International Monetary System

1. International Monetary System • Exchange Rate Systems • Floating Rate System vs Fixed Exchange Rate Systems • Brief History • The Eurocurrency Market

2. Exchange Rate Systems Classifications of exchange rate systems • An economist’s classification • Floating Exchange Rate Systems • Fixed Exchange Rate Systems • The IMF’s classification • More Flexible Systems • Limited Flexibility Systems • Pegged systems

3. Exchange Rate Systems cont’d • Floating (Flexible) Exchange Rate Systems • Exchange rates determined by forces of demand and supply • Demand for local currency • Supply of local currency • Depreciation and Appreciation • Movements in Exchange Rates correct BOP deficits or surpluses • no need for external adjustment mechanism E.g. U.K in deficit against U.S => £ in excess supply => £ falls in value => Export cheaper Import expensive => Deficit eliminated $/£ S D0 D1 £

4. Exchange Rate Systems cont’d • Fixed Exchange Rate Systems • Exchange Rates Determined by Governments (Central Banks) • Devaluation and Revaluation • Involve mechanisms to Correct Deficits or Surpluses in BOP • Illustration of a price adjustment Mechanism • Because exchange rate is not allowed to affect prices, government attempts to influence price levels • Deficit requires decreasing money supply - reducing general price level • Surplus requires increasing money supply - increasing general price level • E.g. U.K. £ in a dollar standard exchange rate system. Say U.K. has deficit against U.S. • Deficit requires buying local currency (decreasing money supply) • Surplus requires selling local currency (increasing money supply) => £ in excess supply => U.K. buys £ in currency market => general price level in U.K. falls => deficit reduced => Speculation: Keep track of reserve (in currencies) - devaluation likely if country keeps losing reserve

5. Exchange Rate Systems cont’d Advantages of Floating Rate Systems • Better adjustment for BOP imbalances • Insulates countries from changes in inflation, wage levels and unemployment in other countries • Independence of Monetary and Fiscal Policies • Better Liquidity • No need to hold foreign exchange reserve • No need defending inappropriate exchange rate Disadvantage of Floating Rate Systems • Increased volatility of exchange rate • foreign exchange risk • Inflationary

6. Exchange Rate Systems cont’d Contemporary Currency Arrangements • Exchange arrangement (e.g. the Euro area) • Dollarization • Pegged to a Currency (to dollar, FF, etc. ) - about 62 countries • Pegged to a Basket of Currencies (e.g. to the SDR) • SDR (Special Drawing Right) - a unit of account created by IMF • weighted value of currencies of 5 IMF countries with largest trade • 39% U.S Dollar; 21% German Mark; 18% Japanese Yen; 11% FF; 11% British Pound • Flexible against a Single Currency • Managed Float • Predominately market forces; Gov’t intervene to maintain “order” • Independently Floating

7. Major Exchange Rate Agreements • 1944 Bretton Woods Conference • 1971 Smithsonian Agreement • 1972 European Joint Float Agreement • 1976 Jamaica Agreement • 1979 European Monetary System (EMS) created • 1985 Plaza Accord • 1987 Louvre Accord • 1991 Treaty of Maastricht

8. Major Exchange Rate Agreements • 1944 Bretton Woods Conference • The U.S. dollar is convertible into gold at $35/ounce • Other currencies pegged to the dollar • Created IMF and World Bank • 1971 Exchange rate turmoil • dollar falls off the gold standard • most currencies begin to float on world markets • 1971 Smithsonian Agreement (Group of Ten) • dollar devalued to $38/oz of gold • other currencies revalued against the dollar • 4.5% band adopted • 1972 European Joint Float Agreement • “The snake” adopted by EEC

9. Major Exchange Rate Agreements • 1976 Jamaica Agreement • Floating rates declared “acceptable” • 1979 European Monetary System (EMS) • European Exchange Rate Mechanism (ERM) established to maintain currencies within a 2.25% band around central rates • European currency unit (ECU) created • 1985 Plaza Accord (Group of Ten) • The Group of Ten form an agreement to cooperate in controlling volatility and bringing down the value of the dollar • 1987 Louvre Accord • The Group of Five agree to maintain current levels

10. 1991 Treaty of Maastricht • European community members agree to pursue a broad agenda of economic, financial and monetary reforms • A single European currency is proposed as the ultimate goal of monetary union • 1999 Introduction of the euro • Emu-zone currencies are pegged to the euro • European bonds convert to the euro • 2002 The euro begins public circulation

11. Eurocurrency market Eurocurrency: bank deposits or loans residing outside of the country issuing the currency. E.g. Eurodollars: dollar denominated deposits residing in non-U.S. banks. • Few regulations • No reserve requirements, • No interest rate regulations or caps, • No withholding taxes, • No deposit insurance requirements, or credit allocation regulations; • Less stringent disclosure requirements • Low risk • Relatively short maturities: Maturities of less than 5 years • Low interest rate risk: Interest rates tied to a variable rate base such as the London Interbank Offer Rate (LIBOR) • Low default risk: Traded between large commercial banks, investment banks and multinational corporations • Highly competitive • Daily volume of several hundred billion dollars ensures competitive bid and offer prices

12. Spreads in domestic and Eurocurrency credit markets