The International Monetary System: Chapter Two

The International Monetary System
Chapter Two
Copyright © 2012 by the McGraw-Hill Companies,
Inc. All rights reserved.
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

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International Monetary System
What is the international monetary system? the overall

financial environment in which multinational corporations and
international investors operate.
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
• 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.

Gresham’s Law
• Gresham’s Law implies that the least valuable metal
is the one that tends to circulate.
• Suppose that you were a citizen of Germany during
the period when there was a 20 German mark coin
made of gold and a 5 German mark coin made of
silver.
– If gold suddenly and unexpectedly became much more
valuable than silver, which coins would you spend if you
wanted to buy a 20-mark item and which would you keep?

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.

• 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

• 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.

• The pound is pegged to gold at 5 pounds per ounce, whereas 1
ounce of gold is worth 10 francs
• The exchange rate between the pound and the franc is 2
francs per pound.
• Suppose that one pound is trading for 1.80 francs at the
moment.
• Since the pound is undervalued in the exchange market,
people will buy pounds with francs
1000 francs = 555.55 pounds
555.55 pounds /5 = 111.11 ounces of gold
111.11 ounces of gold x 10 francs = 1111.11 francs
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

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.

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.

Bretton Woods System: 1945-1972
German
British mark French
pound franc
Par
Value
• The U.S. dollar was U.S. dollar

pegged to gold at
$35/ounce and other Pegged at $35/oz.
currencies were pegged
to the U.S. dollar. Gold

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.

Current Exchange Rate Arrangements
• Free Float
– The largest number of countries, about 33, allow market forces to
determine their currency’s value.
• Managed Float
– About 46 countries combine government intervention with market
forces to set exchange rates.
• Pegged to another currency
– Such as the U.S. dollar or euro.
• No national currency
– Some countries do not bother printing their own currency. For
example, Ecuador, Panama, and El Salvador have dollarized.
Montenegro and San Marino use the euro.

• Currency Board
– Fixed exchange rates combined with restrictions on the issuing
government.
– Eliminates central bank functions such as monetary policy and lender
of last resort (e.g., Hong Kong).
• Conventional Peg
– Exchange rate publicly fixed to another currency or basket of
currencies.
– Country buys or sells foreign exchange or uses other means to control
the price of the currency (e.g., Saudi Arabia, Jordan, and Morocco).

• Stabilized Arrangement
– A spot market exchange rate that remains within a margin
of 2 percent for six months or more and is not floating
(e.g., China, Angola, and Lebanon).
• Crawling Peg
– Like the conventional peg, but the crawling peg is adjusted
in small amounts at a fixed rate of change or in response to
changes in macro indicators, (e.g., Bolivia, Iraq, and
Nicaragua).

The Value of the U.S. Dollar since 1960

The Euro
• The euro is the currency of the European Monetary Union,
adopted by 11 Member States on January 1, 1999.
• There are 7 euro notes and 8 euro coins.
• The notes are: €500, €200, €100, €50, €20, €10, and €5. The
coins are: 2 euro, 1 euro, 50 euro cent, 20 euro cent, 10, euro
cent, 5 euro cent, 2 euro cent, and 1 euro cent.
• The euro itself is divided into 100 cents, just like the U.S.
dollar.

Euro Area
• Austria
• Belgium
• Cyprus  Ireland
• Finland  Italy
• France  Luxembourg
• Germany  Malta
• Greece  The Netherlands
 Portugal
 Slovenia
 Slovakia
 Spain

Value of the Euro in U.S. Dollars

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.

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.

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.

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.
– An influx of foreign capital can lead to an
overvaluation in the first place.

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 bonds were forced
into bankruptcy.
• The region experienced a deep, widespread recession.


Origins of the Asian Currency Crisis
• As capital markets were opened, large inflows of private
capital resulted in a credit boom in the Asian countries.
• Fixed or stable exchange rates also encouraged unhedged
financial transactions and excessive risk-taking by both
borrowers and lenders.
• The real exchange rate rose, which led to a slowdown in
export growth.
• Also, Japan’s recession (and yen depreciation) hurt.

• If the Asian currencies had been allowed to depreciate in real
terms (not possible due to the fixed exchange rates), the
sudden and catastrophic changes in exchange rates observed in
1997 might have been avoided
• Eventually something had to give—it was the Thai bhat.
• The sudden collapse of the bhat touched off a panicky flight of
capital from other Asian countries.

Lessons from the Asian Currency Crisis
• A fixed but adjustable exchange rate is problematic in
the face of integrated international financial markets.
– A country can attain only two the of three conditions:
1. A fixed exchange rate.
2. Free international flows of capital.
3. Independent monetary policy.

China’s Exchange Rate
• China maintained a fixed exchange rate between the renminbi (RMB) yuan and the
U.S. dollar for a long time.
– The RMB floated between 2005 and 2008 and then again starting in 2010.
• There is mounting pressure from China’s trading partners for a stronger RMB.

Potential as a Global Currency
• For the RMB to become a full-fledged global
currency, China will need to satisfy these conditions:
– Full convertibility of its currency.
– Open capital markets with depth and liquidity.
– The rule of law and protection of property rights.
• The United States and the euro zone satisfy these
conditions.

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.

• 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.

• 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.

Currency Crisis Explanations
• In theory, a currency’s value mirrors the fundamental strength
of its underlying economy, relative to other economies, in the
long run.
• In the short run, currency trader expectations play a much
more important role.
• In today’s environment, traders and lenders, using the most
modern communications, act on fight-or-flight instincts. For
example, if they expect others are about to sell Brazilian reals
for U.S. dollars, they want to “get to the exits first.”
• Thus, fears of depreciation become self-fulfilling prophecies.

Fixed versus Flexible Exchange Rate Regimes
• Some countries, including the United States and
possibly Japan, prefer flexible exchange rates,
while others, the members of the EMU and many
developing countries, would like to maintain
fixed exchange rates.
• It is worthwhile to examine some of the
arguments advanced in favor of fixed versus
flexible exchange rates

• Arguments in favor of flexible exchange rates:
– Easier external adjustments.
– National policy autonomy.
• a balance-of payment deficit -> excess supply
of the country’s currency -> the external value
of the country’s currency will depreciate ->
the balance-of-payments disequilibrium will
disappear

• As long as the exchange rate is allowed to be
determined according to market forces,
external balance will be achieved
automatically
-> the government does not have to take policy
actions to correct the balance-of-payments
disequilibrium
-> the government can use its monetary and
fiscal policies to pursue whatever economic
goals it chooses Copyright © 2014 by the McGraw-Hill Companies,
• Arguments against flexible exchange rates:
– Exchange rate uncertainty may hamper international trade ->
when future exchange rates are uncertain, businesses tend to
avoid foreign trade -> resources will be allocated suboptimally
on a global basis -> However, firms can hedge exchange risk
by means of currency forward or options contracts, uncertain
exchange rates do not necessarily hamper international trade.
– No safeguards to prevent crises.

Under a fixed rate regime, the government may have to
take contractionary (expansionary) monetary and fiscal
policies to correct the balance-of-payments deficit
(surplus) at the existing exchange rate.
-> the government cannot use the same policy tools
to pursue other economic objectives.
-> As a result, the government loses its policy
autonomy under a fixed exchange rate regime

• Suppose the exchange rate is $1.40/€ today.

• In the next slide, we see that demand for the euro far
exceeds supply at this exchange rate.
• The United States experiences trade deficits.
• 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.

Dollar price per €
(exchange rate)
Supply (S)
$1.60
Dollar depreciates (flexible
regime)
$1.40
Demand (D)
Trade deficit
QS QD = QS QD Q of €
• 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 shift corresponds to contractionary
monetary and fiscal policies.

Dollar price per €
Contractionary Supply (S)

(exchange rate)
policies
(fixed regime)
$1.40
Demand (D)
Demand (D*)
QD* = QS Q of €

The International Monetary System: Chapter Two

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The International Monetary System: Chapter Two

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The International Monetary System

Copyright © 2014 by the McGraw-Hill Companies,

What is the international monetary system? the overall

Institutional framework within which:

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• Bimetallism: Before 1875

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Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

$30 = 1 ounce of gold = £6

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Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

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• The U.S. dollar was U.S. dollar

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• Flexible exchange rates were declared acceptable to the IMF

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

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Copyright © 2014 by the McGraw-Hill Companies,

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Copyright © 2014 by the McGraw-Hill Companies,

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– No safeguards to prevent crises.

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• Suppose the exchange rate is $1.40/€ today.

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

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Contractionary Supply (S)

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