Final Exam Study Notes - Chapter 10-The International Monetary System

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12 Oct 2010
MGT491 FINAL EXAM NOTES ± Chapter 10: The International Monetary System
x International monetary system ± refers to the institutional arrangements that govern exchange rates
x Chapter 9 ± assumed that the foreign exchange market was the primary institution for determining exchange rates
and the impersonal market forces of DD and SS determined the relative inflation rates and interest rates
x When a foreign exchange market determines the relative value of a currency ± country is adhering to a floating
exchange rate regime
x US $, EU euro, Japanese ¥ and British £ all use a floating system against each other ± their exchange rates are
determined by market forces and fluctuate against each other day to day, if not minute by minute
x However the exchange rates of many currencies are not determined by the free play of market forces, some
governments adopt other institutional arrangements
x Pegged Exchange Rate
o Pegged exchange rate ± means the value of the currency is fixed relative to a reference currency, and
then the exchange rate between that currency and other currencies is determined by the reference
currency exchange
x Dirty Float
o Other countries try to hold the value of their currency within some range against an important
reference currency, or a basket of currencies
Float because in theory the value is determined by market forces, but it is a dirty float because
the central bank of a country will intervene in the foreign exchange market to try to maintain
the value of its currency if it depreciates too rapidly against an important reference currency
x Fixed Exchange Rate
o Other countries have operated with a fixed exchange rate, in which the values of a set of currencies
are fixed against each other at some mutually agreed-on exchange rate
o Before the euro was introduced, several member states of the European union operated with fixed
exchange rates within the context of the European Monetary System (EMS)
The Gold Standard
x Origin in the use of gold coins as a medium of exchange, unit of account and store of value ± practice that dates to
ancient times
o When international trade was limited in volume, payment for goods purchased from another country
was typically made in gold or silver
o However as the volume of international trade expanded after the industrial revolution, a more
convenient means of financing international trade was needed ± shipping large quantities of gold and
silver around the world was impractical
o Solution was to arrange for payment in paper currency and for governments to agree to convert the
paper currency into gold on demand at a fixed rate
Mechanics of the Gold Standard
x The Gold Standard ± pegging currencies to gold and guaranteeing convertibility
x Given a common gold standard, the value of any currency in units of any other currency (the exchange rate) was
easy to determine
x Gold Par Value ± the amount of a currency needed to purchase one ounce of gold
x From the gold par values of two currencies, it was possible to calculate what the exchange rate was for converting
one currency into the other
Strength of the Gold Standard
x Contained a powerful mechanism for achieving balance-of-trade equilibrium by all countries
x Country it said to be in balance-of-trade equilibrium when the income its residents earn from exports is equal to the
money its residents pay to other countries for imports (the current account of its balance of payments is in balance)
x Adjustment mechanism ± if Japan has a trade surplus, there is a net flow RIJROGIURP86WR-DSDQ86VPRQH\
increases) in Japan. Rise in price of Japanese goods will decrease demand for these goods, while fall in price of
US goods will increase demand for those. Japan will buy more from the US and the US will buy less from Japan
until equilibrium is achieved.
The Period between the Wars: 1918-1939
x The Gold Standard worked well from 1870s until start of WW1 in 1914 when it was abandoned
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higher prices were everywhere by the end of the war
x Many great nations including US, GB and France returned to the gold standard by end of 1920s
x Many countries had difficulties with this return to pegging their currencies against gold, and net result was
shattering of any remaining confidence in the system
x Countries devaluing their currencies at will, nobody could be sure how much gold a currency could buy
devalued its currency while they were holding onto it
x Pressure put on gold reserves of various countries, forcing them to suspend gold convertibility by the start of WW2
the gold standard was finished
The Bretton Woods System
x 1944 ± representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international
monetary system
x With the collapse of the gold standard and the great depression recent, they were determined to build an enduring
economic order that would facilitate postwar economic growth
x Consensus that fixed exchange rates were desirable, wanted to void the competitive devaluations of currencies
x Agreement reached at Bretton Woods established 2 multinational institutions:
o International Monetary Fund (IMF)
o World Bank
x IMF ± maintain order in the international monetary system
x World bank ± promote general economic development
x Also called for a system of fixed exchange rates that would be policed by the IMF
x All countries were to fix the value of their currency in terms of gold but were not required to exchange their
currencies for gold ± only the $ remained convertible to gold at a set price
x Each country decided what it wanted its exchange rate to be compared to the dollar and then calculated the gold
par value of the currency based on that rate
x All participating countries agreed to maintain the value of their currencies within 1% of the par value by buying or
selling currencies or gold as needed
x Also had a commitment not to use devaluation as a weapon of competitive trade policy, however if a currency
became too weak to defend a devaluation of up to 10% would be allowed without IMF approval ± larger
devaluations required approval
The Role of the IMF
x Heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment,
hyperinflation in Germany and elsewhere, and genera economic disintegration that occurred between the two
world wars
x Aim of the Bretton Woods agreement was to try to avoid a repetition of that chaos through a combination of
discipline and flexibility
x Discipline:
o Fixed exchange rate regime imposes discipline in 2 ways:
Need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings
stability to the world trade environment
Fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price
o Fixed exchange rates are seen as a mechanism for controlling inflation and imposing economic
discipline on countries
x Flexibility:
o Recognized that a rigid policy of fixed exchange rates would be too inflexible
Would probably break down just as the gold standard had
persistent balance-of-payment deficit could force the country into recession and create high
Built flexibility into the system ± lending facilities and adjustable parities
o IMF stood ready to lend foreign currencies to members to tide them over during short periods of
balance-of-payments deficits, when a rapid tightening of monetary or fiscal policy would hurt domestic
Pool of gold and currencies contributed by IMF members provided the resources for these
lending operations
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By providing deficit-laden countries with short-term foreign currency loans, IMF funds would
buy time for countries to bring down their inflation rates and reduce their balance-of-payments
Belief was that such loans would reduce pressures for devaluation and allow for a more
orderly and less painful adjustment
o Countries were to be allowed to borrow a limited amount from the IMF without adhering to any specific
agreements, however extensive drawings from IMF funds would require a country to agree to
increasingly stringent IMF supervision of its macroeconomic policies
apply to countries that had suffered permanent adverse effects in the demand for their products
Without devaluation, country would experience high unemployment and a persistent trade
The Role of the World Bank
x Official name ± International Bank for Reconstruction and Development (IBRD)
x Need to reconstruct war-torn economies of Europe was foremost importance at Bretton Woods
x Initial mission ± to help finance the building of EuropeVHFRQRP\E\SURYLGLQJORZ-interest loans
o US overshadowed the World Bank in this respect with the Marshall Plan through which the US lent
money directly to European nations to help them rebuild
x %DQNWXUQHGLWVDWWHQWLRQWR³GHYHORSPHQIXQFWLRQ± began lending money to third world nations
o Concentrated on public-sector projects such as power stations, road building, other transportation
o Also heavily supported agriculture, education, population control, urban development
x Bank lends money under 2 schemes:
o IBRD ± money is raised through bond sales in the international capital market ± borrowers pay what
Bank offers low-interest loans to risky customers whose credit rating is often poor, such as the
governments of underdeveloped nations
o International Development Association (IDA) ± resources to fund these loans raised through
subscriptions from wealthy members such as the US, Japan and Germany, loans go only to the
poorest nations receive grants and no-interest loans
The Collapse of the Fixed Exchange System
x Worked well until late 1960s, finally collapsed in 1973 and was replaced by a managed-float system
x US dollar ± as the only currency that could be converted into gold, and served as a reference point for all other
currencies, dollar occupied a central place in the system ± any pressure on the dollar to devalue could break the
system and that is what occurred
x The Bretton Woods system had a problem ± could no work if the US dollar was under speculative attack, could
only work as long as the US inflation rate remained low and the US did not run a balance-of-payments deficit.
Once these things occurred, the system soon became strained to the breaking point
The Floating Exchange Rate Regime
x Followed the collapse of the fixed exchange rate system
x Formalized in January 1976 when IMF members met in Jamaica and agreed to the rules for the international
monetary system that are still in place today
The Jamaica Agreement
x Main elements:
o Floating rates were declared acceptable, IMF members were permitted to enter the foreign exchange
o Gold was abandoned as a reserve asset, IMF returned its gold reserves to members at the current
market price, placing the proceeds in a trust fund to help poor nations, IMG members permitted to sell
their own gold reserves at the market price
o Total annual IMF quotas ± amount member countries contribute to the IMF ± were increased, non-oil-
exporting less developed countries were given greater access to IMF funds
x After Jamaica, the IMF continued its role of helping countries cope with macroeconomic and exchange rate
problems, within the context of a very different exchange rate regime
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