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Chapter 10.docx

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University of Ottawa

Chapter 10The Global Monetary SystemIntroductioninstitutional arrangement that countries adopt to International Monetary Systemgovern exchange ratesFloating exchange ratesa system under which the exchange rate for converting one currency into another is continuously adjusted depending on the laws of supply and demandoFour majors currencies US dollar Euro yen British pound are determined by market forces and are free to float against each otherPegged exchange ratecurrency value is fixed relative to a reference currencyoExchange rate with a third party is determined relative to the reference currencyDirtyfloat systema countrys currency is nominally allowed to float freely against other currencies but the government will intervene if the currency deviates too far from its fair value compared to a reference currency such as the US dollaroMost of the time the central bank of a country has this function the countrys primary monetary authorityoThe central bank also issues currency administers monetary policy holds member banks deposits and facilitates the nations banking industryFixed exchange rateexchange rate for converting a currency into another is mutually agrred on and fixedWhen a nation experiences significant economic problems its currency might start to depreciate rapidly In that case a government can try to use foreign currency held in reserve to buy its own currency and thereby increase demand and raise the price again If the governments foreign exchange reserve is not sufficient it can call on multinational institutions such as the IMF for loansIMF gives loans and therefore requires the government to adopt policies designed to correct economic problems in the countryHistorical backgroundBefore industrial revolution payment for goods purchased from another country in goldBut volume of international trade increased and paper currency was introducedThe gold standard pegging currencies to gold and guaranteeing convertibilityAdvantage of gold standardoHelps to achieve balanceoftradeequilibriumoBalanceoftradeequilibrium when the income the residents earn from exports is equal to the money they pay for importsoImagine only USA and Japan are trading goodsoWhen Japan has more exports to the US than imports from the US there is a net flow of gold from the US to Japan which will lead to inflation in JapanoAs the prices in Japan rise and the prices in the US fall Japanese people will start purchasing more goods from the US and less Japanese goods until a balanceoftradeequilibrium is achievedoThis adjustment mechanism is so powerful that even today some people think the world should return to a gold standardThe time between the wars 19181939During WW I governments financed massive military expenditures by printing money and many abandoned gold standardAfter the war Great Britain returned to gold standard at prewar parity level despite inflationthis priced British goods out of foreign markets and pushed the country into a deep depressionForeign investors lost confidenceand began converting pounds into goldGovernment couldnt satisfy high demand for gold and suspended convertibility in 1931US returned to gold standard in 1934 but raised the price per ounce of gold which led to devaluation of the dollar compared to other currenciesMany countries did the same causing a cycle of competitive devaluationsGold standard in Canadao18541914o 19261931By the start of WW II in 1939 the gold standard was deadThe Bretton Woods System1944 conference at Breeton Woods New Hampshire to design a new international monetary systemOutcomes
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