Chapter 3 The International Monetary System

1. Chapter 3 The International Monetary System • Exchange Rate Systems • International Monetary System • European Monetary System and Monetary Union • Emerging Market Currency Crises

2. 3.A Exchange Rate Systems • Free (“clean”) float • Exchange rates are determined by currency supply and demand with no government intervention. • As economic parameters change, market participants adjust their current and expected future currency needs. • Shifts in currency needs in turn shift currency supply and demand schedules, as seen in Chapter 2. • Managed (“dirty”) float • Central banks intervene to reduce economic volatility. • Three categories of intervention • Smoothing out daily fluctuations – central bank buys or sells currency to smooth exchange rate adjustments. • Leaning against the wind – measures taken to moderate or prevent short- or medium-term exchange rate fluctuations caused by random events. • Unofficial pegging – a country pegs the value of its currency to a foreign currency to protect the value of its exports. Chapter 3: The International Monetary System

3. 3.A Exchange Rate Systems • Target zone arrangement • Countries agree to adopt economic policies that maintain their exchange rates within a specific range. • Designed to minimize exchange rate volatility and enhance economic stability in participating countries. • Requires coordination of economic policy objectives and practices. • Fixed-rate system • Governments maintain target exchange rates. • Central banks buy/sell currency to increase (“revalue”)/decrease (“devalue”) exchange rates when exchange rates threaten to deviate from their stated par values by more than an agreed-on percentage. • Monetary policy becomes subordinate to exchange rate policy. • Hybrid system – current international system consisting of free-float, managed-float, and pegged currencies. Chapter 3: The International Monetary System

4. 3.B International Monetary System (1) • Gold Standard – participating countries fixed the prices of their currencies in terms of a specified amount of gold. • Because the value of gold is fairly stable over time, the gold standard ensured long-run price stability for both individual countries and groups of countries, aka Self-balancing feature in Econ303 • Classical Gold Standard(1821-1914) • Characterized by price-specie-flow mechanism • Changes in the price level in one country were offset by an automatic balance of payments (“BOP”) adjustment. • As U.S. exchange rate falls, exports rise, causing BOP surplus and inflow of foreign gold. • U.S. prices rise, foreign prices fall • U.S. exports fall, foreign exports rise • BOP equilibrium achieved Chapter 3: The International Monetary System

5. 3.B International Monetary System (3) • Gold Exchange Standard(1925-1931) • The U.S. and England could hold only gold reserves • Other nations could hold both gold and dollars/pounds as reserves. • In 1931, England departed from gold given massive gold and capital flows stemming from an unrealistic exchange rate, ending the Gold Exchange Standard. • 1931-1944 • Beggar thy neighbor devaluations – countries devalued their currencies to maintain trade competitiveness, leading to a trade war. Chapter 3: The International Monetary System

6. 3.B International Monetary System (4) • Bretton Woods System (1946-1971) • Bretton Woods Conference, 1944 • New postwar monetary system • Allied nations pledged to maintain a fixed (pegged) exchange rate in terms of the dollar or gold. • 1 ounce of gold = $35 • Exchange rates could fluctuate only within 1% of their stated par values. • Fixed rates were maintained by central bank intervention in foreign exchange markets. Chapter 3: The International Monetary System

7. 3.B International Monetary System (5) • Bretton Woods System (1946-1971), continued • Bretton Woods Conference, 1944, continued • Two new institutions created • International Monetary Fund (IMF) – created to promote monetary stability • Role has evolved over time • Oversees exchange rate policies in 182 member countries • Advises developing countries on economic policy • Lender of last resort • Moral hazard – expectation of IMF bailouts leads investors to underestimate risks of lending to governments that pursue irresponsible policies • International Bank for Reconstruction and Development (World Bank) – created to lend money to countries to rebuild their war-damaged infrastructures Chapter 3: The International Monetary System

8. 3.B International Monetary System (6) • Bretton Woods System (1946-1971), continued • Collapse of Bretton Woods system • Inflation in the U.S. stemming from the Johnson Administration printing money instead of raising taxes to finance Viet Nam conflict. • West Germany, Japan, and Switzerland would not accept the inflation that a fixed exchange rate with the dollar would have imposed on them. Chapter 3: The International Monetary System

9. 3.B International Monetary System (7) • Post-Bretton Woods System (1971-Present) • Smithsonian Agreement • Dollar was devalued to 1/38 of an ounce of gold. • Other currencies revalued by agreed-on amounts in terms of the dollar. • Attempts to set new fixed rates unsuccessful. • International floating exchange rate system instituted in 1973. • System supposed to reduce economic volatility and facilitate free trade. • Floating rates would offset international differences in inflation. • Real exchange rates would stabilize given gradual changes in underlying conditions affecting trade and productivity of capital. • Nominal exchange rates would stabilize if countries coordinated their monetary policies to achieve inflation rate convergence. • However, currency volatility has increased due to non-monetary global economic shocks (e.g., changing oil prices). Chapter 3: The International Monetary System

10. 3.C European Monetary System (1) • European Monetary System (EMS) • Began operating in March 1979. • Purpose: Foster monetary stability in the European Community (EC) • Members established the European Currency Unit (ECU), a composite currency consisting of fixed amounts of the 12 EC member currencies. • The quantity of each currency reflected each country’s relative economic strength within the ECU. • In 1992, the EC became the European Union (EU). • The EU currently has 27 member states. Chapter 3: The International Monetary System

11. 3.C European Monetary System (3) • European Monetary Union (EMU, or EU) • Maastricht Treaty • Formalized the EC’s moved toward a monetary union • EC nations would establish the European Central Bank with sole power to issue a single currency (euro). • On January 1, 1999, the euro became a currency and conversion rates for the euro were locked in for member countries. • On January 1, 2002, member countries’ currencies were replaced by euro bills and coins. • To join the EU, countries were subjected to the Maastricht criteria • Government debt ≤ 60% of GDP • Budget deficit ≤ 3% of GDP • Inflation ≤ 1.5 percentage points above the average rate of Europe’s three lowest-inflation countries • Long-term interest rates ≤ 2 percentage points above the average interest rate in the three lowest-inflation countries Chapter 3: The International Monetary System

12. 3.C European Monetary System (4) • European Monetary Union (EMU, or EU), continued • Consequences of EU • Lower cross-border currency conversion costs • Eliminated risk of currency fluctuations • Facilitated cross-border price comparisons • Encouraged flow of trade and investments among member countries • Greater integration of Europe’s capital, labor, and commodity markets • Increased Europe’s competitiveness • Greater coordination of monetary policy Chapter 3: The International Monetary System

13. 3.D Emerging Market Currency Crises (1) • Currency crises spread from one country to another by two means. • Trade links – e.g., when Argentina is in crisis, it imports less from Brazil, causing Brazil’s economy to contract and its currency to weaken. Brazil’s contraction will in turn affect other trade partners. • The financial system – distress in one emerging market causes investors to exit other countries with similar risk profiles. • Common denominator in promoting currency crises: Countries issue too much short-term debt closely linked to the dollar. When the dollar depreciates, the cost of repaying dollar-linked bonds soars. Chapter 3: The International Monetary System

14. 3.D Emerging Market Currency Crises (2) • Circumventing emerging market crises • Currency controls • Abandoning free capital movement to insulate a country’s currency from speculative attacks, e.g. China • However: • Open capital markets channel savings to where they are most productive; • Developing nations need foreign capital and know-how; and • Currency controls have led to corruption. • Freely floating currency – floating rates absorb the pressures created in emerging countries that simultaneously peg their exchange rates and pursue independent monetary policy. • Permanently fix the exchange rate – through dollarization, use of a currency board, or a monetary union, an economy can permanently fix its exchange rate, e.g. Hong Kong Chapter 3: The International Monetary System