IB 150 Lecture Notes - Lecture 16: Devaluation, Public Float, Capital Market

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IB 150 – Lecture 16
International Monetary System
Introduction
The international monetary system refers to the institutional arrangements that govern
exchange rates.
Floating exchange rates occur when the foreign exchange market determines the relative
value of a currency
The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against
each other
Fixed exchange rate occurs when a set of currencies are fixed against each other at some
mutually agreed upon exchange rate
Pegged exchange rates occur when the value of a currency is fixed relative to a reference
currency
Dirty float occurs when countries hold the value of their currency within a range of a
reference currency
Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of
government intervention
The Gold Standard (1870-1914)
Under this regime, countries pegged their currencies to gold, and guaranteed to exchange a
particular quantity of money for an ounce (or grain) of gold
By 1880 most countries were on the gold standard
It enables countries to achieve balance of trade equilibrium (value of exports equals value
of imports)
History of Gold Standard
Roots in old mercantile trade
Inconvenient to ship gold, changed to paper redeemable for gold
Want to achieve balance-of-trade equilibrium
The gold standard dates back to ancient times when gold coins were a medium of exchange,
unit of account, and store of value.
Balance of Trade Equilibrium
Decreased money supply = price decline
As prices decline, exports increase and trade goes into equilibrium
Increased money supply = price inflation
Exchange Rate under Gold Standard
Gold Par Value
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The amount of currency to purchase an ounce of gold, e.g.,
$1.00 = 23.22 grains of gold (1Oz = 480 grains)
$20.67 = 1 ounce of gold (480/23.22)
$35.00 = 1 ounce of gold (1934)
Exchange rate under the gold standard
Based on the par values of different currencies
Why Did the Gold Standard Collapse in 1914?
The gold standard worked well from the 1870s until 1914
Many governments financed their World War I expenditures by printing money and so
created hyper inflation
People lost confidence in the system
Demand on gold for their currency put pressure on countries’ gold reserves and forced
them to suspend gold convertibility
Attempt to revive it after WWI failed due to the Great Depression
By 1939, the gold standard was dead
Post WWI, war heavy expenditures affected the value of dollars against gold.
U.S. raised dollars to gold from $20.67 to $35 per ounce.
Other countries followed suit and devalued their currencies.
The Bretton Woods System (1944)
44 countries met at Bretton Woods and created the IMF, the World Bank, and the fixed rate
exchange rate regime
IMF maintained order in monetary system
World Bank promoted general economic development
The fixed rate regime
US$ convertible to gold at $35/1oz. of gold
Other currencies set their exchange rates to US dollars
The exchange rates are to vary within 1% of fixed rates
Collapse of the Bretton Woods
Devaluation pressures on US dollar in the 60s
Lyndon B. Johnson’s policies
Vietnam war financing
Welfare program financing
Nixon ended gold convertibility of US dollars in 1971
US dollar was devaluated and dealers started speculating against it for further devaluation
Bretton Woods fixed exchange rates was finally abandoned in January 1972
The system relied on an economically well managed U.S., when the U.S. began to print
money, run high trade deficits, and experience high inflation, the system was strained to the
breaking point. And it finally collapsed.
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