 1945-1972
• 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.
• Greshams Law implied that it would be the least
  valuable metal that would tend to circulate. Bad
  money drives out the good.

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Classical Gold Standard 1875-1914

• During this period in most major countries
• Gold alone was assured of unrestricted coinage
• There was two-way convertibility between gold and
  national currencies at a stable ratio.
• Gold could be freely exported or imported.
• The exchange rate between two countrys
  currencies would be determined by their relative
  gold contents.

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Classical Gold Standard 1875-1914

• 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

30 6 5 1
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Classical Gold Standard 1875-1914

• 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.

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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.

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Classical Gold Standard 1875-1914

• 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.

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The Relationship between Money and Growth

• Money is needed to facilitate economic
  transactions.
• MVPY ?The equation of exchange.
• Assuming velocity (V) is relatively stable, the
  quantity of money determines the level of
  spending.
• If sufficient monetary instruments are not
  available, it may restrain the level of economic
  transactions.
• If income (Y) grows but money (M) is constant,
  prices (P) must fall. This creates a deflationary
  trap.
• Deflationary episodes were common in the U.S.
  during the Gold Standard.

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Interwar Period 1915-1944

• 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

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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.

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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.

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Bretton Woods System 1945-1972
U.S. dollar
Pegged at 35/oz.
Gold
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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

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Composition of SDR
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The Flexible Exchange Rate Regime 1973-Present.

• Flexible exchange rates were declared acceptable
  to the IMF members in Jamaica Jan. 1976.
• 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.

16
Value of since 1965
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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 (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.

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European Monetary System

• Eleven European countries maintain exchange rates
  among their currencies within narrow bands, and
  jointly float against outside currencies.
• Objectives
• To establish a zone of monetary stability in
  Europe.
• To coordinate exchange rate policies vis-à-vis
  non-European currencies.
• To pave the way for the European Monetary Union.

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What Is the Euro?

• The euro is the single currency of the European
  Monetary Union which was adopted by 11 Member
  States on 1 January 1999.
• These original member states were Belgium,
  Germany, Spain, France, Ireland, Italy,
  Luxemburg, Finland, Austria, Portugal and the
  Netherlands.

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EURO CONVERSION RATES
 
l
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The Euro

• The sign for the new single currency looks like
  an E with two clearly marked, horizontal
  parallel lines across it.
• It was inspired by the Greek letter epsilon, in
  reference to the cradle of European civilization
  and to the first letter of the word 'Europe'.
• All insurance and other legal contracts continued
  in force with the substitution of amounts
  denominated in national currencies with their
  equivalents in euro.

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Value of the Euro in U.S. Dollars

• January 1999 to July 2004

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Theory of Optimum Currency Areas

• Cost and benefits depend on how well integrated
  its economy is with those of its potential
  partners
• Fixed exchange rates are most appropriate for
  areas closely integrated through international
  trade and mobility of the factors of production

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Optimum Currency Areas Benefits
Monetary Efficiency Gain

• Monetary Efficiency Gain
• Savings that arise from floating rates
• Uncertainty
• Confusion
• Calculation
• Transaction costs

GG
Close economic integration leads to inter-network
price stability
Degree of Economic Integration
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Optimum Currency Areas Costs
Economic Stability Loss

• Economic Stability Loss
• Giving up ability to use exchange rate and
  monetary policy stability of output and
  employment
• Under fixed exchange rates monetary policy has no
  power to affect domestic output
• Reduce economic stability loss due to output
  market disturbances

LL
Degree of Economic Integration
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Optimum Currency Area Decisions

• Variability in their product markets makes
  countries less willing to enter fixed exchange
  rate areas
• After the 1973 oil shocks countries were
  unwilling to revive the Bretton Woods system of
  fixed exchange rates
• Fixed rate of exchange best serve the economic
  interests of each of its members when the degree
  of economic integration is high

Gain or Loss
GG
Loss Exceeds Gain
Gain Exceeds Loss
LL
?0
Degree of Economic Integration
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Optimum Currency Areas

• Degree of Economic Integration
• They trade a lot with each other
• There is high degree of labor mobility among them
• Economic shocks they face are highly correlated
  (systematic shocks)
• There exists a federal fiscal system to transfer
  fund to regions that suffer adverse shocks

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The European Union

• Trade
• EU members export from 10 to 20 of their output
  to other EU members
• The US exports about 2 of its GNP to EU members
• Mobility of Labor
• The US has only small differences in the
  unemployment rate between regions because of
  almost complete mobility
• Europe has certain impediments to mobility
• Language
• Culture
• Regulations

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The Long-Term Impact of the Euro

• If the euro proves successful, it will advance
  the political integration of Europe in a major
  way, eventually making a United States of
  Europe feasible.
• It is likely that the U.S. dollar will lose its
  place as the dominant world currency.
• The euro and the U.S. dollar will be the two
  major currencies.

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The Mexican Peso Crisis

• On 20 December, 1994, the Mexican government
  announced a plan to devalue the peso against the
  dollar by 14 percent.
• This decision changed currency traders
  expectations about the future value of the peso.
• They stampeded for the exits.
• In their rush to get out the peso fell by as much
  as 40 percent.

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How does a devaluation affect foreign investors?

• If a U.S. investor purchases a Mexican asset,
  they must purchase pesos first.
• When the asset is sold the proceeds must be
  exchanged for prior to being repatriated, the
  U.S. investors return is affected by the
  exchange rate at that time.
• If it is higher (peso appreciation) the return to
  U.S. investor is larger in terms.
• If peso has depreciated, the returns will be
  lower.

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The Mexican Peso Crisis

• The Mexican Peso crisis is unique in that it
  represents the first serious international
  financial crisis touched off by cross-border
  flight of portfolio capital.
• Two lessons emerge
• It is essential to have a multinational safety
  net in place to safeguard the world financial
  system from such crises.
• An influx of foreign capital can lead to an
  overvaluation in the first place.

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The Asian Currency Crisis

• The Asian currency crisis turned out to be far
  more serious than the Mexican peso crisis in
  terms of the extent of the contagion and the
  severity of the resultant economic and social
  costs.
• Many firms with foreign currency bonds were
  forced into bankruptcy.
• The region experienced a deep, widespread
  recession.

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Currency Crisis Explanations

• In theory, a currencys value mirrors the
  fundamental strength of its underlying economy,
  relative to other economies. In the long run.
• In the short run, currency traders expectations
  play a much more important role.
• In todays environment, traders and lenders,
  using the most modern communications, act by
  fight-or-flight instincts. For example, if they
  expect others are about to sell Brazilian reals
  for U.S. dollars, they want to get to the exits
  first.
• Thus, fears of depreciation become
  self-fulfilling prophecies.

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Fixed vs Flexible Exchange Rate Regimes

• Arguments in favor of flexible exchange rates
• Easier external adjustments.
• National policy autonomy.
• Arguments against flexible exchange rates
• Exchange rate uncertainty may hamper
  international trade.
• No safeguards to prevent crises.

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Fixed vs Flexible Exchange Rate Regimes

• Suppose the exchange rate is 1.40/ today.
• In the next slide, we see that demand for British
  pounds far exceed supply at this exchange rate.
• The U.S. experiences trade deficits.

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Fixed vs Flexible Exchange Rate Regimes
Dollar price per (exchange rate)
Q of
42
Flexible Exchange Rate Regimes

• Under a flexible exchange rate regime, the dollar
  will simply depreciate to 1.60/, the price at
  which supply equals demand and the trade deficit
  disappears.

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Fixed versus Flexible Exchange Rate Regimes
Supply (S)
Dollar price per (exchange rate)
Demand (D)
1.40
Demand (D)
Q of
D S
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Fixed versus Flexible Exchange Rate Regimes

• Instead, suppose the exchange rate is fixed at
  1.40/, and thus the imbalance between supply
  and demand cannot be eliminated by a price
  change.
• The government would have to shift the demand
  curve from D to D
• In this example this corresponds to
  contractionary monetary and fiscal policies.

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Fixed versus Flexible Exchange Rate Regimes
Supply (S)
Contractionary policies
Dollar price per (exchange rate)
(fixed regime)
Demand (D)
1.40
Demand (D)
Q of
D S
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