International Monetary System

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• International Monetary System
• (chapter 2)

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International Monetary System

• International monetary system institutional
  framework within which international payments are
  made, movements of capital are accommodated, and
  exchange rates among currencies are determined
• To buy foreign goods and services you need
  foreign money/currency/exchange
• Foreign exchange rate the price of one
  countrys currency in units of another currency

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Evolution of the International Monetary System

• Bimetallism Before 1875
• - 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.
• Classical Gold Standard 1875-1914
• - The exchange rate between two countrys
  currencies would be determined by their relative
  gold contents

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Ex if the dollar is pegged to gold at U.S.20.67
1 ounce of gold, and the British pound is
pegged to gold at 4.2474 1 ounce of gold, it
must be the case that the exchange rate is
determined by the relative gold contents Ex
Lets assume that the current market exchange
rate is 5 per . Using the information from the
above example, how would you take advantage of
this situation?
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• Highly stable exchange rates under the classical
  gold standard provided
• an environment that was conducive to
  international trade and investment
• Shortcomings
• - as more gold is discovered or brought into the
  country money
• supply increases leading to inflation
• 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

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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
• weakening/deterioration/depreciation/devaluation
  of a currency refers to a drop in foreign
  exchange value of a currency. The opposite of
  devaluation is revaluation/appreciation
• -attempts were made to restore the gold standard,
  but participants lacked the political will to
  follow the rules of the game

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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
• - 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

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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(XR) 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 HK dollar to the U.S. dollar
• No national currency
• Some countries do not bother printing their own,
  they just use the U.S. dollar. For example,
  Ecuador has recently dollarized

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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 member states
are Belgium, Germany, Spain, France, Ireland,
Italy, Luxemburg, Finland, Austria, Portugal and
the Netherlands Greece joined the club in
2001 The euro itself is divided into 100
cents Monetary policy conducted by European
Central Bank
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Benefits and costs of Monetary Union (Euro)

• Benefits
• reduced transaction costs
• elimination of the XR risk
• promote cross-border investments and mergers
• increase the depth and liquidity of the European
  financial markets
• promote political cooperation
• Costs
• Loss of monetary and XR independence

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The Mexican Peso Crisis
On December 20, 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. In their rush to get out the
peso fell by as much as 40 percent. Faced with an
international crises, US administration and IMF
put together a 53 billion bail-out plan that
stabilized the markets 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
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Why the peso devaluation was bad for foreign
investors?
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The Asian 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
• On July 2, 1997 the Thai baht was suddenly
  devalued
• Within days was followed by Philippine
  peso,Malaysian ringgit, Indonesian rupiah
• By the end of 1997, Thai baht and Korean won lost
  50 of the value Indonesian rupiah fell 80
• Many firms with foreign currency bonds were
  forced into bankruptcy
• The region experienced a deep, widespread
  recession with annual industrial reduction
  declines between 10 to 20

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Currency Crises Explanations

• In theory, a currencys value mirrors the
  monetary and fiscal policies,
• and the fundamental strength of its underlying
  economy, relative
• to other economies.
• the monetary and fiscal policies were too lax
  suggesting a
• weaker currency
• large inflows of capital during the years before
  the crisis that
• (i) didnt result in currency appreciation and
  (ii) was wasted in
• unprofitable investments
• - fixed XR encouraged unhedged financial
  transactions
• poor corporate governance
• poor credit and risk management of the financial
  institutions

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Lessons from the currency crises

• A country can control only two out of the
  following three conditions (i) a fixed exchange
  rate, (ii) free international flow of capital (no
  capital control) (iii) independent monetary
  policy
• Liberalization of financial markets when combined
  with weak financial institutions, property rights
  and business laws creates problems
• Fiscal and monetary discipline is very important
• Better financial disclosure is important

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Learning outcomes

• Discuss the exchange rate arrangements under the
  Classical Gold
• Standard under the Bretton Woods System
• Understand the differences between fixed and
  floating exchange rates
• Discuss the current exchange rate arrangements
• Discuss the European Monetary System
• Know background information about the Euro
• Benefits and costs of the European Monetary
  Union
• Provide a brief discussion of the Mexican and
  Asian crises
• Discuss several factors responsible for the
  onset and development
• of the currency crises
• Lessons from the currency crises
• Recommended end-of-chapter questions 4, 5, 9, 12