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What is an international monetary system?
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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.
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Bimetallism: Before 1875
Britain- until 1816 (Neapoleonic war)
US – until 1873 (dropped silver dollar)
France – until 1878
China, India, Germany – Silver standard
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Classical Gold Standard:
1875-1914
The gold standard had its origin in the use of gold
coins as a medium of exchange, unit of account,
and store of value.
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 country’s 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
which is attributed to David Hume, Scottish
philosopher
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price-specie-flow mechanism
If any country has
Net Exports > Gold inflow > Increase in Money
supply > Increase in price level > Slower the exports
Net Imports > Gold outflow > decrease in Money
supply > decrease in price level > encourage exports
This mechanism was intended to restore
equilibrium automatically
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Rules of the game
Fix an official gold price or “mint parity” and allow free
convertibility between domestic money and gold at that
price.
Impose no restrictions on the import or export of gold by
private citizens, or on the use of gold for international
transactions.
Issue national currency and coins only with gold backing,
and link the growth in national bank deposits to the
availability of national gold reserves.
If Rule I is ever temporarily suspended, restore
convertibility at the original mint parity as soon as
possible.
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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 if
govt. finds it politically necessary to pursue national
objectives that are inconsistent with gold standards.
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The Interwar
Interwar Years,1915-1944
Period: 1918-1939
With the eruption of WW-I in 1914, the gold
standard was suspended.
The interwar years were marked by severe economic
instability and hyperinflation in Europe.
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The Interwar
Interwar Years,1915-1944
Period: 1918-1939
After war, Return to Gold Standard
1919
U.S. returned to gold
1922
A group of countries (Britain, France, Italy, and
Japan) agreed on a program calling for a general
return to the gold standard and cooperation among
central banks in attaining external and internal
objectives.
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The
The Interwar
Interwar
Interwar Years,1915-1944
Years,
Period: 1918-1939
1925
Britain returned to the gold standard
1929
The Great Depression was followed by bank
failures throughout the world.
1931
Britainwas forced off gold when foreign holders
of pounds lost confidence in Britain’s commitment
to maintain its currency’s value.
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The
TheInterwar
Interwar Years,
Period:
Interwar 1918-1939v
1915-1944
Years, 1918-1939
International Economic Disintegration
Many countries suffered during the Great Depression.
Major economic harm was done by restrictions on
international trade and payments.
These beggar-thy-neighbor policies provoked foreign
retaliation and led to the disintegration of the world
economy.
Exchange rates fluctuated as countries widely used
“predatory” depreciations of their currencies as a means
of gaining advantage in the world export market.
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Interwar Period: 1915-1944
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Bretton Woods System:
1945-1972
Named for meeting of 44 nations at Bretton
Woods, New Hampshire in July 1944.
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 Bretton Woods system was a dollar-based gold
exchange standard.
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Bretton Woods System:
1945-1972
German
British mark French
pound franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
Bretton Woods System:
1945-1972
Triffin Paradox
To satisfy the growing need for reserve, the US had to run balance
of payment deficit continuously which may eventually impair the
public confidence in the dollar
1960 – US gold stock fell short of foreign dollar holdings
created concern about viability of system
Creation of artificial reserve called SDR in 1970
SDR is basket currency allotted to IMF members
Weighted avg. of 16 currencies – more than 1 % share in
world export, 1981 only 5 currencies
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Bretton Woods System:
1945-1972
Smithsonian Agreement
To save the bretton woods system G-10 met at
Smithsonian institution in Washington.
the price of gold was raised to 38$
Each country revalued its currency by 10%
The band of 1% expanded to 2.25%
February 1973, further devaluation by 42$
By March 1973, Japan and European currecies
were allowed to float and end of Bretton woods
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Collapse of the Bretton Woods System: Process
of dollar devaluation
ounce of gold
Dollar value per
35
38
42.22
1944
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The Flexible Exchange Rate Regime:
1973-Present.
Jamaica Agreement in January 1976
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
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 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 has recently dollarized.
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IMF Classification
The current exchange rate system is a hybrid of many different arrangements.
The International Monetary Fund classifies these exchange rate regimes into
eight specific categories. The eight categories span the spectrum of exchange
rate regimes from rigidly fixed to independently floating:
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IMF Classification
Other Conventional Fixed Peg Arrangements: The country pegs its
currency at a fixed rate to a major currency or a basket of currencies , where
the exchange rate fluctuates within a narrow margin or at most ±1% around a
central rate.
Pegged Exchange Rates within Horizontal Bands: The value of the
currency is maintained within margins of fluctuation around a formal fixed
peg that are wider than ±1% around a central rate.
Crawling Pegs: The currency is adjusted periodically in small amounts at a
fixed, pre-announced rate or in response to changes in selective quantitative
indicators.
Exchange Rates within Crawling Pegs: The currency is maintained within
certain fluctuation margins around a central rate that is adjusted periodically at
a fixed pre-announced rate or in response to change in selective quantitative
indicators.
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IMF Classification
Managed Floating with No Pre-Announced Path for the Exchange Rate:
The monetary authority influences the movements of the exchange rate
through active intervention in the foreign exchange market without specifying
or pre-committing to a pre-announced path for the exchange rate.
Independent Floating: The exchange rate is market determined, with central
bank intervening only to moderate the speed of change and to prevent
excessive fluctuations, but not attempting to maintain it at or drive it to any
particular level.
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Arguments favoring floating rates
1. Better adjustment
2. Better confidence
3. Better liquidity
4. Gains from freer trade
5. Increased independence of policy
Easier external adjustments.
National policy autonomy
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Arguments against floating rates:
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Fixed versus 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 versus Flexible
Exchange Rate Regimes
Dollar price per £
Supply
(exchange rate)
(S)
Demand
$1.40 (D)
Trade deficit
S D Q of £
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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
Dollar price per £
Supply
(exchange rate)
(S)
$1.60
Dollar depreciates Demand
$1.40 (flexible regime) (D)
Demand (D*)
D=S Q of £
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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
Dollar price per £
Contractionary
Supply
(exchange rate)
policies (S)
(fixed regime)
Demand
$1.40 (D)
Demand (D*)
D* = S Q of £
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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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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 trader’s
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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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 currency’s value mirrors the fundamental
strength of its underlying economy, relative to other
economies in the long run.
In the short run, currency trader’s expectations play a
much more important role.
In today’s 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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Quiz Time
1. Explain the mechanism which restores the balance of
payments equilibrium when it is disturbed under the gold
standard.
2. Discuss the advantages and disadvantages of the gold standard.
3. What were the main objectives of the Bretton Woods system?
4. Explain how the special drawing rights (SDR) is constructed.
Also, discuss the circumstances under which the SDR was
created.
5. List the advantages of the flexible exchange rate regime.
6. Criticize the flexible exchange rate regime from the viewpoint
of the proponents of the fixed exchange rate regime.
7. Discuss the criteria for a ‘good’ international monetary system.
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