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International Monetary System

International Monetary System. Chapter Two. Chapter Two 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 The Argentine Peso Crisis

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International Monetary System

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  1. International Monetary System Chapter Two

  2. Chapter Two 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 • The Argentine Peso Crisis • Fixed versus Flexible Exchange Rate Regimes

  3. Evolution of the International Monetary System • Bimetallism: Before 1875 • Classical Gold Standard: 1875-1914 • Interwar Period: 1915-1944 • Bretton Woods System: 1945-1972 • The Flexible Exchange Rate Regime: 1973-Present

  4. Bimetallism: Before 1875 • Bimetallism was a “double standard” in the sense that both gold and silver were used as money. • Some countries were on the gold standard, some on the silver standard, and some on both. • Both gold and silver were used as an international means of payment, and the exchange rates among currencies were determined by either their gold or silver contents.

  5. Gresham’s Law • Gresham’s Law implies that the least valuable metal is the one that tends to circulate. “Bad(abundant) money drives our good (scarce) money”

  6. Classical Gold Standard: 1875-1914 • During this period in most major countries: • Gold alone was assured of unrestricted coinage. • There was two-way convertibility between gold and national currencies at a stable ratio. • Gold could be freely exported or imported. • The exchange rate between two country’s currencies would be determined by their relative gold contents.

  7. Classical Gold Standard: 1875-1914 For example, if the dollar is pegged to gold at U.S. $30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: $30 =1 ounce of gold = £6 $30 =£6 $5 = £1

  8. Classical Gold Standard: 1875-1914 • Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. • Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

  9. Price-Specie-Flow Mechanism • Suppose Great Britain exports more to France than France imports from Great Britain. • This cannot persist under a gold standard. • Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. • This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. • The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

  10. Classical Gold Standard: 1875-1914 • There are shortcomings: • The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. • Even if the world returned to a gold standard, any national government could abandon the standard. 2-10

  11. Interwar Period: 1915-1944 • Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. • Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game.” • The result for international trade and investment was profoundly detrimental.

  12. Interwar Period: 1915-1944 • The interwar period was characterized by economic nationalism, failure to restore the gold standard, economic and political instabilities, bank failures and panicky flights of capital across borders. • During this period, US dollar emerged as the dominant world currency, gradually replacing the British pound for the role.

  13. Bretton Woods System: 1945-1972 • Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. • The purpose was to design a postwar international monetary system. • The goal was exchange rate stability without the gold standard. • The result was the creation of the IMF and the World Bank.

  14. German mark British pound French franc Par Value Par Value Par Value Bretton Woods System: 1945-1972 • The U.S. dollar was pegged to gold at $35 /ounce and other currencies were pegged to the U.S. dollar. U.S. dollar Pegged at $35/oz. Gold

  15. The Flexible Exchange Rate Regime: 1973-Present • 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.

  16. The Value of the U.S. Dollar since 1960

  17. European Monetary System • European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. • European Monetary System (EMS) was launched in 1979. • Objectives: • To establish a zone of monetary stability in Europe. • To coordinate exchange rate policies vis-à-vis non-European currencies. • To pave the way for the European Monetary Union. 2-17

  18. European Monetary System • There are two main instruments of the EMS are; • European Currency Unit • Exchange Rate Mechanism • European Currency Unit(ECU) is a basket currency constructed as a weighted average of the currencies of member countries of the European Union. • ECU serves as the accounting unit of the EMS and plays an important role in the workings of the exchange rate mechanism.

  19. European Monetary System • Exchange Rate Mechanism (ERM) refers to the procedure by which EMS member countries collectively manage their exchange rates. • ERM is the operational part of the EMS. • Currencies within the ERM are expected to remain within given limits of their bilateral central rates compared to other currencies in the ECU.

  20. European Monetary System • The band which the currency was allowed to deviate from the parity with the other currencies was widened. • A turbulence existed in the EMS. • EU countries signed Maastricht Treaty in 1991. • The treaty requires that the EMS will irrevocably fix exchange rates among the countries and introduce a common European currency, replacing individual currencies.

  21. European Monetary System Maastricht Treaty; • Keep government budget deficit/GDP below 3 % • Keep gross public debts below 60 % of GDP • Achieve a high degree of price stability • Maintain its currency within the prescribed exchange rate changes of the ERM

  22. What Is the Euro? • With the launching the euro, the European Monetary Union (EMU) was created in 1999. • The EMU is an extension of EMS and European Currency Unit was the precursor of the euro.

  23. What Is the Euro? • The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. • These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands. • 4 members countries of EU(Denmark, Greece, Sweden and UK) did not join the first wave. 2-23

  24. What Is the Euro? • Greece joined the euro club in 2001, • Slovenia adopted the euro in 2007, • Cyprus & Malta did so in 2008, • Slovakia in 2009 • Estonia in 2011

  25. The Long-Term Impact of the Euro • As 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 possible 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.

  26. The benefits of Monetary Union • Reduce transaction costs and the elimination of exchange rate uncertainty. • Enhance efficiency and competitiveness of the European economy. • Creates conditions conducive to the development of the continental capital markets with depth and liquidity. • Promote political cooperation and peace in Europe.

  27. Costs of Monetary Union • The main cost of monetary union is the loss of national monetary and exchange rate policy independence. • The more trade-dependent and less diversified a country’s economy is the more prone to asymmetric shocks that country’s economy would be. 2-27

  28. Costs of Monetary Union • As an example, if the economy of Oklahoma was dependent on gas and oil, and oil prices fall on the world market, then Oklahoma might be better off if it had its own currency rather than relying on the U.S. dollar. • This example shows that perhaps the benefits of monetary union typically outweigh the costs. 2-28

  29. Macroeconomic Data for Major Economies

  30. The Mexican Peso Crisis • On December 20, 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, and they stampeded for the exits. • In their rush to get out the peso fell by as much as 40 percent.

  31. The Mexican Peso Crisis • The Mexican Peso 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. Disclosure requirements, transparency • An influx of foreign capital can lead to an overvaluation in the first place.

  32. The Asian Currency Crisis • The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. • Many firms with foreign currency debts were driven to extreme financial distress. • The region experienced a deep, widespread recession.

  33. The Asian Currency Crisis

  34. The Asian Currency Crisis

  35. Origins of the Asian Currency Crisis • Several factors are responsible for the onset of the Asian Currency Crisis: - A weak domestic financial system - Free international capital flows - Contagion effects of changing market sentiment - Inconsistent economic policies

  36. Lessons from the Asian Currency Crisis • Countries first strengthen their domestic financial system and then liberalize their financial markets. • The government should strengthen its system of financial-sector regulation and supervision. • Banks should base their lending decisions on economic merits rather than political considerations. • The reliable financial data should be provided to the public in a timey fashion.

  37. Lessons from the Asian Currency Crisis • A country should encourage foreign direct investments and equity and long-term bond investment; should not encourage short term investments. • Countries should not restore the same fixed exchange rate system unless they are willing to impose capital controls. • Economists are talking about the “so-called trilemma” and “incompatible trinity”

  38. The Argentinean Peso Crisis • In 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar at parity. • The initial economic effects were positive: • Argentina’s chronic inflation was curtailed. • Foreign investment poured in. • As the U.S. dollar appreciated on the world market the Argentine peso became stronger as well.

  39. The Argentinean Peso Crisis • However, the strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of peso–dollar parity in January 2002. • The unemployment rate rose above 20 percent. • The inflation rate reached a monthly rate of 20 percent.

  40. The Argentinean Peso Crisis 2-40

  41. The Argentinean Peso Crisis • There are at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis: • Lack of fiscal discipline • Labor market inflexibility • Contagion from the financial crises in Brazil and Russia 2-41

  42. Fixed versus 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. 2-42

  43. Fixed versus Flexible Exchange Rate Regimes

  44. Fixed versus Flexible Exchange Rate Regimes • Suppose the exchange rate is $1.40/€ today. • In the next slide, we see that demand for euro far exceeds supply at this exchange rate. • The U.S. experiences trade deficits. 2-44

  45. Supply (S) Demand (D) $1.40 Trade deficit QS QD Fixed versus Flexible Exchange Rate Regimes Dollar price per € (exchange rate) Q of € 2-45

  46. 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. 2-46

  47. $1.60 Dollar depreciates (flexible regime) Fixed versus Flexible Exchange Rate Regimes Supply (S) Dollar price per € (exchange rate) Demand (D) $1.40 Demand (D*) Q of € QD = QS 2-47

  48. 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. 2-48

  49. Fixed versus Flexible Exchange Rate Regimes Supply (S) Contractionary policies Dollar price per € (exchange rate) (fixed regime) Demand (D) $1.40 Demand (D*) Q of € QD* = QS 2-49

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