Module 1.

The International Monetary System

Chapter 2

Massey University | massey.ac.nz | 0800 MASSEY

Outline

⚫ Evolution of the international monetary system

⚫ Summary: alternative exchange rate systems
⚫ European Monetary System
⚫ The euro and the European Monetary Union
⚫ Major currency crises
⚫ Fixed versus flexible exchange rate regimes
⚫ The incompatible trinity
 International Monetary System
International monetary system is the institutional
framework within which international payments are
made, movements of capital are accommodated, and
exchange rates among currencies are determined.

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

 Bimetallism: Before 1875
A “double standard” that gold and silver were used
as international means of payment.
⚫ Bank notes are fully redeemable for gold or silver,
and vice versa.
⚫ The exchange rate between gold and silver was
fixed officially.

❖ The exchange rates among currencies were

determined by either their gold or silver contents.
Example
Suppose the United States and Great Britain are on
the gold standard
⚫ the dollar is pegged to gold at U.S. $30 = 1 ounce
of gold,
⚫ the British pound is pegged to gold at £6 = 1 ounce
of gold,
➢ The dollar-pound exchange rate is determined by
the relative gold contents:
$30 = 1 ounce of gold = £6
➢ $5 = £1
The Gresham’s Law

➢ The least valuable metal would tend to circulate.

The Gresham’s Law: bad (more abundant) money

drives out the good (more scarce) money.
Classical Gold Standard: 1875-1914

⚫ Gold alone was assured of unrestricted coinage.

⚫ A 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
was determined by their relative gold contents.
Trade imbalance under the Gold Standard
Suppose Great Britain exported more to France than it
imported from France. Can this persist?
➢ A net flow of gold from France to Great Britain.
➢ Depress the price level in France and increase the
price level in Britain.
➢ Slow exports from Great Britain and encourage
exports from France.
➢ Trade imbalance will be corrected automatically.
The Merit of Classical Gold Standard

The price-specie-flow mechanism - automatic

corrections of international imbalances of payment
and misalignment of exchange rates.
➢ Stable exchange rates provided an environment
conducive to international trade and investment.

However, the supply of newly minted gold is restricted

- the lack of sufficient monetary reserves hamper the
growth of world trade and investment.
 Interwar Period: 1915-1944
⚫ Many countries used “predatory” depreciations of
currencies to gain advantage in international trade.
➢ The sterilization of gold.

• Currency debasement - decrease the amount of

precious metal in a coin while continuing to
circulate it at face value.
⚫ The result for international trade and investment
was profoundly detrimental.
Bretton Woods System: 1945-1972
In 1944, 44 nations met at Bretton Woods, New
Hampshire to discuss the design of a postwar
international monetary system.
Goal: to achieve exchange rate stability without the
gold standard.
Created:
⚫ The IMF and the World Bank.
⚫ The gold-exchange standard.
Bretton Woods System: 1945-1972
⚫ US$ was pegged to gold at $35 per ounce.
⚫ 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.
➢ A a dollar-based gold exchange standard.
Illustration of Bretton Woods System

German
British mark French
pound franc
Par
Value

U.S. dollar

Pegged at $35/oz.

Gold
 Special Drawing Rights (SDRs)
⚫ Two key reserve assets (gold and the U.S. dollar)
became inadequate for supporting the growing world
trade and financial development.
⚫ A new international reserve asset, SDR, is created
and allocated by the IMF in 1969 to supplement
member countries' official reserves.
⚫ Currently, the value of SDR is based on a basket of
five major currencies: US$, euro, £, JPY and RMB.
⚫ SDRs can be exchanged for freely usable currencies.
Special Drawing Rights (SDRs)
The value of the SDR is based on a weighted average of the
values of a basket of currencies comprising the U.S. dollar,
euro, Chinese renminbi, Japanese yen, and pound sterling.
Year 2022
U.S. dollar 0.4338
Euro 0.2931
Chinese yuan 0.1228
Japanese yen 0.0759
Pound sterling 0.0744
Source: IMF website
https://www.imf.org/en/About/Factsheets/Sheets/2023/special-drawing-
rights-sdr
Collapse of the Gold Exchange Standard
The fast growth of the world economy and global trade
demand more international reserve assets.
⚫ US government had to run BOP deficits continuously.
⚫ 1970: the gold content of US$ more than halved due
to the cost of Vietnam war and high oil & food price.
⚫ Germany, Switzerland and France demanded gold
from the U.S. government.
⚫ 1971: U.S. government suspended the convertibility of
US$ into gold, US$ devalued against gold.
Flexible Exchange Rate Regime: 1973 -
⚫ JPY and major European currencies started to float
in 1973.
⚫ Flexible exchange rates were declared acceptable
to the IMF members in 1976.
⚫ Central banks were allowed to intervene in the exchange
rate markets to iron out unwarranted volatilities.
⚫ Non-oil-exporting countries and less-developed countries
were given greater access to IMF funds.
A Brief History of New Zealand Currency
⚫ 1840s: circulation of British and other foreign coins.
⚫ 1858: British coins were made legal tender by law.
⚫ 1897: British and Australian coins both widely used.
⚫ 1914: gold coin started to withdraw from circulation.
⚫ 1933: introduced own coins, designed after British coins.
⚫ 1960s: changed to decimal coinage system.
⚫ 1979: crawling peg to a currency basket.
⚫ 1985: free float
Summary: Fixed Exchange Rate System
⚫ Government maintains fixed rates.
⚫ If rates threatened, central banks buy/sell currency.
⚫ Monetary policies are coordinated.

✓ MNCs know the future exchange rates.

 Governments can revalue their currencies.
 Each country is vulnerable to the economic conditions in
other countries.
Summary: Floating Exchange Rate System
⚫ Exchange rates are determined by market forces without
governmental intervention.
✓ Each country is more insulated from the economic problems
of other countries.
✓ Central bank intervention just to control FX rates not needed.
✓ Governments are not constrained by the need to maintain FX
rates when setting new policies.
✓ Less capital flow restrictions are needed, thus enhancing
market efficiency.
 MNCs need to manage their exposure to FX risk.
Other Exchange Rate Systems
⚫ Managed Float
⚫ market forces combined with government intervention.
⚫ Pegged (to another currency or basket of currencies)
⚫ Market forces constrained to upper and lower range of
rates.
⚫ Adjust economic policies to maintain target.
⚫ No national currency
⚫ Ecuador and Panama (dollar), San Marino (euro).
 The European Monetary System
Established in 1970s, European countries maintain
exchange rates among their currencies within narrow
bands, and jointly float against outside currencies.
Objectives:
⚫ Establish a zone of monetary stability in Europe.
⚫ Coordinate exchange rate policies against non-
European currencies.
⚫ Pave the way for the European Monetary Union.
The Euro
⚫ The single currency of the EMU.
⚫ Adopted by 11 Member States on 1 January 1999.
Now has 19 member states.
⚫ Initially an invisible currency only used for
electronic payments.
⚫ Banknotes and coins were introduced 01/01/2002.

Official website of the ECB:

http://www.ecb.int/euro/intro/html/index.en.html
Costs of Monetary Union
Close macroeconomic policy coordination is required.
⚫ Loss of national monetary policy independence.
⚫ Loss of exchange rate policy independence.

A more trade-dependent and less economically

diversified country is more vulnerable to shocks to the
economy.
❑ The eurozone debt crisis 2010: started in Greece,
then spread to Irish Republic, Portugal and other
eurozone countries..
The Argentinean Peso Crisis

⚫ In 1991: the pass of law for convertibility between

the peso and the U.S. dollar at parity.
⚫ Initially, received positive economic effects:
⚫ Argentina’s chronic inflation was curtailed.
⚫ Foreign investment poured in.

⚫ Appreciation of U.S. dollar caused the peso to

become stronger.
➢ Hurt exports and caused economic downturn.
The Argentinean Peso Crisis

▪ Lack of fiscal discipline

▪ Labor market inflexibility
▪ Contagion from the financial crises in Brazil and
Russia
❑ unemployment rate > 20%,
❑ monthly inflation as high as 20%.

➢ Peso–dollar parity was abandoned in Jan. 2002.

The Mexican Peso Crisis

The 1st serious international financial crisis touched

off by cross-border flight of portfolio capital.

⚫ On 20/12/1994, Mexican government announced a

plan to devalue the peso against the dollar by 14%.
⚫ Currency traders are worried about the future value
of the peso.
➢ They rushed to get out of the peso
➢ The peso fell by as much as 40% in two weeks.
The Asian Currency Crisis
⚫ Capital markets were opened - large inflows of capital.
⚫ A credit boom - fixed or stable exchange rates encouraged
unhedged financial transactions and excessive risk-taking.
⚫ Export growth slowed down.
⚫ Thai baht collapsed in 1997.
⚫ Touched off panicky flight of capital from other countries.
⚫ Many firms with foreign currency bonds bankrupted.
⚫ The region experienced a deep, widespread recession.
Lessons from the Currency Crises
⚫ An influx of foreign capital can lead to an
overvaluation of a currency.
⚫ Fixed but adjustable exchange rate is problematic
in the face of integrated international financial
markets
⚫ It is essential to have a multinational safety net in
place to safeguard the world financial system from
such crises.
Fixed or Flexible, How to Choose?
Arguments in favor of flexible exchange rates:
⚫ Easier external adjustments.
⚫ National fiscal and monetary policy autonomy.
⚫ Significant international reserve is not necessary.

Arguments against flexible exchange rates:

⚫ Exchange rate uncertainty may hamper
international trade.
⚫ No safeguards to prevent crises.
External Adjustment Mechanism under Fixed
versus Flexible Exchange Rate Regimes

Example:

⚫ Suppose the exchange rate is $1.20/£ today.

⚫ In the next slide, we see that demand for the pound
far exceeds supply at this exchange rate.
⚫ The United States experiences trade deficits.
 External Adjustment Mechanism:
Fixed versus Flexible Exchange Rates
Dollar price per £
(exchange rate)

Supply of £ (S)

$1.20
Demand for £ (D)
U.K. Trade surplus
U.S. Trade deficit

QS QD Q of £
Adjustment under Flexible Exchange Rate Regime
Dollar price per £
(exchange rate) Supply of £ (S)

Pound appreciates
$1.40 Dollar depreciates
$1.20
Demand for £ (D)

QS QD = QS QD Q of £

Under a flexible exchange rate regime, the dollar will

simply depreciate to $1.40/£, the price at which
supply equals demand and the trade deficit disappears.
Adjustment under a Fixed Rate Regime

⚫ Instead, suppose the exchange rate is “fixed” at

$1.20/£, and thus the imbalance between supply
and demand cannot be eliminated by a price
change.
⚫ The UK government would have to shift the
demand curve from D to D*, or shift the supply
curve right.
⚫ In this example, this shift corresponds to
contractionary monetary and fiscal policies.
Adjustment under Fixed Exchange Rate Regime

Supply of £ (S)
Dollar price per £
(exchange rate)

Contractionary
policies (UK)
$1.20 Demand for £ (D)

Demand for £ (D*)

QD* = QS Q of £
QD = QS QD
Adjustment under Fixed Exchange Rate Regime

Supply of £ (S)
Dollar price per £
(exchange rate)

Supply of £ (S*)

$1.20 Demand for £ (D)

QS* = QD Q of £
QD = QS
International Monetary System Constrain

Characteristics of a “perfect” exchange rate regime:

1. Fixed/stable exchange rate,
2. Unrestricted money flows,
3. Independent monetary policy.

The incompatible trinity - a country can attain only two

of the three conditions.
Homework:
Chapter 2: 1-4, 9-12.

Next Week:

Spot and forward foreign exchange markets

Exchange rate quotations (chapter 5)