Chapter 8-9 International Monetary System

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You should master: Features of a good international monetary system; Rules of the games, and the advantages and disadvantages of the three international monetary systems; The fundamental and immediate cause for the collapse of the Bretton Woods system; Some terms, like gold points,

1.1. What is an international monetary system?

Narrowly speaking, it refers to international exchange rate system. There are three international exchange rate systems in history: the gold standard, the Bretton Woods, and the floating exchange rate system.

1.2. Features of a good international monetary system

Adjustment : a good system must be able to adjust imbalances in balance of payments quickly and at a relatively lower cost; Stability and Confidence: the system must be able to keep exchange rates relatively fixed and people must have confidence in the stability of the system; Liquidity: the system must be able to provide enough reserve assets for a nation to correct its balance of payments deficits without making the nation run into deflation or inflation.

1.3 Classification of international monetary system

gold standard, gold exchange standard fiduciary standard Floating exchange rate system Fixed exchange rate system

II. The gold standard system(1880---1914) Fixed Rate System The world economy operated under a system of fixed dollar exchange rates between the end of World War II and 1973, with central banks routinely trading foreign exchange to hold their exchange rates at internationally agreed levels.

Two kinds of the fixed exchange rates

1. The fixed exchange rate system under the gold standard 2. Notes in circulation system of fixed exchange rate system 3. Gold Standard: provisions of the gold content of the monetary unit. 4. The gold content of the contrast determine the exchange rate. 5. Coins can freely casting; freely convertible; freedom of input and output.

2.1 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. In the event of a short-run liquidity crisis associated with gold outflows, the central bank should lend freely to domestic banks at higher interest rates (Bagehots Rule). If Rule I is ever temporarily suspended, restore convertibility at the original mint parity as soon as practical.

2.2 Factors that determine or affect the exchange rates

Factors that determine the exchange rates: the mint parity E.g. US$1= British Factors that influence the exchange rates: gold points and the demand for and supply of foreign exchange

2.3 Adjustment of balance of payments deficits or surpluses

Price-specie flow mechanism: Deficit gold flow out of the country gold reserve decrease money quantity theory of money supply decrease price level decrease exchange rate fixed export go up, import go down, deficit disappear The adjustment of surplus is the opposite.

2.4 Remarks and comments

An international gold standard avoids the asymmetry inherent in a reserve currency standard by avoiding the Nth currency problem. Under a gold standard, each country fixes the price of its currency in terms of gold by standing ready to trade domestic currency for gold whenever necessary to defend the official price.

The collapse of the gold standard system

It is virtually a pound standard system : Britain and British pounds position in the system Outbreak of World War I.

Advantage of the Gold Standard

Because there are N currency and N prices of gold in terms of those currencies, no single country occupies a privileged position within the system: each is responsible for pegging its currencys price in terms of the official international reserve asset, gold. Gold standard rules also require each country to allow unhindered imports and exports of gold across its borders.

Benefits and drawbacks of the Gold Standard

Benefits: 1. Symmetry 2. Price level and value of national money are more stable and predictable 3. Enhance international transactions

Drawbacks:
1. Constraints on the use of monetary policy to fight unemployment. 2. Tying currency values to gold ensures a stable overall price level only if the relative price of gold is stable.gold discovery in South America 3. An international payments system based on gold is problematic because central banks cannot increase their holdings of international reserves as their economies grow unless there are continual new gold discoveries. 4. The gold standard gives gold-producing countries power to influence the world economy

The Gold Exchange Standard

Halfway between the gold standard and a pure reserve currency standard is the gold exchange standard. Central banks reserves consist of gold and currencies whose prices in terms of gold are fixed, and each central bank fixes its exchange rate to a currency with a fixed gold price. More flexibility in the growth of international reserves.

3. The Bretton Woods System1944-1973

3.1 How this system came into being The harms and disasters that the two Wars brought the world.

3.2 Rules of the game

Fix an official par value for domestic currency in terms of gold or a currency tied to gold as a numeraire. In the short run, keep the exchange rate pegged within 1% of its par value, but in the long-run leave open the option to adjust the par value unilaterally if the IMF concurs. Permit free convertibility of currencies for current account transactions, but use capital controls to limit currency speculation.

Fixed Exchange Rates under currency-circulation system

Notes in circulation under the Bretton Woods system. 1944 Bretton Woods agreement The result of a compromise by the United Kingdom to the United States "double hook" system. 1% National currencies 1=35

dollar

Yen ...
Lire ...

How to sustain the Fixed Rate

1. Use gold reserves 2. By making use of discount policies 3. Foreign exchange controls 4. Official devaluationslast resort

3.3 Features of the system

IMF to see that this system runs on smoothly More flexibility in exchange rates More channels to correct imbalances in balance of payments

3.4 Adjustment of balance of payments imbalances

Offset short-run balance of payments imbalances by use of official reserves and IMF credits, and sterilize the impact of exchange market interventions on the domestic money supply Adjust fundamental imbalances by change the par value permanently, provided agreed by the IMF

3.4 Adjustment of balance of payments imbalances

Subordinate domestic monetary and fiscal policies to maintain fixed exchange rate (use monetary policy to keep price level and fiscal policy--government expenditures minus tax revenues--- to offset imbalances between private savings and investment): Deficit contractionary monetary or fiscal policy price level decrease exchange rate fixed export go up, import go down, deficit disappear The adjustment of surplus is the opposite.

3.5 Remarks and comments

Advantages Disadvantages: exchange rates are not flexible, Triffin Paradox

Triffin Paradox
liquidity
U.S. run deficits
U.S. run surplus

confidence

3.6 Collapse of the Bretton Woods System: Process of dollar devaluation

Dollar value per ounce of gold 35 1

38

42.22

1944

1971

1973

Abandoned Gold Exchange Standard

The post-World War II reserve currency system centered on the dollar was, in fact, originally set up as a gold exchange standard. While foreign central banks did the job of pegging exchange rates, the U.S. Federal Reserve was responsible for holding the dollar price of gold at $35 an ounce. By the mid-1960s, the system operated in practice more like a pure reserve currency system than a gold standard. President Nixon unilaterally severed the dollars link to gold in August 1971, shortly before the system of fixed dollar exchange rates was abandoned.

4. The present Floating Exchange Rate

System (1973-present)
4.1 How this system came into being A system of no system An order of no order---Features of this system No par values, between home currency and foreign currency or gold No upper or lower limits of exchange rate fluctuations The government has no obligation to maintain exchange rate fixed, it can choose any kind of exchange rate system, flexible rates are legal

1. 2. 3. 4. 5.

4.2 Rules of the game

Smooth short-term variability in the dollar exchange rate, but do not commit to an official par value or to long-term exchange rate stability Permit free convertibility of currencies for current account transactions, while endeavoring to eliminate all remaining restrictions on capital account transactions Use the U.S. dollar as the intervention currency and keep official reserves primarily in U.S. treasury bonds Modify domestic monetary policy to support major exchange rate interventions, reducing the money supply when the national currency is weak against the dollar and expanding the money supply when the national currency is strong

4.3 Features of this system

More currencies can be used as reserve assets Governments began to cooperate to intervene in the foreign exchange markets and to coordinate their domestic policies to achieve common prosperity Many different kinds of exchange rates appear

Types of floating exchange rates

1. 2.

1. 2. 3. 4.

Whether there is a dirty hand: Free Float/Clean Float Managed Float/Dirty Float Whether there is a Connection with other currencies: Single Float 27 Pegged Float(1) (2) SDR; ECU; Joint Float Crawling peg

4.4 Adjustment of imbalances in balance of payments

IMF credits Change of exchange rates: devaluations or revaluations Coordination between governments: the Plaza Agreement, the Lourve Accord, etc Domestic policies: Two-gap theory C+I+G+X=C+S+T+M X-M=(S-I)+(T-G)

5. Should we return to a fixed rate system?

What kind of international monetary system should we adopt? What are the advantages and disadvantages of fixed and floating exchange rate system respectively?

5.1 Arguments favoring floating rates

1. 2. 3. 4. 5. 6. Better adjustment Better confidence Better liquidity Gains from freer trade Avoiding the so-called Peso Problem Increased independence of policy

5.2 Arguments against floating exchange rates: Flexible rates

1. Cause uncertainty and inhibit international trade and investment 2. Cause destabilizing speculation 3. Will not work for open economies 4. Are inflationary 5. Are unstable because of small trade elasticities 6. Cause structural unemployment

Krugman & Obstfeld (1)

1. Discipline. Central banks freed from the obligation to fix their exchange rates might embark on inflationary policies. 2. Destabilizing speculation and money market disturbances. Speculation on changes in exchange rates could lead to instability in foreign exchange markets. 3. Injury to international trade and investment. Floating rates would make relative international prices more unpredictable.

Krugman & Obstfeld (2)

4. Uncoordinated economic policies. The door would be opened to competitive currency practices harmful to the would economy. 5. The illusion of greater autonomy. Floating exchange rates would not really give countries more policy autonomy. Changes in exchange rates would have such pervasive macroeconomic effects that central banks would feel compelled to intervene heavily in foreign exchange markets even without a formal commitment to peg.

5.3 Selection of Fixed & Floating Exchange Rates