CHAPTER 3

The International Monetary System

PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS I. FIVE MARKET MECHANISMS

A. Freely Floating (Clean Float) 1. Market forces of supply and demand determine rates. 2. Forces influenced by a. price levels b. interest rates c. economic growth 3. Rates fluctuate over time randomly.

ALTERNATIVE EXCHANGE RATE SYSTEMS B. Managed Float (Dirty Float)

1. Market forces set rates unless excess volatility occurs. 2. Then, central bank determines rate.

ALTERNATIVE EXCHANGE RATE SYSTEMS C. Target-Zone Arrangement

1. Rate Determination a. Market forces constrained to upper and lower range of rates. b. Members to the arrangement adjust their national economic policies to maintain target.

ALTERNATIVE EXCHANGE RATE SYSTEMS D. Fixed Rate System

1. Rate determination a. Government maintains target rates. b. If rates threatened, central banks buy/sell currency. c. Monetary policies coordinated.

ALTERNATIVE EXCHANGE RATE SYSTEMS D. Fixed Rate System (cont)

2. Some Government Controls: a. On global portfolio investments. b. Ceilings on direct foreign direct insurance. c. Import restrictions.

ALTERNATIVE EXCHANGE RATE SYSTEMS E. Current System

1. A hybrid system a. Major currencies:use freely-floating method b. Others move in and out of various fixed-rate systems.

PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM I. THE USE OF GOLD
A. Desirable properties B. In short run: High production costs limit short-run changes. C. In long run: Commodity money insures stability.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM II.The Classical Gold Standard (1821-1914)
A. Major currencies on gold standard. 1. Involved commitment by nations to fix the price of domestic currency in terms of a specific amount of gold.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

2. 3. Maintenance involved the buying and selling of gold at that price. Disturbances in Price Levels: Would be offset by the pricespecie*-flow mechanism.

* specie refers to gold coins

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM a. Price-specie-flow mechanism had automatic adjustments:
1.) 2.) 3.) When a balance of payments surplus led to a gold inflow; Gold inflow led to higher prices which reduced surplus; Gold outflow led to lower prices and increased surplus.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM III. The Gold Exchange Standard (1925-1931)
A. B. Only U.S. and Britain allowed to hold gold reserves. Others could hold both gold, dollars or pound reserves.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

C. Currencies devalued in 1931 - led to trade wars. Bretton Woods Conference - called in order to avoid future protectionist and destructive economic policies

D.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM IV. The Bretton Woods System(1946-71) A. The Bretton Woods Agreement
1. U.S.$ was key currency; valued at $1 = 1/35 oz. of gold. 2. All currencies linked to that price in a fixed rate system. 3. Exchange rates allowed to fluctuate by 1% above or below initially set rates.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM B. Collapse, 1971

1. Causes: a. U.S. high inflation rate b. U.S.$ depreciated sharply.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM V. Post-Bretton Woods System (1971-Present) A. Smithsonian Agreement, 1971
US$ devalued to 1/38 oz. of gold. By 1973: World on a freely floating exchange rate system.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM B. OPEC and the Oil Crisis (1973-1974)
1. 2. 3. 4. OPEC raised oil prices four fold; Exchange rate turmoil resulted; Caused OPEC nations to earn large surplus B-O-P. Surpluses recycled to debtor nations which set up debt crisis of 1980s.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

C. Dollar Crisis (1977-78)

1. U.S. B-O-P difficulties 2. Result of inconsistent monetary policy in U.S. 3. Dollar value falls as confidence shrinks.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

D. The Rising Dollar (1980-85)

1. 2. 3. U.S. inflation subsides as the Fed raises interest rates Rising rates attracts global capital to U.S. Result: Dollar value rises.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

E. The Sinking Dollar:(1985-87)

1. 2. 3. Dollar revaluated slowly downward; Plaza Agreement (1985) G-5 agree to depress US$ further. The Louvre Agreement (1987) G-7agree to support the falling US$.

A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

F. Recent History (1988-Present)

1. 2. 3. 1988 US$ stabilized Post-1991 Confidence resulted in stronger dollar 1993-1995 Dollar value falls

PART III. THE EUROPEAN MONETARY SYSTEM

I. INTRODUCTION A. The European Monetary System (EMS) 1. A target-zone method (1979) 2. Close macroeconomic policy coordination required.

THE EUROPEAN MONETARY SYSTEM B. EMS Objective:

to provide exchange rate stability to all members by holding exchange rates within specified limits.

THE EUROPEAN MONETARY SYSTEM

C. European Currency Unit (ECU)

a cocktail of European currencies with specified weights as the unit of account. 1. Exchange rate mechanism (ERM) each member determines mutually agreed upon central cross-rate for its currency.

THE EUROPEAN MONETARY SYSTEM

2. Member Pledge: to keep within 15% margin above or below the central rate.

D. EMS ups and downs

1. Foreign exchange interventions failed due to lack of support by coordinated monetary policies.

THE EUROPEAN MONETARY SYSTEM

2. Currency Crisis of Sept. 1992
a. System breaks down b. Britain and Italy forced to withdraw from EMS.

G. Failure of the EMS

members allowed political priorities to dominate exchange rate policies.

THE EUROPEAN MONETARY SYSTEM H. Maastricht Treaty

1. Called for Monetary Union by 1999 (moved to 2002) 2. Established a single currency: the euro 3. Calls for creation of a single central EU bank 4. Adopts tough fiscal standards

THE EUROPEAN MONETARY SYSTEM I. Costs / Benefits of A Single Currency

A. Benefits 1. Reduces cost of doing business 2. Reduces exchange rate risk B. Costs 1. Lack of national monetary flexibility.