The International 2

Monetary System Chapter Two

Chapter Objective:
 This chapter serves to introduce the student to the institutional
framework within which: (1) International payments are made, (2) The
movement of capital is accommodated, (3) Exchange rates are
determined.

Chapter Outline
 Evolution of the International Monetary System
 Current Exchange Rate Arrangements
 European Monetary System
 Euro and the European Monetary Union
 The Mexican Peso Crisis
 The Asian Currency Crisis
 Fixed versus Flexible Exchange Rate Regimes
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 Evolution of the
International Monetary System

 Definition: IMS is institutional framework within which

international payments are made, movements of capital are
accommodated, and exchange rates among currencies are
determined
 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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 Evolution of the International
Monetary System

Bimetallism (prior to 1875)

 Gold and Silver used as international means of payment
and the exchange rate among currencies was determined
by either their gold or silver content.

 Gresham’s law - exchange ratio between two metals

was officially fixed, therefore only more abundant metal
was used, driving the more scarce metal out of
circulation

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 Evolution of the International
Monetary System (contd.)
Classic Gold Standard (1876 - 1913)
 During this period in most major countries:
1. gold alone is assured of unrestricted coinage
2. two-way convertibility between gold and national currencies at a
stable ratio
3. gold is freely exported or imported
 The exchange rate between two country’s currencies would
be determined by their relative gold contents
 Highly stable exchange rates under the classical gold
standard provided an environment that was conducive to
international trade and investment.
 Price-specie-flow mechanism corrected misalignment of
exchange rates and international imbalances of payment

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 Evolution of the International
Monetary System (contd.)

Interwar period (1915 – 1944)

 characterized by:
 Economic nationalism
 Attempts and failure to restore gold standard
 Economic and political instability
 These factors highlighted some of the shortcomings of the
gold standard
 The result for international trade and investment was profoundly
detrimental.

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 Evolution of the International
Monetary System (contd.)

Bretton Woods System (1944 – 1973)

 Creation of the International Monetary Fund (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.
 US dollar based gold exchange standard
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 Evolution of the International
Monetary System (contd.)

 Bretton Woods System (1944 – 1973)

German
British mark French
pound franc
Par
P
r Value Va ar
Pa lue lue
Va
U.S. dollar

Pegged at $35/oz.
Gold 7
 Evolution of the International
Monetary System (contd.)

Bretton Woods System (1944 – 1973)

 Problem with the system is that U.S. constantly incurred
trade deficits as other countries wanted to maintain US$
reserves (Triffin Paradox)
 Special Drawing Rights (SDR) – new reserve asset,
(US$, FF, DM, BP, JY)
 Smithsonian Agreement (1971) – US$ devalued to
$38/oz.
 European, Japanese currencies allowed to float–Mar 1973

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 Evolution of the International
Monetary System (contd.)

Flexible Exchange Rate Regime (1973–present)

 Jamaica Agreement (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 asset.
 Non-oil-exporting countries and less-developed countries were
given greater access to IMF funds.

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 Contemporary Currency Regimes

 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 (or horizontal band around) another currency
 Such as the U.S. dollar or euro
 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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 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.
 Currencies depreciate (or appreciate) to reflect the
equilibrium value in flexible exchange rates
 Governments must adjust monetary or fiscal policies to return
exchange rates to equilibrium value in fixed exchange rate
regimes

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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
Supply
Dollar price per £
(exchange rate)

(S)

Demand
$1.40 (D)

Trade deficit

S D Q of £ 13
 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
Dollar price per £
(exchange rate)

(S)

$1.60
Dollar depreciates Demand
$1.40 (flexible regime) (D)

Demand (D*)

D=S Q of £ 15
 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
Dollar price per £

Contractionary
(exchange rate)

policies (S)
(fixed regime)

Demand
$1.40 (D)

Demand (D*)

D* = S Q of £ 17
 European Monetary System (EMS)

 EMS was created in 1979 by EEC countries to maintain

exchange rates among their currencies within narrow bands, and
jointly float against outside currencies.
 Objectives:
 Establish zone of monetary stability
 Coordinate exchange rates vis-à-vis non-EMS countries
 Develop plan for eventual European monetary union
 Exchange rate management instruments:
 European Currency Unit (ECU)
 Weighted average of participating currencies
 Accounting unit of the EMS
 Exchange Rate Mechanism (ERM)
 Procedure by which countries collectively manage exchange rates

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 What Is the Euro (€)?
 The euro is the single currency of the
EMU which was adopted by 11 Member Euro Conversion Rates
States on 1 January 1999. 1 Euro is Equal to:
 These original member states were: 40.3399 BEF Belgian franc
Belgium, Germany, Spain, France, 1.95583 DEM German mark
Ireland, Italy, Luxemburg, Finland, 166.386 ESP Spanish peseta
Austria, Portugal and the Netherlands.
6.55957 FRF French franc
 Prominent countries initially missing
.787564 IEP Irish punt
from Euro :
 Denmark, Greece, Sweden, UK
1936.27 ITL Italian lira
 Greece: did not meet convergence
40.3399 LUF Luxembourg
2.20371 NLG franc guilder
Dutch
criteria, was approved for inclusion
on June 19, 2000 (effective Jan. 13.7603 ATS Austrian
2001) 200.482 PTE schilling
Portuguese
5.94573 FIM escudo
Finnish
markka 19
 Benefits and Costs of the
Monetary Union
 Transaction costs reduced and  Loss of national monetary
FX risk eliminated and exchange rate policy
 Creates a Eurozone – goods, independence
people and capital can move  Country-specific asymmetric
without restriction shocks can lead to extended
 Compete with the U.S. recessions
 Approximately equal in terms of
population and GDP
 Price transparency and
competition

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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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 Emerging Market Crises
 The Mexican Peso Crisis (1994)
 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.
 The 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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 Emerging Market Crises
 Asian Crisis (1997)
 Prelude to a disaster:
 Thailand – fastest growing country – 1985 – 1994
 High spending and low savings => inflation (and high interest rates)
 Thai baht linked to the U.S. dollar prior to July 1997
 Corporations & banks tied together
 Massive governmental borrowing
 Some foreign investors recognized potential weaknesses in the baht
 Outflow of funds
 Downward pressure on baht
 The baht was delinked from the U.S. dollar in July 2, 1997 and the Thai
government attempted to intervene to control the slide in the baht
 Government intervention was futile
 IMF/Japan rescue package - US$20 billion – August ‘97

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 Emerging Market Crises

 Asian Crisis (1997)

 Contagious effects of the decline in the Thai baht
 SE Asian countries integrated by trade
 Demand for other regional countries products decline

 Other countries also characterized by high interest rates and

stable (government-controlled) currencies

 Most affected countries
 Malaysia, Philippines and Indonesia
 The Russian and Brazilian Crises perhaps propagated by
the Asian Crisis

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