Chapter 8-9 International Monetary System

You should master:

(1) Features of a good international monetary system;

(2) Rules of the games, and the advantages and disadvantages of the three international monetary systems;

(3) The fundamental and immediate cause for the collapse of the Bretton Woods system;

(4) Some terms, like gold points,

1.1. What is an international monetary system?

Narrowly speaking, it refers to international exchange rate system.

There are three international exchange rate systems in history: the gold standard, the Bretton Woods, and the floating exchange rate system.

1.2. Features of a good international monetary system

Adjustment : a good system must be able to adjust imbalances in balance of payments quickly and at a relatively lower cost;

Stability and Confidence: the system must be able to keep exchange rates relatively fixed and people must have confidence in the stability of the system;

Liquidity: the system must be able to provide enough reserve assets for a nation to correct its balance of payments deficits without making the nation run into deflation or inflation.

1.3 Classification of international monetary system

gold standard,

gold exchange standard

fiduciary standard

Floating exchange rate system

Fixed exchange rate system

II. The gold standard system(1880---1914)

Fixed Rate System

The world economy operated under a system of fixed dollar exchange rates between the end of World War II and 1973, with central banks routinely trading foreign exchange to hold their exchange rates at internationally agreed levels.

Two kinds of the fixed exchange rates

1. The fixed exchange rate system under the gold standard

2. Notes in circulation system of fixed exchange rate system

3. Gold Standard: provisions of the gold content of the monetary unit.

4. The gold content of the contrast determine the exchange rate.

5. Coins can freely casting; freely convertible; freedom of input and output.

2.1 Rules of the gameFix an official gold price or “mint parity” and allow free convertibility between domestic money and gold at that price.Impose no restrictions on the import or export of gold by private citizens, or on the use of gold for international transactions.Issue national currency and coins only with gold backing, and link the growth in national bank deposits to the availability of national gold reserves.In the event of a short-run liquidity crisis associated with gold outflows, the central bank should lend freely to domestic banks at higher interest rates (Bagehot’s Rule).If Rule I is ever temporarily suspended, restore convertibility at the original mint parity as soon as practical.

2.2 Factors that determine or affect the exchange rates

Factors that determine the exchange rates: the mint parity

E.g. US$1= British ￡

Factors that influence the exchange rates: gold points and the demand for and supply of foreign exchange

2.3 Adjustment of balance of payments deficits or surpluses

Price-specie flow mechanism: Deficit gold flow out of the country gold reserve decrease money supply decrease quantity theory of money price level decrease exchange rate fixed export go up, import go down, deficit disappearThe adjustment of surplus is the opposite.

2.4 Remarks and comments

An international gold standard avoids the asymmetry inherent in a reserve currency standard by avoiding the “Nth currency” problem. Under a gold standard, each country fixes the price of its currency in terms of gold by standing ready to trade domestic currency for gold whenever necessary to defend the official price.

The collapse of the gold standard system

It is virtually a pound standard system :

Britain and British pound’s position in the system

Outbreak of World War I.

Advantage of the Gold Standard

Because there are N currency and N prices of gold in terms of those currencies, no single country occupies a privileged position within the system: each is responsible for pegging its currency’s price in terms of the official international reserve asset, gold. Gold standard rules also require each country to allow unhindered imports and exports of gold across its borders.

Benefits and drawbacks of the Gold Standard

Benefits:

1. Symmetry

2. Price level and value of national money are more stable and predictable

3. Enhance international transactions

Drawbacks:1. Constraints on the use of monetary policy to

fight unemployment.2. Tying currency values to gold ensures a stable

overall price level only if the relative price of gold is stable.→gold discovery in South America

3. An international payments system based on gold is problematic because central banks cannot increase their holdings of international reserves as their economies grow unless there are continual new gold discoveries.

4. The gold standard gives gold-producing countries power to influence the world economy

The Gold Exchange Standard

Halfway between the gold standard and a pure reserve currency standard is the gold exchange standard. Central banks’ reserves consist of gold and currencies whose prices in terms of gold are fixed, and each central bank fixes its exchange rate to a currency with a fixed gold price.

More flexibility in the growth of international reserves.

3. The Bretton Woods System1944-1973

3.1 How this system came into being

The harms and disasters that the two Wars brought the world.

3.2 Rules of the game

Fix an official par value for domestic currency in terms of gold or a currency tied to gold as a numeraire.In the short run, keep the exchange rate pegged within 1% of its par value, but in the long-run leave open the option to adjust the par value unilaterally if the IMF concurs.Permit free convertibility of currencies for current account transactions, but use capital controls to limit currency speculation.

Fixed Exchange Rates under currency-circulation system

Notes in circulation under the Bretton Woods system. 1944 Bretton Woods agreement

The result of a compromise by the United Kingdom to the United States "double hook" system.

金块金块

美元 dollar

National currencies

Yen ...

Lire ...

1 盎司 =35 美元

1% 幅度波动

How to sustain the Fixed Rate

1. Use gold reserves （储备项目）2. By making use of discount policies （资

本项目）3. Foreign exchange controls （或签订互换

货币协定）4. Official devaluations （ last resort ）

3.3 Features of the system

IMF to see that this system runs on smoothly

More flexibility in exchange rates

More channels to correct imbalances in balance of payments

3.4 Adjustment of balance of payments imbalances

Offset short-run balance of payments imbalances by use of official reserves and IMF credits, and sterilize the impact of exchange market interventions on the domestic money supply

Adjust fundamental imbalances by change the par value permanently, provided agreed by the IMF

3.4 Adjustment of balance of payments imbalances

Subordinate domestic monetary and fiscal policies to maintain fixed exchange rate (use monetary policy to keep price level and fiscal policy---government expenditures minus tax revenues--- to offset imbalances between private savings and investment): Deficit contractionary monetary or fiscal policy price level decrease exchange rate fixed export go up, import go down, deficit disappearThe adjustment of surplus is the opposite.

3.5 Remarks and comments

Advantages

Disadvantages: exchange rates are not flexible, Triffin Paradox

Triffin Paradox

U.S. run deficits U.S. run deficits

U.S. run surplusU.S. run surplus

liquidity

confidence

3.6 Collapse of the Bretton Woods System: Process of dollar devaluation

Dollar value per

ounce of gold

1944 1971 1973

11盎司值美元盎司值美元35

3842.22 脱钩浮动脱钩浮动

Abandoned Gold Exchange Standard

The post-World War II reserve currency system centered on the dollar was, in fact, originally set up as a gold exchange standard. While foreign central banks did the job of pegging exchange rates, the U.S. Federal Reserve was responsible for holding the dollar price of gold at $35 an ounce. By the mid-1960s, the system operated in practice more like a pure reserve currency system than a gold standard. President Nixon unilaterally severed the dollar’s link to gold in August 1971, shortly before the system of fixed dollar exchange rates was abandoned.

4. The present Floating Exchange Rate System (1973-present)

4.1 How this system came into being“A system of no system” “An order of no order”----Features of this system

1. No par values, between home currency and foreign currency or gold

2. No upper or lower limits of exchange rate fluctuations3. The government has no obligation to maintain exchange

rate fixed, it can choose any kind of exchange rate system, flexible rates are legal

4. 外汇市场供求决定汇率5. 国际收支变化是影响汇率的主要因素

4.2 Rules of the gameSmooth short-term variability in the dollar exchange rate, but do not commit to an official par value or to long-term exchange rate stabilityPermit free convertibility of currencies for current account transactions, while endeavoring to eliminate all remaining restrictions on capital account transactionsUse the U.S. dollar as the intervention currency and keep official reserves primarily in U.S. treasury bondsModify domestic monetary policy to support major exchange rate interventions, reducing the money supply when the national currency is weak against the dollar and expanding the money supply when the national currency is strong

4.3 Features of this system

More currencies can be used as reserve assetsGovernments began to cooperate to intervene in the foreign exchange markets and to coordinate their domestic policies to achieve “common prosperity” Many different kinds of exchange rates appear

Types of floating exchange rates

Whether there is a dirty hand:1. Free Float/Clean Float2. Managed Float/Dirty Float

Whether there is a Connection with other currencies:

1. Single Float 英镑，美元，日元等 27 个国家。2. Pegged Float(1) 钉住某一种货币： (2) 钉住一

揽子货币： SDR; ECU; 。3. Joint Float 欧共体。4. Crawling peg

4.4 Adjustment of imbalances in balance of payments

IMF creditsChange of exchange rates: devaluations or revaluationsCoordination between governments: the Plaza Agreement, the Lourve Accord, etcDomestic policies: “Two-gap theory” C+I+G+X=C+S+T+M

X-M=(S-I)+(T-G)

5. Should we return to a fixed rate system?

What kind of international monetary system should we adopt?

What are the advantages and disadvantages of fixed and floating exchange rate system respectively?

5.1 Arguments favoring floating rates

1. Better adjustment

2. Better confidence

3. Better liquidity

4. Gains from freer trade

5. Avoiding the so-called “Peso Problem”

6. Increased independence of policy

5.2 Arguments against floating exchange rates: Flexible rates

1. Cause uncertainty and inhibit international trade and investment

2. Cause destabilizing speculation3. Will not work for open economies4. Are inflationary5. Are unstable because of small trade

elasticities6. Cause structural unemployment

Krugman & Obstfeld (1)

1. Discipline. Central banks freed from the obligation to fix their exchange rates might embark on inflationary policies.

2. Destabilizing speculation and money market disturbances. Speculation on changes in exchange rates could lead to instability in foreign exchange markets.

3. Injury to international trade and investment. Floating rates would make relative international prices more unpredictable.

Krugman & Obstfeld (2)

4. Uncoordinated economic policies. The door would be opened to competitive currency practices harmful to the would economy.

5. The illusion of greater autonomy. Floating exchange rates would not really give countries more policy autonomy. Changes in exchange rates would have such pervasive macroeconomic effects that central banks would feel compelled to intervene heavily in foreign exchange markets even without a formal commitment to peg.

5.3 Selection of Fixed & Floating Exchange Rates

固定汇率制和浮动汇率制的选择取决于一国的国情：大国还是小国；发展中国家还是发达国家；此事古难全