International Finance

Lecture 2

International Monetary System

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Objectives
 Learn how the international monetary system has evolved from the
days of the gold standard to today’s eclectic currency arrangement
 Explain the currency regime choices faced by emerging markets

 Explore into other Exchange rate Regimes

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The Evolution of Capital Mobility

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The gold standard (1876-1913)
 A stable world currency system for many decades before WW 1.
 Reason: credible commitment of participating countries to exchange gold for
goods and services

 Under the classical gold standard:

 the monetary authority in each country fixes its currency value in reference to
1 oz. of gold and stands ready to buy or sell any amount of gold at that price.
 Example: US Reserve Bank agrees to buy and sell gold at US$400/ounce;
BoE at GBP250/ounce

 Fixed exchange rate is established between any 2 currencies and it is called ‘mint
parity’.
 Example: US$/GBP = 400/250=1.6

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 The Collapse of Gold Standard in the Inter-War
Years(1914-1944)
 Gold standard collapsed during WW II as governments suspended the
convertibility of their currencies and prohibited export of gold

 In 1926, a flexible exchange system adopted to control inflation.

 Under this standard, ₤ can be exchanged for gold, while other currencies can
be converted into ₤.

 In 1931, the French decided not to hold ₤ , instead exchange their ₤ for gold

 Consequently, Britain made their ₤ inconvertible into gold.

 That marked the end of gold standard, and followed by a decade of Great
Depression (1931-1939)

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 Why Gold Standard failed?
 Pre-war parities were inappropriate because of widely divergent inflation rates
among countries (the larger gold reserve countries had their currency value high
and deficit countries with very low currency value)
 Prices and wages became rigid (particular downward)
 Countries tended to sterilize BoP imbalances on a greater scale because of
concern about domestic economic instability.
 UK was no longer the single dominant financial center

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Bretton Woods System(1945-1973)
Objectives:
* to promote international capital flows
* to expand international trade
* to contribute to monetary stability.

 Resulted in the Gold Exchange Standard or US Dollar Standard

 Creation of post-war international monetary system
 Creation of World Bank and International Monetary Fund (IMF)
 The World bank to support development programs in developing countries
 The IMF to lend money for reserve management purposes
 It is a fixed but adjustable exchange rate system

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Bretton Woods System
Under this system:
 Gold was fixed at US$35/ounce

 other member countries required to peg their currencies to US$.

 The system allows the actual rates to fluctuate within ±1% of the par value.

 If the actual rate moved beyond 1% of the official par, the central bank had to
intervene in the forex market by buying or selling the domestic currency
against US$ .
 The buying and selling would affect the official reserves of the country but can
stabilize the forex rate.
 If the reserves decline to a point where the country could not maintain its par
value, then the currency is devalued.

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Bretton Woods System: 1945-1973

German
mark French
British
pound franc
Par Pa
a r Value Va r
P ue lue
a l
V
U.S. dollar

Pegged at $35/oz.

Gold
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Problems with Bretton Woods System
 First Problem: The adjustable peg system lacked stability, certainty and
automaticity of the gold standard, and the flexibility of the floating system.
 Government had to demonstrate the existence of fundamental disequilibrium
before they can adjust their par values.
 This led Britain to devalued the ₤ twice between 1949 and 1967.
 Second problem: Speculation causes destabilizing effect under such a
system where devaluation announcements made the currency fall more than
warranted
 Reason:
 speculators sell a currency when it is weak, thinking it may fall further.

 When a currency is under pressure , it can only be devalued, motivating

speculators to short sell it and make the weakening currency worse
 3rd problem: Lack of liquidity creating mechanism; the need to hold more US$
in their reserves

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 Problems with Bretton Woods System
 In 1960s, the global liquidity shortage caused a concern which led to the
emergence of ‘Triffin Paradox’ :-

 Triffin Paradox simply means:

 To avoid US$ liquidity shortage, the US must run a deficit BoP, (to import more
than export) and this would undermine the US$.

 To avoid speculation against US$, the deficit must shrink, which would create a
liquidity shortage.

 Therefore, the US$ had to abandon the peg and allow other countries to
manage their currencies with the US$ reserves that they were holding

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An Eclectic Currency Arrangement (1973 – 1997)
 Since March 1973, exchange rates have become much more volatile and less
predictable than they were during the “fixed” period
 There have been numerous, significant world currency events over the past 30
years
 The IMF classifies all exchange rate regimes into eight specific categories

1) Exchange arrangements with no separate legal tender

2) Currency board arrangements
3) Other conventional fixed peg arrangements
4) Pegged exchange rates within horizontal bands
5) Crawling pegs
6) Exchange rates within crawling pegs
7) Managed floating with no pre-announced path
8) Independent floating

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IMF Classification of Currency Regimes
• The IMF’s regime classification methodology in effect since January
2009
• Category 1: Hard Pegs
– Countries that have given up their own sovereignty over monetary policy
– E.g. dollarization or currency boards
• Category 2: Soft Pegs
– Known as fixed exchange rates, with five subcategories of classification
• Category 3: Floating Arrangements
– Mostly market driven, these may be free floating or floating with
occasional government intervention
• Category 4: Residual
– The remains of currency arrangements that don’t well fit the previous
categorizations
IMF Exchange Rate Classifications
IMF Exchange Rate Classifications
Taxonomy of Exchange Rate Regimes
Fixed Exchange Rate System
 The exchange rate is held constant between two currencies, mostly between
US$ and another currency
 Any disequilibrium in exchange rate will lead to government intervention.
 Fixed rate referenced to:
 Gold
 Specified currency
 Basket of currencies
 Advantages
 No exchange rate risk
 Disadvantages
o Exchange rate may not reflect real currency value
o Mostly real exchange rate disequilibrium occurs during this regime
(Currency devalue or revalue)

o Sensitive to economic conditions of other countries. Require coordination of

economic policy with other countries to maintain fixed exchange rate
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Freely Floating Exchange Rate System
 Rate is determined by market forces i.e. the supply and demand of the
currency without government intervention
 Advantage
o More insulated from other country’s inflation(Monetary independence)
o Exchange rate should reflect real currency value
 Disadvantage
o Rates fluctuate over time randomly
o Not a preferred currency for trading

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Managed Float Exchange Rate System
 Rate is determined by market forces, but occasionally with central banks
intervention to smooth out large fluctuations.
 Somewhere between fixed and freely floating exchange rate systems
 Also called “dirty float”.
 Advantages
 Smooth out large fluctuation in forex market.
 To enable govt. to achieve its economic objectives.
 Disadvantages
o Govt. manipulate rates to benefit at the expense of other country. (conflict
of interest)

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Fixed Versus Flexible Exchange Rates
 A nation’s choice as to which currency regime to follow reflects national
priorities about all facets of the economy, including:
 inflation,
 unemployment,
 interest rate levels,
 trade balances, and
 economic growth.

 The choice between fixed and flexible rates may change over time as
priorities change.

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Fixed Versus Flexible Exchange Rates

 Countries would prefer a fixed rate regime for the following reasons:
 stability in international prices
 inherent anti-inflationary nature of fixed prices

 However, a fixed rate regime has the following problems:

 Need for central banks to maintain large quantities of hard currencies and
gold to defend the fixed rate
 Fixed rates can be maintained at rates that are inconsistent with economic
fundamentals

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 Target Zone Arrangement
 An exchange rate is allowed to fluctuate within a desired band
 The rate is adjusted periodically to reflect the changes in economic fundamentals.
 E.g. RMB/US$ is allowed to float within a narrow band of +/- 0.5%
 Advantages
 Less fluctuation in exchange rates
 Less govt. intervention relative to fixed rate system
 Disadvantages
 Subject to speculation
 No control of local interest rates.

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Attributes of the “Ideal” Currency
 Exchange rate stability – the value of the currency would be fixed in
relationship to other currencies so traders and investors could be relatively
certain of the foreign exchange value of each currency in the present and near
future

 Full financial integration – complete freedom of monetary flows would be

allowed, so traders and investors could willingly and easily move funds from
one country to another in response to perceived economic opportunities or risk

 Monetary independence – domestic monetary and interest rate policies

would be set by each individual country to pursue desired national economic
policies, especially as they might relate to limiting inflation, combating
recessions and fostering prosperity and full employment

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Attributes of the “Ideal” Currency

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 A Single Currency for Europe: The Euro

In December 1991, the members of the European Union met at

Maastricht, the Netherlands, to finalize a treaty that changed Europe’s
currency future.
This treaty set out a timetable and a plan to replace all individual EMS
currencies with a single currency called the euro.
To prepare for the EMU, a convergence criteria was laid out whereby each
member country was responsible for managing the following to a specific
level:
 Nominal inflation rates
 Long-term interest rates
 Fiscal deficits
 Government debt
In addition, a strong central bank, called the European Central Bank
(ECB), was established in Frankfurt, Germany.
 A Single Currency for Europe: The Euro

 EMU initiated by 11 members in 1999 and with 28 member states by 2014.

 The euro affects markets in three ways:
 Cheaper transactions costs in the eurozone
 Currency risks and costs related to uncertainty are reduced
 Price transparency and increased price-based competition
Emerging Markets and Regime Choices
 A currency board exists when a country’s central bank commits to back its
monetary base – its money supply – entirely with foreign reserves at all
times.
 This means that a unit of domestic currency cannot be introduced into the
economy without an additional unit of foreign exchange reserves being
obtained first (usually the US$ being the major reserve currency)
 Argentina moved from a managed exchange rate to a currency board in
1991
 In 2002, the country ended the currency board as a result of substantial
economic and political turmoil

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Emerging Markets and Regime Choices
 Dollarization is the use of the US dollar as the official currency of the
country.
 One attraction of dollarization is that sound monetary and exchange-rate
policies no longer depend on the intelligence and discipline of domestic
policymakers.
 Panama has used the dollar as its official currency since 1907
 Ecuador replaced its domestic currency with the US dollar in September,
2000
 Arguments against dollarization include
o Loss of sovereignty over monetary policy
o Loss of power of seignorage, the ability to profit from its ability to print its
own money
o The central bank of the country no longer can serve as lender of last resort

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