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Evolution of International Monetary Systems: Past, Present, and Future

This article explores the progression of international financial structures and their relation to domestic monetary systems, from commodity money to paper currency and the gold standard. It examines the impact of exchange rates on trade and the role of central banks in controlling money supply.

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Evolution of International Monetary Systems: Past, Present, and Future

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  1. FIN 40500: International Finance Exchange Rate Systems; Past, Present, and Future

  2. The evolution of the international financial structure is really an extension of the evolution of domestic monetary systems • Recall that money must satisfy three basic properties: • Unit of Account • Store of Value • Medium of Exchange Initially, currencies were defined as standardized weights of metal One US Dollar = 0.056 ounces of Gold Price of Gold = $17.86 per ounce Paper currency was initially a proxy for the underlying metal Nixon removed dollar convertibility completely in 1971 – the beginning of the current international system!

  3. During the days of commodity money (i.e. gold coins), the money supply was essentially fixed. Households choose money holdings based on income, interest rates and prices In the long run, the price level equates supply and demand

  4. One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold! When gold production outpaces economic growth (which drives money demand), prices rise.

  5. One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold! However, when gold production can’t keep up with economic growth, prices must fall.

  6. One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold! REAL GDP PER CAPITA (000s) During the late 1800’s to the early 1900’s, US growth averaged around 3% per year

  7. One problem with the commodity system is that prices were subject to random fluctuations in the supply of the commodity – in this case, gold! New mining technologies rapidly increase gold production Gold Discovered at Sutter’s Mill, CA – California gold rush begins

  8. Correspondingly, we had severe deflation followed by severe inflation!!

  9. International trade will dictate the international flow of gold. British ships sail to the US with gold to buy American goods (US Exports = Inflow of gold) American ships set sail for England – loaded with gold to buy British goods (US Imports = Outflow of gold)

  10. If the US runs a trade deficit with Britain, then gold is flowing out of the US and into Britain US prices fall relative to British prices which reduces the trade deficit Note: the exchange rate is fixed at 1!!

  11. As early as 1600, paper money began to be used as a proxy for gold. Acme National Bank Assets Liabilities $100 $100 Individual deposits $100 worth of gold Bank issues $100 worth of notes Reserve Ratio = 100%

  12. However, banks would create more notes than it held in gold! Acme National Bank Assets Liabilities $100 (Gold) $100 (Notes) + $100 (Loan) + $100 (Notes) $200 $200 The notes are loaned out to create a business loan The bank prints $100 worth of new notes Reserve Ratio = 50% The reserve ratio is dependant on the bank’s loan policy

  13. Now the supply of money us related to the supply of gold, but that relationship can change! (rr = reserve ratio) Households choose money holdings based on income, interest rates and prices

  14. The trade adjustment process was unaffected because international transactions were done in gold. Acme National Bank The conversion would pull $50 in notes out of circulation in the US Assets Liabilities - $50 (Gold) - $50(Notes) A $50 import would require a conversion of notes into gold That gold would flow to England to be exchanged for British gold notes

  15. Therefore, bank notes didn’t interfere with the stabilizing force of gold flows – trade deficit countries would see a net outflow of gold which would contract the money supply US prices fall relative to British prices which reduces the trade deficit Note: the exchange rate is still fixed at 1!!

  16. However, reserves/money supplies were influenced by gold prices Suppose that Acme bank is currently maintaining a 50% reserve ratio Assets Liabilities $100 (Gold) $200 (Notes) An increase in gold prices causes individuals to return their bank notes and redeem them for gold (say, $50 worth) Assets Liabilities $100 (Gold) $200 (Notes) -$50 (Gold) -$50 (Notes)

  17. Assets Liabilities The loss of gold reserves causes the reserve ratio to drop to 33% $100 (Gold) $200 (Notes) -$50 (Gold) -$50 (Notes) $50 (Gold) $150 (Notes) The increase in gold supplies returns the price of gold to its initial level The contraction of gold notes lowers the money supply – forcing down prices

  18. By 1860, most countries had adopted national currencies (i.e. had turned their money supply process over to a single entity.) The values of these currencies were maintained by tying them to gold – the beginning of the gold standard era • In the US, we went through three “phases” of money supply: • The US Treasury • Nationally Chartered Banks • The Federal Reserve System

  19. The Gold Standard had three basic rules: • In each country, currency was convertible into gold on demand at a fixed, pre-specified rate ($20.67 = 1 oz) • Each country allowed for coinage of gold at a mint • No restrictions on imports/exports of gold US Federal Reserve System Assets Liabilities 10 tons (320,000 oz) x $20.67/oz $6,614,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) The US maintained approximately an 11.7% reserve ration during the gold standard era

  20. The key property of the gold standard is that the central bank is left with very little flexibility to control the supply of it’s nation’s currency: US Federal Reserve System Assets Liabilities $6,614,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) + $10,000,000 (Gold) + $10,000,000 (US Currency) Suppose that the federal reserve wishes to increase the supply of currency – it undertakes an open market purchase of gold

  21. US Federal Reserve System Assets Liabilities $6,614,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) + $10,000,000 (Gold) + $10,000,000 (US Currency) - $10,000,000 (Gold) - $10,000,000 (US Currency) Rising gold prices causes individuals to redeem their currency for gold.– This contracts the money supply and returns to price of gold to parity

  22. US Federal Reserve System Assets Liabilities $6,614,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) + $10,000,000 (TBills) + $10,000,000 (US Currency) Alternatively, the Federal could use the newly printed money to buy Treasury Bills – however, this influences the reserve ratio A drop in the reserve ratio lowers the value of a currency

  23. US Federal Reserve System Assets Liabilities Reserve Ratio 10 tons (320,000 oz) x $20.67/oz $6,614,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) Suppose that the Federal Reserve raised the price of gold to $35 US Federal Reserve System Assets Liabilities Reserve Ratio 10 tons (320,000 oz) x $35.00/oz $11,200,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills)

  24. Devaluations also allow the central bank to increase the money supply US Federal Reserve System Assets Liabilities Reserve Ratio 10 tons (320,000 oz) x $35.00/oz $11,200,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) + Gold + Currency in Circ. If the fed increases the price of gold to $35 while in private markets, the price of gold is $25, individuals will buy gold in private markets (demand for gold rises) $35 $25

  25. The gold standard created an implied exchange rate system P = $20.67 $20.67 e = = 4.25 L 4.87 P* = L 4.87 • If e = $5.00 (the pound is overvalued), an arbitrage opportunity exists • Buy gold in US ($1 = 1/20.67 oz) • Sell gold in Britain (1/20.67)*L4.87 = L.2356 • Convert Pounds back to $s ( L.2356 * 5.00 = $1.18)

  26. Trade deficits would tend to depreciate the dollar in currency markets – this would lead to gold flowing out of the US through arbitrage $20.67 P = $20.67 e = = 4.25 L 4.87 P* = L 4.87 US Federal Reserve System Assets Liabilities These gold flows will contract the money supply in the US and lower US reserve assets – what can the Fed do about this? 10 tons (320,000 oz) x $35.00/oz $11,200,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) - Gold - Currency in Circ.

  27. Monetary systems such as the gold standard left currencies open to speculative attacks. US Federal Reserve System Suppose that speculators believed that the US Fed would devalue its currency (i.e. raise the price of gold). The correct move would be to buy gold in preparation. Assets Liabilities 10 tons (320,000 oz) x $35.00/oz $11,200,400 (Gold) $56,222,400 (US Currency) $49,608,000 (T-Bills) - Gold - Currency in Circ. As current gold prices rose above the central banks conversion rate, individuals buy gold from the fed and sell it in open markets – the money supply contracts and the Fed’s reserves drop. $45 $35

  28. Currency pegs operate exactly like a gold standard except that the reserve asset becomes another country’s currency: Assets Liabilities Reserve Ratio 10 Million Euro x $1.12/Euro $11,200,000 (Euro) $60,808,000 (US Currency) $49,608,000 (T-Bills) For example, if the US decided to peg to the Euro at a price of $1.12 per Euro, we would need to acquire Euro assets (either cash or Euro bonds) There is one big difference here…what is it?

  29. Mama knows best! “If Billy jumped off the Brooklyn Bridge, would you do it to?” Under a gold standard, the commodity to which you are pegged is in relatively fixed supply – Euros ARE NOT in fixed supply, but are controlled by the ECB.

  30. Currency pegs force you to “adopt” the monetary policy of the country to which you are pegging: Assets Liabilities Reserve Ratio 10 Million Euro x $1.12/Euro $11,200,000 (Euro) $60,808,000 (US Currency) $49,608,000 (T-Bills) + Euro Reserves + US Currency Suppose that the ECB increases the supply of Euros – this will (all else equal) cause the dollar to appreciate – the Fed would need to buy Euro in currency markets

  31. Further, currencies that are pegged are subject to speculative attacks. Assets Liabilities 10 Million Euro x $1.12/Euro $11,200,000 (Euro) $60,808,000 (US Currency) Reserve Ratio $49,608,000 (T-Bills) - Euro Reserves - US Currency Suppose that the markets believe that the dollar is overvalued (i.e. that the $1.12 per Euro is too low) The profitable move would be to buy Euro from the Fed with the intention of selling them back later at a higher price– this will cost the Fed its Euro reserves!!

  32. The Bretton Woods System (1945 – 1972) 1L = $2.80 $35/oz. 625 Lira = $1 DM 2 = $1 The dollar became the “nominal anchor” - tying (indirectly) every other currency to gold

  33. $35/oz. DM 2 = $1 Assets Liabilities Assets Liabilities $100M (Gold) $500M (Currency) $30M ($) DM 100M (Currency) DM 10 (Gold) $400M (T-Bills) DM 30M (Bonds) While gold would be the primary reserve asset in the US, $s were the primary reserve asset in Europe

  34. $35/oz. DM 2 = $1 Assets Liabilities Assets Liabilities $100M (Gold) $500M (Currency) $30M ($) DM 100M (Currency) DM 10 (Gold) $400M (T-Bills) DM 30M (Bonds) - Dollar Reserves - DM Suppose that trade imbalances were causing a Deutschemark depreciation. Germany would be obliged to use its dollar reserves to buy back its currency – this costs them reserves!!

  35. $35/oz. DM 2 = $1 Assets Liabilities Assets Liabilities $100M (Gold) $500M (Currency) $30M ($) DM 100M (Currency) DM 10 (Gold) $400M (T-Bills) DM 30M (Bonds) + Dollar Reserves + DM However, if the US ran a trade deficit that was causing the dollar to depreciate (all other currencies are appreciating), again Germany would need to respond – buying dollars

  36. The Twin Deficits Trade Balance Government Deficit With the Vietnam War and Johnson’s Great Society programs, the US began running sizable trade deficits and government deficits – this creates a perceived weakness in the dollar.

  37. The perceived weakness of the dollar materializes in two ways: $35/oz. DM 2 = $1 Assets Liabilities Assets Liabilities $100M (Gold) $500M (Currency) $30M ($) DM 100M (Currency) DM 10 (Gold) $400M (T-Bills) DM 30M (Bonds) - Gold - US Dollars + Dollar Reserves + DM Upward pressure on gold prices forces the Fed to sell gold – losing reserves Downward pressure on the dollar forces European countries to buy dollars – increasing their dollar reserves

  38. In 1967-1968: the British pound devalues to $2.40 (-14%). This triggers a massive run on US gold. The US loses $3.2B (20% of reserves) in three months! Private market prices of gold rise as high as $45! Convertibility of gold is suspended in open markets 1970-1971: In an effort to stimulate the economy (and to get re-elected), Nixon pressures the Fed to cut interest rates 1969 1971 1967 1966 1968 1970 1972 1969-1971: The US enters a recession. This creates even more speculation against the dollar. August 15, 1971: Nixon officially closes the gold window. Without implicit gold backing, the system totally collapses.

  39. The ERM (European Exchange Rate Mechanism) was the precursor to the Euro. The Basis of the ERM was the ECU (European Currency Unit) Total = $1.02 Per ECU

  40. DM 3.64 = 1 ECU Assets Liabilities Each country in the mechanism pegged to the ECU at a specified rate (essentially the same rate as the dollar) 30M ECU DM 100M (Currency) DM 10 (Gold) DM 30M (Bonds) Each country’s foreign exchange reserves were made up of cash/assets of all the member countries

  41. 1992: George Soros speculates against the pound. The pound is devalued by 25%. Italy and Britain drop out of the ERM 1998: Euro introduced. ECU converted to Euros at 1:1 rate. 1995 2000 1979 1972 1992 1998 2002 1979: European Community Members agree to the European Exchange Rate Mechanism January 2002: Euros begin circulating

  42. The Euro-zone consists of 12 countries Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain Will Join…. (2007 Slovenia (2008) Estonia, Cyprus, Latvia, Malta (2009) Slovakia, Lithuania (2010) Czech Republic, Hungary (2011) Poland (Not Before 2012) Sweden (???) Bulgaria, Romania

  43. The Eurozone is an example of a currency union – the strictest of exchange rate systems. A currency union is very much a “permanent peg”. Its important that countries pegged to one another are similar in economic structure • A Budget Deficit of no more than 3% of GDP • National debt of no more than 60% of GDP • Inflation within 1.5% of 3 best performing EU countries • Long term interest rates within 2% of 3 lowest interest rate EU countries Eurozone countries must meet strict entry requirements Note: France and Germany routinely violate these conditions!

  44. What does the future hold for exchange systems? Currency unions seem to be the trend! • Currency Unions Currently in Operation • European Union: Euro • West African Economic and Monetary Union (7 countries): CFA Franc • East Caribbean Monetary Union (8 countries): East Caribbean Dollar • Gulf Cooperation Council Monetary Union • Unions Still in the Planning Stages • Central American Monetary Union • Asia Currency Union • North American Monetary Union: Amero?

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