chapter 2 international monetary system management 3460 institutions and practices in international...
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Chapter 2International Monetary System
Management 3460 Institutions and Practices in
International Finance
Fall 2003Greg Flanagan
September 16-22, 2003 2
Chapter Objectives:
This chapter serves to introduce the student to the institutional framework within which:
international payments are made;
movement of capital is accommodated;
exchange rates are determined.
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Outline Money The evolution of the International Monetary
System Current Exchange Rate Arrangements Euro and the European Monetary Union Currency Crisis
Mexican Peso CrisisAsian Currency Crisis
Fixed versus Flexible Exchange Rate Regimes
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Money Means of exchange Unit of account Store of value Commodity money Fiat money Characteristics of good money:
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Bimetallism: Before 1875 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, some on both. Both gold and silver were used as international
means of payment and the exchange rates among currencies were determined by either their gold or silver contents.
Gresham’s Law: ‘bad money drives out good money’ implied that it would be the least valuable metal that
would tend to circulate. Not ‘systematic’-- many disruptions in trade.
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Classical Gold Standard:1875-1914
Gold standard est. 1821 Bank of England pound notes redeemable for gold.
Full gold standard 100%
partial: more notes than gold.
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Classical Gold Standard:1875-1914
ConditionsGold 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.
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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.
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Price-specie-flow mechanism.
Arbitrage will keep the exchange rates equal. Trade flows will adjust to exchange rates by the
flow of gold. Money Supply X Velocity =Prices X Quantities.
MsV=PQ M = f (Gold) If V and Q constant G Ms P eXports iMports Guntil X=M (trade balance)
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Price-specie-flow mechanism.
Problems:Limited supply of new gold restricts the
growth of world trade and investment due to insufficient medium of exchange.
National economies respond to the exchange rate (gold reserves) rather than real production possibilities.
any national government could abandon the standard.
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Interwar Period: 1915-1944.
Gold flow ceased due to WW1 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 in the 1920s to restore the gold standard, however, major countries (i.e.USA, GB) ‘sterilized’ gold in order to pursue domestic interests.
Hyperinflation in Germany, the stock market crash, and the great depression result gold standard abandoned.
international trade and investment was profoundly diminished.
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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 International Monetary Fund (IMF) and the World Bank.
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Bretton Woods System: 1945-1972
US$ based Gold exchange Standard: the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar.
Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary.
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Bretton Woods System: 1945-1972
Increasing U.S. trade deficits occurred in the late 1950s and 1960s. Triffin Paradox: need for reserves M > X $
outflow more $ than gold at $35 per ounce. France wants Gold for $ pressure on reserves Interest Equalization Tax (1963) and the Foreign
Credit Restraint Program (1965-68) Special Drawing Rights (SDR) established by IMF Smithsonian agreement: US$38/ounce; band
2.25% 1973 US$42/ounce 1973 the US$ is released from the gold standard.
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Special Drawing Rights Weighted average of currencies
Currency 1981-85 1986-90 1991-95 1996-2000
2001-2005
US$ 42 42 40 39 45
Euro 29German Mark
19 19 21 21
Japanese Yen
13 15 17 18 15
British pound
13 12 11 11 11
French Franc
13 12 11 11
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Supply and Demand Review
A digression
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The Market Model Demand and Supply
Shows how the price and output of a commodity are determined in a competitive market.
When relevant variables change it shows how these changes affect the price and output.
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Demand (coffee)
Price. We expect that as the price goes up, the quantity demanded goes down and vice versa.
Income. Changes in income modify people’s consumption opportunities. It is hard to say a priori, however, what effect such changes have on consumption of a given good. normal good: as incomes go up, people
use some of their additional income to purchase more coffee.
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Demand
inferior good: it may be that as incomes increase, people consume less coffee, perhaps spending their money on cognac instead.
We expect that changes in income affect demand one way or the other, but in some cases it is hard to predict the direction of the change. Px Inferior good: I D& v. v.Normal good: I D& v. v.
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Demand Prices of related goods.
substitutes: if the price of tea goes up people can substitute coffee for tea, this increase in the price of tea increases the amount of coffee people wish to consume.
complements: if the price of cream goes up and if people consume coffee and cream together, this tends to decrease the amount of coffee consumed.
Tastes. The extent to which people “like” a good affects the amount they demand.
Expectations
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Demand A demand schedule (or demand curve) is the
relation between the market price of a good and the quantity demanded of that good during a given time period, other things being the same. (Economists often use the Latin for “other things being the same,” ceteris paribus.) Dx = F(Px, I, Psub, Pcomp, T, Ex, etc.)
Dx =f(Px)c.p. A hypothetical demand schedule for coffee is
represented graphically by curve Dc=f(Pc)
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Demand Curve
Change in ‘Quantity Demanded’ due to a change in Price
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Increase in Demand due some variable other than Price
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Supply Price. We expect that as the price goes up, the
quantity supplied goes up and vice versa. It is reasonable to assume that the higher the price per pound of coffee, the greater the quantity profit-maximizing firms are willing to supply.
Costs, or Prices of inputs. Coffee producers employ inputs to produce coffee—labour, land, and fertilizer. If their input costs go up, the amount of coffee that they can profitably supply at any given price goes down.
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Supply Conditions of production. The most important
factor here is the state of technology. If there is a technological improvement in coffee production, the supply increases.
Other variables. also affect production conditions. For agricultural goods, weather is important. Several years ago, for example, flooding in Latin America seriously reduced the coffee crop.
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Supply A supply schedule (or supply curve) is the
relation between the market price of a good and the quantity demanded of that good during a given time period, other things being the same. (Economists often use the Latin for “other things being the same,” ceteris paribus.) Sx = F(Px, Costs, Tech, etc.)
Sx =f(Px)c.p. A hypothetical supply schedule for coffee is
represented graphically by curve Sc=f(Pc)
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Supply Curve
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Decrease in Supply due some variable other than Price
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Equilibrium
The demand and supply curves provide answers to a set of hypothetical questions: If the price of coffee is $2 per pound, how much are consumers willing to purchase? If the price is $1.75 per pound, how much are firms willing to supply? Neither schedule by itself tells us the actual price and quantity. But taken together, the schedules determine price and quantity.
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Equilibrium
equilibrium—a situation that tends to be maintained unless there is an underlying change in the system.
Quantity demanded equals quantity supplied.
In the next Figure the demand schedule Dc is superimposed on the supply schedule Sc.
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Market Equilibrium
September 16-22, 2003 32
i.e. suppose the price is P1 dollars per pound. At this price, the quantity demanded is Q1 and the quantity supplied is Q1
Price P1 cannot be maintained, because firms want to supply more coffee than consumers are willing to purchase. This excess supply tends to push the price down, as suggested by the arrows.
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Decrease in Supply due to some variable other than price changing. i.e. Costs of production increase.
September 16-22, 2003 34
Arbitrage
Market AP
QY
PA
Y*
S
D
P
QY
Market B
S
Y*
PB
D
D*
S*
Pe
Buy in the low market DSell in the high market S
Arbitrage brings markets together over space,bringing a common price (except transaction costs).
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Back to the Main History
September 16-22, 2003 36
The Flexible Exchange Rate System 1973—
The Jamaica Agreement 1976 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.
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The Flexible Exchange Rate System 1973—
The IMF continued assistance to countries experiencing Balance of Payments and foreign exchange problems.
And non-oil-exporting countries and less-developed countries were given greater access to IMF funds.
However, assistance was conditional on practicing IMF proscribed economic policy resentment and dissent.
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1973—The Flexible Exchange Rates:
The Plaza Accord 1985G5 Agreed to let the $US slide
The Louvre Accord 1987G7 cooperate for greater exchange
rate stability More closely coordinate economic
policies
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Current Exchange Rate Arrangements
Independent FloatMarket determined
Some management (intervention) to moderate the rate of fluctuations.
The largest about 41 countries, (including Canada).
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Current Exchange Rate Arrangements
Managed Float Active government intervention in
market forces to set exchange rates.
With no preannounced path for the exchange rate
About 42 countries
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Current Exchange Rate Arrangements
Exchange rates with crawling bandsCentral rate with +/- margins
Adjusted periodically on set dates or due to set quantitative indicators.
~6 countries
i.e. Venezuela
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Current Exchange Rate Arrangements
Crawling PegsAdjusted periodically on set dates or
due to set quantitative indicators.
~4 countries
i.e. Bolivia
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Current Exchange Rate Arrangements
Pegged with horizontal bandsFormal or de facto fixed rate with
margins greater than +/- 1%
5 countries
i.e. Denmark
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Current Exchange Rate Arrangements
Conventional Pegged rate pegged to a major currency ($) or
basket of currencies (SDR)
Narrow band fluctuation <1%
~40 countries
i.e. China
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Current Exchange Rate Arrangements
Currency Board arrangements Legislated commitment to exchange
domestic currency for a specified currency at a fixed exchange rate
Combined with restrictions on the issuing authority 9bioard) to ensure its legal obligations.
i.e. Hong Kong US$; Estonia €
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Current Exchange Rate Arrangements
No separate Currency (legal tender) Another country’s currency circulate
or the country belongs to a currency union
i.e. Ecuador US$
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European Monetary System
The euro € is the single currency of the European Monetary Union which was adopted by 12 Member States on 11 on January 1st 1999. and Greece in 2000.
Marks, Francs, Lira, etc. are no longer independent currencies.
Fixed exchange rates:European Central Bank
September 16-22, 2003 48
1 Euro is Equal to:
40.3399 BEF Belgian franc
1.95583 DEM German mark
166.386 ESP Spanish peseta
6.55957 FRF French franc
.787564 IEP Irish punt
1936.27 ITL Italian lira
40.3399 LUF Luxembourg franc
2.20371 NLG Dutch gilder
13.7603 ATS Austrian schilling
200.482 PTE Portuguese escudo
5.94573 FIM Finnish markka
40.750 GRD Greek Drachma
September 16-22, 2003 49
European Monetary SystemBenefits
Reduced transaction costselimination of exchange rate uncertaintyNo hedging costs
Promote cross border investments and tradeIncreased competition prices
Integration of financial marketsContinental capital markets
Political cooperation and peace
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European Monetary SystemCosts
Loss of sovereignty over national monetary and exchange rate policies.
Mundell: Theory of optimal common currency area. currency common factor resource
mobility: differing economic conditions mean resources move.
Immobility of resources different currencies adjust to differing economic conditions.
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The ‘Trilemma’
1. Fixed Exchange rate.2. Free international flows of capital3. An independent monetary policy
Can choose only two
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The ‘Trilemma’
Fixed ratesreduce uncertainty foreign tradetie monetary and fiscal policies to
exchange rate maintenance
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The ‘Trilemma’
Flexible exchange ratesincrease uncertainty.
• however, hedging can be used
monetary and fiscal policies can be independent and used to achieve other goals.
No safeguards to prevent currency crises.
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Fixed versus Flexible Exchange Rate Regimes
Suppose the exchange rate is US$1.40/£ today.
In the next slide, we see that the quantity demanded for British pounds far exceed the quantity supplied at this exchange rate.
The U.S. experiences trade deficits.
September 16-22, 2003 55
Fixed versus Flexible Exchange Rate Regimes
QS QDQ of £
Dol
lar
pric
e pe
r £
(exc
hang
e ra
te)
$1.40
Trade deficit
Demand (D)
Supply (S)
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Fixed versus Flexible Exchange Rate Regimes
Supply (S)
Demand (D)
Demand (D*)
QD = QS
Dollar depreciates (flexible regime)
Q of £
Dol
lar
pric
e pe
r £
(exc
hang
e ra
te)
$1.60
$1.40
September 16-22, 2003 57
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.
September 16-22, 2003 58
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.
September 16-22, 2003 59
Fixed versus Flexible Exchange Rate Regimes
If the exchange rate is “fixed” at US$1.40/£, and thus the imbalance between supply and demand cannot be eliminated by a price change.
The US government would have to intervene in order to demand or supply
i.e. a shift of demand from D to D* through contractionary monetary and fiscal policies.
September 16-22, 2003 60
Fixed versus Flexible Exchange Rate Regimes
Supply (S)
Demand (D)
QD* = QS
(fixed regime)
Q of £
Dol
lar
pric
e pe
r £
(exc
hang
e ra
te)
$1.40
Demand (D*)
Contractionary policies (T )
September 16-22, 2003 61
Fixed versus Flexible Exchange Rate Regimes
Supply (S)
Demand (D)
QD = QS*
(fixed regime)
Q of £
Dol
lar
pric
e pe
r £
(exc
hang
e ra
te)
$1.40
Contractionary policies i
Supply (S*)