ADM 3318 Chapter 10: ADM 3318 - GLOBAL BUSINESS TODAY
16 Jun 2018
School
Department
Course
Professor
Global Money System
Introduction
The international monetary system refers to the institutional arrangements that
countries adopt to govern exchange rates
•
Foreign exchange market was the primary institution for determining exchange
rates and impersonal market forces of demand and supply determined the
relative value of any two currencies
The supply and demand is influenced by their respective countries'
relative inflation rates and interest rates
○
•
When the foreign exchange market determine the relative value of a currency it
is adhering to a floating exchange rate regime
The world's four major trading currencies are all free to float against each
other
USD, EUR, JPY, GBP
§
○
Their exchange rates are determined by market forces and fluctuate
against each other on a day-to-day basis
○
•
Many currency rates are not determined by the free play market, but by other
institutional arrangements
All of these require some degree of government intervention in the
foreign exchange market to maintain the value of a currency
§
Many nations peg their currencies, primarily to the USD to EUR
A pegged exchange rate means the value of the currency is fixed
relative to a reference currency
§
○
Other nations try to hold the value of their currency within some range
against important reference currency, like the USD
This is a dirty-float system
It is float because the value of the currency is determined by
market forces, but it is dirty float because of the central bank
of a country will intervene in the foreign exchange market to
try to maintain the value of its currency
□
§
○
Other nations have operated with a fixed exchange rate system
This is where the value of a set of currencies are fixed against each
other at some mutually-agreed-upon exchange rate
§
○
•
The Gold Standard
Mechanics of the good standard
Pegging currencies to gold and guaranteeing convertibility is known as the
gold standard
○
By 1880, most companies had adopted this standard
○
•
Strength of the gold standard
A country is said to be balance-of-trade equilibrium when the income its
residents earn from exports is equal to the money its residents pay to
people in other countries for imports
○
When one countries pays another, the gold flow automatically reduced
from the payer to the payee
The payer will likely reduce imports and the payee will likely
increase imports
§
○
•
The Period between the wars, 1918-1939
The start of the WWI marked the end of the gold standard era
Most countries suspended the convertibility of domestic bank notes into
gold and the free movement of gold between countries
○
•
By the start of the WWII in 1939, the gold standard was dead•
The Bretton Woods System
At the height of WWII, representatives of 44 countries met at Bretton Woods,
to design a new international money system
The statement were determined to build an enduring economic order that
would facilitate post-war economic growth
○
•
The agreement established two multinational institutions, the International
Money Fund (IMF), and the World Bank
IMF had the task of maintaining order in the international money system
The agreement also called for a system of fixed exchange rates that
would be policed by the IMF
All countries had to fix the value of their currencies in terms
of gold, but were not required to exchange their currencies
for gold
□
§
○
The world bank would was there to promote general economic
development
○
•
Another part of the agreement was that there was a commitment to not to use
devaluation as a weapon of competitive trade policy
•
The Role of the IMF
Their main job was to avoid a repetition of the chaos through a
combination of discipline and flexibility
Discipline
A fixed exchange rate regime imposes discipline in two ways
The need to maintain a fixed exchange rate puts a brake
on competitive devaluation and brings stability to the
world trade environment
®
A fixed exchange rate regime imposes monetary
discipline on countries, thereby curtailing price inflation
®
□
§
Flexibility
The agreement wanted to avoid high unemployment, so they
built limited flexibility into the system
□
Two major features of the IMF Articles of Agreement fostered
this flexibility
IMF lending facilities and adjustable parties
®
□
§
○
The IMF stood ready to lend foreign currencies to members to tide them
over during short periods of balance-of-payment deficits, when a rapid
tightening of money or fiscal policy would hurt domestic employment
A pool of gold and currencies contributed by IMF member provided
the resources for these lending operations
§
○
IMF would help countries buy time and bring down the inflation rates and
reduce their balance-of-payments deficit
○
•
The Role of the World Bank
The bank's initial mission was to help finance the building of Europe's
economy by providing low-interest loans
However, the US took over and started lending European nations
the money
§
○
Then the World Bank turned its attention to "development" and began
lending money to Third World nations
○
The bank lends its money under two schemes
Under the IBRD scheme
Money is raised through bond sales in the international
market
□
Borrowers pay what the bank calls a market rate of interest□
The bank offers low-interest loans to risky customers whose
credit rating is often poor
□
§
Under a scheme overseen by the International Development Agency
(IDA)
This is an arm of the bank that was created in 1960□
Resources to fund IDA loans were raised through
subscriptions from wealthy members
□
IDA loans go only to the poorest countries
Borrowers have 50 years to repay at interest of 1
percent a year
®
□
§
○
•
The Collapse of the Fixed Exchange Rate System
In the 1960s, the system first started to fail, and completely collapsed in 1973 •
The USD was the only currencies that could be converted into gold, and was the
reference point for all other currencies
The USD occupied a central place in the system
○
Any pressure on the USD to devalue could wreak havoc with the system,
which is what happened
○
•
The foreign exchange market became increasingly convinced that the USD
would have to be devalued
This would mean that all countries had to agree to simultaneously revalue
against the USD, which many didn’t want to do
○
•
To prevent currencies from appreciating against the USD, the foreign market
was closed
Once it reopened, the currencies of Japan and most European countries
were floating against the USD
○
The floating system was viewed as a temporary fix to unmanageable
speculation in the foreign exchange market
○
•
The Floating Exchange Rate Regime
The floating exchange rate regime was formalized in Jamaica in 1976 when IMF
members agreed to the rules for the international money system that are in
place today
•
The Jamaican Agreement
The meeting revised the IMF's Articles to reflect the new reality of floating
exchange rates
○
The main elements include
Floating rates were declared acceptable
§
Gold was abandoned as a reserve asset
§
Total annual IMF quotas (the amount member countries contribute
to the IMF) was increase to $41 billion USD
Now it has increased to $400 billion USD □
§
○
•
Exchange rates since 1973
Since 1973, exchange rates have become much more volatile and less
predictable than they were before
This volatility has been partly due to a number of unexpected
shocks to the world monetary system…
The oil crisis in 1971, when the price of oil quadrupled □
The loss of confidence in the dollar that followed the rise of
US inflation
□
The oil crisis in 1979, when oil prices increased dramatically □
The unexpected rise in the dollar between 1980-1985□
The rapid fall of the US dollar against JPY between 1993-1995□
The partial collapse of the European Money System in 1992□
The 1997 Asian currency crisis □
The decline of the value of the USD in the mod- to late-2000s □
The global financial crisis of 2008 and sovereign debt crisis in
the EU during 2010
□
§
○
The changing values of the USD shows the factors that affect currencies
generally
The driving force for the appreciation in the value of the USD was
the foreigners who continued to invest in USD financial assets
§
○
•
Fixed vs. Floating Exchange Rates
The Case for Floating Exchange Rates
There are two main elements for the case of floating exchange rates
Monetary Policy Autonomy
Under a fixed system, a country's ability to expand or contract
its money supply as it sees fit is limited by the need to
maintain exchange rate parity
Monetary expansion can lead to inflation
®
Monetary contraction requires high interest rates which
lead to an inflow of money abroad
®
□
Floating exchange rate regime argues that removing the
obligation to maintain exchange rate parity would restore the
money control to a government
If the government wants to increase money supply, it
could do so unencumbered by the need to maintain its
exchange rate
®
□
Although domestic inflation would have an impact on the
exchange rate under floating exchange rate regime, it should
have no impact on businesses' international cost
competiveness due to exchange rate depreciation
□
§
Automatic Trade Balance Adjustments
If a country developed a permanent deficit in its balance of
trade, that could not be corrected by domestic policy, the IMF
would have to agree to currency devaluation
Critics argues of this system that the adjustment
mechanism works much more smoothly under a
floating exchange rate
®
□
If a country is running a trade deficit, the imbalance between
supply and demand of that country's currency in the foreign
exchange markets will lead to depreciation in its exchange
rate
By making its exports cheaper and its imports and its
imports more expensive
®
□
§
○
•
The Case for Fixed Exchange Rates
The case rests on arguments about monetary, discipline, speculation,
uncertainty, and the lack of connection between trade balance and
exchange rates
Monetary discipline
The need to maintain a fixed exchange rate parity ensures
that governments do not expand their money supplies at
inflationary rates
□
Advocates argue that each country should be allowed to
choose its own inflation rate
□
Advocates also argue that governments all too often give in to
political pressures and expand the monetary supply far too
rapidly
A fixed exchange rate regime would ensure that this
does not occur
®
□
§
Speculation
Fixed rate can cause fluctuations in the exchange rate□
A fixed rate regime is a system that will limit the destabilizing
effects of speculation
□
§
Uncertainty
Speculation also adds to the uncertainty surrounding future
currency movements that characterizes floating exchange
regimes
□
A fixed exchange rate, by eliminating such uncertainty,
promotes the growth of international trade and investment
□
§
Trade Balance Adjustments
Advocates of floating exchange rates claim it helps adjust
trade imbalances
Critics question the closeness of the link between the
exchange rate and trade balance
®
□
§
○
•
Exchange Rate Regimes in Practice
Pegged Exchange Rates
Under a pegged exchange rate regime, a country will peg the value of its
currency to that of a major currency
E.g. if the USD rises so will this other currency
§
○
Adopting a pegged exchange rate regime does moderate inflationary
pressures in a country
○
•
Currency Boards
A country that introduces a currency board, it commits itself to converting
its domestic currency on demand into another currency at a fixed
exchange rate
A currency board is the means of controlling a country's currency by
holding reserves of a foreign currency equal at a fixed exchange rate
to at least 100 percent of the domestic currency issue
§
The currency board can issue additional domestic notes and coins
only when there are foreign exchange reserves to back it
This limits the ability for the government to print money,
which creates inflationary pressures
□
§
○
There are some drawbacks
If local inflation rates remain higher than the inflation rate in the
country to which the currency is pegged, the currencies of countries
with currency boards can become uncompetitive and overvalued
§
○
•
Crisis Management By The IMF
After the collapse of the Bretton Woods system, many thought the IMF would
fall as well
•
The activities of the IMF have expanded over the past 30 years
in 1997 they committed more than $110 billion in short-term loans to
troubled Asians countries
○
•
IMF has developed the financial leverage to act aggressively in times of global
financial crisis
•
IMF's activities have expanded because periodic financial crises have continued
to hit many economies in the post Bretton Woods era
•
Financial crises in the post Bretton Woods era
Many broad types of financial crises have occurred over the past quarter
century
○
All these cases have one thing in common, high inflation, a widening
current account deficit, excessive expansion of domestic borrowing, and
asset price inflation
A century crisis occurs when a speculative attack on the exchange
value of a currency results in a sharp depreciation in the value of
the currency or forces authorities to expand large volumes of
international currency reserves and sharply increase interest rates
to defend the prevailing exchange rate
§
A banking crisis refers to a loss of confidence in the banking system
that leads to a run on banks, as individuals and companies withdraw
their deposits
§
A foreign debt crisis in a situation in which a country cannot service
its foreign debt obligations, whether private or government debt
§
○
•
Evaluating the IMF's Policy Prescriptions
All IMF loan packages come with conditions attached
○
The policies are designed to cool overheated economies by reining in
inflation and reducing government spending and debt
○
Inappropriate Policies
One criticism is that IMF's traditional policy prescriptions represent
a "one-size-fits-all" approach to macroeconomics policy that is
inappropriate for many countries
The tight macroeconomic policies imposed by the IMF were
not well suited to countries that were suffering from a
private-sector debt crisis with deflationary undertone
□
§
○
Moral Hazard
A second criticism of the IMF is that its rescue efforts are
exacerbating a problem known to economists as moral hazard
§
Moral hazard arises when people behave recklessly because they
know will be saved I things go wrong
§
○
Lack of Accountability
The final criticism of the IMF is that it has become too powerful for
an institution that lacks any real mechanism for accountability
§
○
Observations
There are some cases where IMF policies have been
counterproductive, or only have limited success
§
○
•
Chapter 10
Friday, January 26, 2018
21:24
Global Money System
Introduction
The international monetary system refers to the institutional arrangements that
countries adopt to govern exchange rates
•
Foreign exchange market was the primary institution for determining exchange
rates and impersonal market forces of demand and supply determined the
relative value of any two currencies
The supply and demand is influenced by their respective countries'
relative inflation rates and interest rates
○
•
When the foreign exchange market determine the relative value of a currency it
is adhering to a floating exchange rate regime
The world's four major trading currencies are all free to float against each
other
USD, EUR, JPY, GBP
§
○
Their exchange rates are determined by market forces and fluctuate
against each other on a day-to-day basis
○
•
Many currency rates are not determined by the free play market, but by other
institutional arrangements
All of these require some degree of government intervention in the
foreign exchange market to maintain the value of a currency
§
Many nations peg their currencies, primarily to the USD to EUR
A pegged exchange rate means the value of the currency is fixed
relative to a reference currency
§
○
Other nations try to hold the value of their currency within some range
against important reference currency, like the USD
This is a dirty-float system
It is float because the value of the currency is determined by
market forces, but it is dirty float because of the central bank
of a country will intervene in the foreign exchange market to
try to maintain the value of its currency
□
§
○
Other nations have operated with a fixed exchange rate system
This is where the value of a set of currencies are fixed against each
other at some mutually-agreed-upon exchange rate
§
○
•
The Gold Standard
Mechanics of the good standard
Pegging currencies to gold and guaranteeing convertibility is known as the
gold standard
○
By 1880, most companies had adopted this standard
○
•
Strength of the gold standard
A country is said to be balance-of-trade equilibrium when the income its
residents earn from exports is equal to the money its residents pay to
people in other countries for imports
○
When one countries pays another, the gold flow automatically reduced
from the payer to the payee
The payer will likely reduce imports and the payee will likely
increase imports
§
○
•
The Period between the wars, 1918-1939
The start of the WWI marked the end of the gold standard era
Most countries suspended the convertibility of domestic bank notes into
gold and the free movement of gold between countries
○
•
By the start of the WWII in 1939, the gold standard was dead
•
The Bretton Woods System
At the height of WWII, representatives of 44 countries met at Bretton Woods,
to design a new international money system
The statement were determined to build an enduring economic order that
would facilitate post-war economic growth
○
•
The agreement established two multinational institutions, the International
Money Fund (IMF), and the World Bank
IMF had the task of maintaining order in the international money system
The agreement also called for a system of fixed exchange rates that
would be policed by the IMF
All countries had to fix the value of their currencies in terms
of gold, but were not required to exchange their currencies
for gold
□
§
○
The world bank would was there to promote general economic
development
○
•
Another part of the agreement was that there was a commitment to not to use
devaluation as a weapon of competitive trade policy
•
The Role of the IMF
Their main job was to avoid a repetition of the chaos through a
combination of discipline and flexibility
Discipline
A fixed exchange rate regime imposes discipline in two ways
The need to maintain a fixed exchange rate puts a brake
on competitive devaluation and brings stability to the
world trade environment
®
A fixed exchange rate regime imposes monetary
discipline on countries, thereby curtailing price inflation
®
□
§
Flexibility
The agreement wanted to avoid high unemployment, so they
built limited flexibility into the system
□
Two major features of the IMF Articles of Agreement fostered
this flexibility
IMF lending facilities and adjustable parties
®
□
§
○
The IMF stood ready to lend foreign currencies to members to tide them
over during short periods of balance-of-payment deficits, when a rapid
tightening of money or fiscal policy would hurt domestic employment
A pool of gold and currencies contributed by IMF member provided
the resources for these lending operations
§
○
IMF would help countries buy time and bring down the inflation rates and
reduce their balance-of-payments deficit
○
•
The Role of the World Bank
The bank's initial mission was to help finance the building of Europe's
economy by providing low-interest loans
However, the US took over and started lending European nations
the money
§
○
Then the World Bank turned its attention to "development" and began
lending money to Third World nations
○
The bank lends its money under two schemes
Under the IBRD scheme
Money is raised through bond sales in the international
market
□
Borrowers pay what the bank calls a market rate of interest□
The bank offers low-interest loans to risky customers whose
credit rating is often poor
□
§
Under a scheme overseen by the International Development Agency
(IDA)
This is an arm of the bank that was created in 1960□
Resources to fund IDA loans were raised through
subscriptions from wealthy members
□
IDA loans go only to the poorest countries
Borrowers have 50 years to repay at interest of 1
percent a year
®
□
§
○
•
The Collapse of the Fixed Exchange Rate System
In the 1960s, the system first started to fail, and completely collapsed in 1973 •
The USD was the only currencies that could be converted into gold, and was the
reference point for all other currencies
The USD occupied a central place in the system
○
Any pressure on the USD to devalue could wreak havoc with the system,
which is what happened
○
•
The foreign exchange market became increasingly convinced that the USD
would have to be devalued
This would mean that all countries had to agree to simultaneously revalue
against the USD, which many didn’t want to do
○
•
To prevent currencies from appreciating against the USD, the foreign market
was closed
Once it reopened, the currencies of Japan and most European countries
were floating against the USD
○
The floating system was viewed as a temporary fix to unmanageable
speculation in the foreign exchange market
○
•
The Floating Exchange Rate Regime
The floating exchange rate regime was formalized in Jamaica in 1976 when IMF
members agreed to the rules for the international money system that are in
place today
•
The Jamaican Agreement
The meeting revised the IMF's Articles to reflect the new reality of floating
exchange rates
○
The main elements include
Floating rates were declared acceptable
§
Gold was abandoned as a reserve asset
§
Total annual IMF quotas (the amount member countries contribute
to the IMF) was increase to $41 billion USD
Now it has increased to $400 billion USD □
§
○
•
Exchange rates since 1973
Since 1973, exchange rates have become much more volatile and less
predictable than they were before
This volatility has been partly due to a number of unexpected
shocks to the world monetary system…
The oil crisis in 1971, when the price of oil quadrupled □
The loss of confidence in the dollar that followed the rise of
US inflation
□
The oil crisis in 1979, when oil prices increased dramatically □
The unexpected rise in the dollar between 1980-1985□
The rapid fall of the US dollar against JPY between 1993-1995□
The partial collapse of the European Money System in 1992□
The 1997 Asian currency crisis □
The decline of the value of the USD in the mod- to late-2000s □
The global financial crisis of 2008 and sovereign debt crisis in
the EU during 2010
□
§
○
The changing values of the USD shows the factors that affect currencies
generally
The driving force for the appreciation in the value of the USD was
the foreigners who continued to invest in USD financial assets
§
○
•
Fixed vs. Floating Exchange Rates
The Case for Floating Exchange Rates
There are two main elements for the case of floating exchange rates
Monetary Policy Autonomy
Under a fixed system, a country's ability to expand or contract
its money supply as it sees fit is limited by the need to
maintain exchange rate parity
Monetary expansion can lead to inflation
®
Monetary contraction requires high interest rates which
lead to an inflow of money abroad
®
□
Floating exchange rate regime argues that removing the
obligation to maintain exchange rate parity would restore the
money control to a government
If the government wants to increase money supply, it
could do so unencumbered by the need to maintain its
exchange rate
®
□
Although domestic inflation would have an impact on the
exchange rate under floating exchange rate regime, it should
have no impact on businesses' international cost
competiveness due to exchange rate depreciation
□
§
Automatic Trade Balance Adjustments
If a country developed a permanent deficit in its balance of
trade, that could not be corrected by domestic policy, the IMF
would have to agree to currency devaluation
Critics argues of this system that the adjustment
mechanism works much more smoothly under a
floating exchange rate
®
□
If a country is running a trade deficit, the imbalance between
supply and demand of that country's currency in the foreign
exchange markets will lead to depreciation in its exchange
rate
By making its exports cheaper and its imports and its
imports more expensive
®
□
§
○
•
The Case for Fixed Exchange Rates
The case rests on arguments about monetary, discipline, speculation,
uncertainty, and the lack of connection between trade balance and
exchange rates
Monetary discipline
The need to maintain a fixed exchange rate parity ensures
that governments do not expand their money supplies at
inflationary rates
□
Advocates argue that each country should be allowed to
choose its own inflation rate
□
Advocates also argue that governments all too often give in to
political pressures and expand the monetary supply far too
rapidly
A fixed exchange rate regime would ensure that this
does not occur
®
□
§
Speculation
Fixed rate can cause fluctuations in the exchange rate□
A fixed rate regime is a system that will limit the destabilizing
effects of speculation
□
§
Uncertainty
Speculation also adds to the uncertainty surrounding future
currency movements that characterizes floating exchange
regimes
□
A fixed exchange rate, by eliminating such uncertainty,
promotes the growth of international trade and investment
□
§
Trade Balance Adjustments
Advocates of floating exchange rates claim it helps adjust
trade imbalances
Critics question the closeness of the link between the
exchange rate and trade balance
®
□
§
○
•
Exchange Rate Regimes in Practice
Pegged Exchange Rates
Under a pegged exchange rate regime, a country will peg the value of its
currency to that of a major currency
E.g. if the USD rises so will this other currency
§
○
Adopting a pegged exchange rate regime does moderate inflationary
pressures in a country
○
•
Currency Boards
A country that introduces a currency board, it commits itself to converting
its domestic currency on demand into another currency at a fixed
exchange rate
A currency board is the means of controlling a country's currency by
holding reserves of a foreign currency equal at a fixed exchange rate
to at least 100 percent of the domestic currency issue
§
The currency board can issue additional domestic notes and coins
only when there are foreign exchange reserves to back it
This limits the ability for the government to print money,
which creates inflationary pressures
□
§
○
There are some drawbacks
If local inflation rates remain higher than the inflation rate in the
country to which the currency is pegged, the currencies of countries
with currency boards can become uncompetitive and overvalued
§
○
•
Crisis Management By The IMF
After the collapse of the Bretton Woods system, many thought the IMF would
fall as well
•
The activities of the IMF have expanded over the past 30 years
in 1997 they committed more than $110 billion in short-term loans to
troubled Asians countries
○
•
IMF has developed the financial leverage to act aggressively in times of global
financial crisis
•
IMF's activities have expanded because periodic financial crises have continued
to hit many economies in the post Bretton Woods era
•
Financial crises in the post Bretton Woods era
Many broad types of financial crises have occurred over the past quarter
century
○
All these cases have one thing in common, high inflation, a widening
current account deficit, excessive expansion of domestic borrowing, and
asset price inflation
A century crisis occurs when a speculative attack on the exchange
value of a currency results in a sharp depreciation in the value of
the currency or forces authorities to expand large volumes of
international currency reserves and sharply increase interest rates
to defend the prevailing exchange rate
§
A banking crisis refers to a loss of confidence in the banking system
that leads to a run on banks, as individuals and companies withdraw
their deposits
§
A foreign debt crisis in a situation in which a country cannot service
its foreign debt obligations, whether private or government debt
§
○
•
Evaluating the IMF's Policy Prescriptions
All IMF loan packages come with conditions attached
○
The policies are designed to cool overheated economies by reining in
inflation and reducing government spending and debt
○
Inappropriate Policies
One criticism is that IMF's traditional policy prescriptions represent
a "one-size-fits-all" approach to macroeconomics policy that is
inappropriate for many countries
The tight macroeconomic policies imposed by the IMF were
not well suited to countries that were suffering from a
private-sector debt crisis with deflationary undertone
□
§
○
Moral Hazard
A second criticism of the IMF is that its rescue efforts are
exacerbating a problem known to economists as moral hazard
§
Moral hazard arises when people behave recklessly because they
know will be saved I things go wrong
§
○
Lack of Accountability
The final criticism of the IMF is that it has become too powerful for
an institution that lacks any real mechanism for accountability
§
○
Observations
There are some cases where IMF policies have been
counterproductive, or only have limited success
§
○
•
Chapter 10
Friday, January 26, 2018 21:24
Global Money System
Introduction
The international monetary system refers to the institutional arrangements that
countries adopt to govern exchange rates
•
Foreign exchange market was the primary institution for determining exchange
rates and impersonal market forces of demand and supply determined the
relative value of any two currencies
The supply and demand is influenced by their respective countries'
relative inflation rates and interest rates
○
•
When the foreign exchange market determine the relative value of a currency it
is adhering to a floating exchange rate regime
The world's four major trading currencies are all free to float against each
other
USD, EUR, JPY, GBP
§
○
Their exchange rates are determined by market forces and fluctuate
against each other on a day-to-day basis
○
•
Many currency rates are not determined by the free play market, but by other
institutional arrangements
All of these require some degree of government intervention in the
foreign exchange market to maintain the value of a currency
§
Many nations peg their currencies, primarily to the USD to EUR
A pegged exchange rate means the value of the currency is fixed
relative to a reference currency
§
○
Other nations try to hold the value of their currency within some range
against important reference currency, like the USD
This is a dirty-float system
It is float because the value of the currency is determined by
market forces, but it is dirty float because of the central bank
of a country will intervene in the foreign exchange market to
try to maintain the value of its currency
□
§
○
Other nations have operated with a fixed exchange rate system
This is where the value of a set of currencies are fixed against each
other at some mutually-agreed-upon exchange rate
§
○
•
The Gold Standard
Mechanics of the good standard
Pegging currencies to gold and guaranteeing convertibility is known as the
gold standard
○
By 1880, most companies had adopted this standard
○
•
Strength of the gold standard
A country is said to be balance-of-trade equilibrium when the income its
residents earn from exports is equal to the money its residents pay to
people in other countries for imports
○
When one countries pays another, the gold flow automatically reduced
from the payer to the payee
The payer will likely reduce imports and the payee will likely
increase imports
§
○
•
The Period between the wars, 1918-1939
The start of the WWI marked the end of the gold standard era
Most countries suspended the convertibility of domestic bank notes into
gold and the free movement of gold between countries
○
•
By the start of the WWII in 1939, the gold standard was dead•
The Bretton Woods System
At the height of WWII, representatives of 44 countries met at Bretton Woods,
to design a new international money system
The statement were determined to build an enduring economic order that
would facilitate post-war economic growth
○
•
The agreement established two multinational institutions, the International
Money Fund (IMF), and the World Bank
IMF had the task of maintaining order in the international money system
The agreement also called for a system of fixed exchange rates that
would be policed by the IMF
All countries had to fix the value of their currencies in terms
of gold, but were not required to exchange their currencies
for gold
□
§
○
The world bank would was there to promote general economic
development
○
•
Another part of the agreement was that there was a commitment to not to use
devaluation as a weapon of competitive trade policy
•
The Role of the IMF
Their main job was to avoid a repetition of the chaos through a
combination of discipline and flexibility
Discipline
A fixed exchange rate regime imposes discipline in two ways
The need to maintain a fixed exchange rate puts a brake
on competitive devaluation and brings stability to the
world trade environment
®
A fixed exchange rate regime imposes monetary
discipline on countries, thereby curtailing price inflation
®
□
§
Flexibility
The agreement wanted to avoid high unemployment, so they
built limited flexibility into the system
□
Two major features of the IMF Articles of Agreement fostered
this flexibility
IMF lending facilities and adjustable parties
®
□
§
○
The IMF stood ready to lend foreign currencies to members to tide them
over during short periods of balance-of-payment deficits, when a rapid
tightening of money or fiscal policy would hurt domestic employment
A pool of gold and currencies contributed by IMF member provided
the resources for these lending operations
§
○
IMF would help countries buy time and bring down the inflation rates and
reduce their balance-of-payments deficit
○
•
The Role of the World Bank
The bank's initial mission was to help finance the building of Europe's
economy by providing low-interest loans
However, the US took over and started lending European nations
the money
§
○
Then the World Bank turned its attention to "development" and began
lending money to Third World nations
○
The bank lends its money under two schemes
Under the IBRD scheme
Money is raised through bond sales in the international
market
□
Borrowers pay what the bank calls a market rate of interest
□
The bank offers low-interest loans to risky customers whose
credit rating is often poor
□
§
Under a scheme overseen by the International Development Agency
(IDA)
This is an arm of the bank that was created in 1960□
Resources to fund IDA loans were raised through
subscriptions from wealthy members
□
IDA loans go only to the poorest countries
Borrowers have 50 years to repay at interest of 1
percent a year
®
□
§
○
•
The Collapse of the Fixed Exchange Rate System
In the 1960s, the system first started to fail, and completely collapsed in 1973 •
The USD was the only currencies that could be converted into gold, and was the
reference point for all other currencies
The USD occupied a central place in the system
○
Any pressure on the USD to devalue could wreak havoc with the system,
which is what happened
○
•
The foreign exchange market became increasingly convinced that the USD
would have to be devalued
This would mean that all countries had to agree to simultaneously revalue
against the USD, which many didn’t want to do
○
•
To prevent currencies from appreciating against the USD, the foreign market
was closed
Once it reopened, the currencies of Japan and most European countries
were floating against the USD
○
The floating system was viewed as a temporary fix to unmanageable
speculation in the foreign exchange market
○
•
The Floating Exchange Rate Regime
The floating exchange rate regime was formalized in Jamaica in 1976 when IMF
members agreed to the rules for the international money system that are in
place today
•
The Jamaican Agreement
The meeting revised the IMF's Articles to reflect the new reality of floating
exchange rates
○
The main elements include
Floating rates were declared acceptable
§
Gold was abandoned as a reserve asset
§
Total annual IMF quotas (the amount member countries contribute
to the IMF) was increase to $41 billion USD
Now it has increased to $400 billion USD □
§
○
•
Exchange rates since 1973
Since 1973, exchange rates have become much more volatile and less
predictable than they were before
This volatility has been partly due to a number of unexpected
shocks to the world monetary system…
The oil crisis in 1971, when the price of oil quadrupled □
The loss of confidence in the dollar that followed the rise of
US inflation
□
The oil crisis in 1979, when oil prices increased dramatically □
The unexpected rise in the dollar between 1980-1985□
The rapid fall of the US dollar against JPY between 1993-1995□
The partial collapse of the European Money System in 1992□
The 1997 Asian currency crisis □
The decline of the value of the USD in the mod- to late-2000s □
The global financial crisis of 2008 and sovereign debt crisis in
the EU during 2010
□
§
○
The changing values of the USD shows the factors that affect currencies
generally
The driving force for the appreciation in the value of the USD was
the foreigners who continued to invest in USD financial assets
§
○
•
Fixed vs. Floating Exchange Rates
The Case for Floating Exchange Rates
There are two main elements for the case of floating exchange rates
Monetary Policy Autonomy
Under a fixed system, a country's ability to expand or contract
its money supply as it sees fit is limited by the need to
maintain exchange rate parity
Monetary expansion can lead to inflation
®
Monetary contraction requires high interest rates which
lead to an inflow of money abroad
®
□
Floating exchange rate regime argues that removing the
obligation to maintain exchange rate parity would restore the
money control to a government
If the government wants to increase money supply, it
could do so unencumbered by the need to maintain its
exchange rate
®
□
Although domestic inflation would have an impact on the
exchange rate under floating exchange rate regime, it should
have no impact on businesses' international cost
competiveness due to exchange rate depreciation
□
§
Automatic Trade Balance Adjustments
If a country developed a permanent deficit in its balance of
trade, that could not be corrected by domestic policy, the IMF
would have to agree to currency devaluation
Critics argues of this system that the adjustment
mechanism works much more smoothly under a
floating exchange rate
®
□
If a country is running a trade deficit, the imbalance between
supply and demand of that country's currency in the foreign
exchange markets will lead to depreciation in its exchange
rate
By making its exports cheaper and its imports and its
imports more expensive
®
□
§
○
•
The Case for Fixed Exchange Rates
The case rests on arguments about monetary, discipline, speculation,
uncertainty, and the lack of connection between trade balance and
exchange rates
Monetary discipline
The need to maintain a fixed exchange rate parity ensures
that governments do not expand their money supplies at
inflationary rates
□
Advocates argue that each country should be allowed to
choose its own inflation rate
□
Advocates also argue that governments all too often give in to
political pressures and expand the monetary supply far too
rapidly
A fixed exchange rate regime would ensure that this
does not occur
®
□
§
Speculation
Fixed rate can cause fluctuations in the exchange rate□
A fixed rate regime is a system that will limit the destabilizing
effects of speculation
□
§
Uncertainty
Speculation also adds to the uncertainty surrounding future
currency movements that characterizes floating exchange
regimes
□
A fixed exchange rate, by eliminating such uncertainty,
promotes the growth of international trade and investment
□
§
Trade Balance Adjustments
Advocates of floating exchange rates claim it helps adjust
trade imbalances
Critics question the closeness of the link between the
exchange rate and trade balance
®
□
§
○
•
Exchange Rate Regimes in Practice
Pegged Exchange Rates
Under a pegged exchange rate regime, a country will peg the value of its
currency to that of a major currency
E.g. if the USD rises so will this other currency
§
○
Adopting a pegged exchange rate regime does moderate inflationary
pressures in a country
○
•
Currency Boards
A country that introduces a currency board, it commits itself to converting
its domestic currency on demand into another currency at a fixed
exchange rate
A currency board is the means of controlling a country's currency by
holding reserves of a foreign currency equal at a fixed exchange rate
to at least 100 percent of the domestic currency issue
§
The currency board can issue additional domestic notes and coins
only when there are foreign exchange reserves to back it
This limits the ability for the government to print money,
which creates inflationary pressures
□
§
○
There are some drawbacks
If local inflation rates remain higher than the inflation rate in the
country to which the currency is pegged, the currencies of countries
with currency boards can become uncompetitive and overvalued
§
○
•
Crisis Management By The IMF
After the collapse of the Bretton Woods system, many thought the IMF would
fall as well
•
The activities of the IMF have expanded over the past 30 years
in 1997 they committed more than $110 billion in short-term loans to
troubled Asians countries
○
•
IMF has developed the financial leverage to act aggressively in times of global
financial crisis
•
IMF's activities have expanded because periodic financial crises have continued
to hit many economies in the post Bretton Woods era
•
Financial crises in the post Bretton Woods era
Many broad types of financial crises have occurred over the past quarter
century
○
All these cases have one thing in common, high inflation, a widening
current account deficit, excessive expansion of domestic borrowing, and
asset price inflation
A century crisis occurs when a speculative attack on the exchange
value of a currency results in a sharp depreciation in the value of
the currency or forces authorities to expand large volumes of
international currency reserves and sharply increase interest rates
to defend the prevailing exchange rate
§
A banking crisis refers to a loss of confidence in the banking system
that leads to a run on banks, as individuals and companies withdraw
their deposits
§
A foreign debt crisis in a situation in which a country cannot service
its foreign debt obligations, whether private or government debt
§
○
•
Evaluating the IMF's Policy Prescriptions
All IMF loan packages come with conditions attached
○
The policies are designed to cool overheated economies by reining in
inflation and reducing government spending and debt
○
Inappropriate Policies
One criticism is that IMF's traditional policy prescriptions represent
a "one-size-fits-all" approach to macroeconomics policy that is
inappropriate for many countries
The tight macroeconomic policies imposed by the IMF were
not well suited to countries that were suffering from a
private-sector debt crisis with deflationary undertone
□
§
○
Moral Hazard
A second criticism of the IMF is that its rescue efforts are
exacerbating a problem known to economists as moral hazard
§
Moral hazard arises when people behave recklessly because they
know will be saved I things go wrong
§
○
Lack of Accountability
The final criticism of the IMF is that it has become too powerful for
an institution that lacks any real mechanism for accountability
§
○
Observations
There are some cases where IMF policies have been
counterproductive, or only have limited success
§
○
•
Chapter 10
Friday, January 26, 2018 21:24
Document Summary
The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates. Foreign exchange market was the primary institution for determining exchange rates and impersonal market forces of demand and supply determined the relative value of any two currencies. The supply and demand is influenced by their respective countries" relative inflation rates and interest rates. When the foreign exchange market determine the relative value of a currency it is adhering to a floating exchange rate regime. The world"s four major trading currencies are all free to float against each other. Their exchange rates are determined by market forces and fluctuate against each other on a day-to-day basis. Many currency rates are not determined by the free play market, but by other institutional arrangements. All of these require some degree of government intervention in the foreign exchange market to maintain the value of a currency. Many nations peg their currencies, primarily to the usd to eur.
