Chapter 3

The International Monetary System

Chapter 3 Outline

A. Exchange Rate Systems

B. International Monetary System
C. European Monetary System and Monetary Union
D. Emerging Market Currency Crises

Chapter 3: The International Monetary System 2

1.A Exchange Rate Systems
 Free float
 Managed float
 Target-zone arrangement
 Fixed-rate system
 Hybrid system

Chapter 3: The International Monetary System 3

2.A Exchange Rate Systems
 Free (“clean”) float
– Exchange rates are determined by currency supply and demand with no
government intervention.
– As economic fundamentals change, market participants adjust their
current and expected future currency needs.
– Shifts in currency needs in turn shift currency supply and demand
schedules, as seen in Chapter 2.
 Managed (“dirty”) float
– Central banks intervene to reduce economic volatility.
– Three categories of intervention
1. Smoothing out daily fluctuations – central bank buys or sells currency to
smooth exchange rate adjustments.
2. Leaning against the wind – measures taken to moderate or prevent short- or
medium-term exchange rate fluctuations caused by random events.
3. Unofficial pegging – a country pegs the value of its currency to a foreign
currency to protect the value of its exports.
Chapter 3: The International Monetary System 4
3.A Exchange Rate Systems
 Target zone arrangement
– Countries agree to adopt economic policies that maintain their exchange
rates within a specific range.
– Designed to minimize exchange rate volatility and enhance economic
stability in participating countries.
– Requires coordination of economic policy objectives and practices.
 Fixed-rate system
– Governments maintain target exchange rates.
– Central banks buy/sell currency to increase (“revalue”)/decrease
(“devalue”) exchange rates when exchange rates threaten to deviate
from their stated par values by more than an agreed-on percentage.
– Monetary policy becomes subordinate to exchange rate policy.
 Hybrid system – current international system consisting of free-
float, managed-float, and pegged currencies.
Chapter 3: The International Monetary System 5
4.A Fixed versus Floating
 Why countries prefer fixed rates?
– Discipline, Stability, Confidence
 Discipline it imposes on fiscal & monetary policy –
instills greater confidence in the currency; anti-
inflationary by nature
– the political costs of abandoning the peg induces
tighter policies
 Stability in international prices which aids growth of
international trade and reduces exchange rate risks
4.A Fixed versus Floating
 Why countries prefer fixed rates?
– Discipline, Stability, Confidence
 Confidence among country’s residents to hold domestic
currency rather than goods or foreign currencies
– Therefore, for a given growth rate in money supply,
higher money demand (the desire to hold money as
opposed to spend it) will imply lower inflation rates
5.A Fixed versus Floating
 However, maintaining fixed rates …
– Requires central banks to maintain large quantities of
international reserves for use in the occasional
defense of fixed rates
– Once in place, fixed rates may be inconsistent with
economic fundamentals (periodic currency crisis)
– Mere declaration of fixed exchange rates is
insufficient to reap the full anti-inflationary benefits …
the policy has to be credible
6.A Fixed versus Floating
 Advantages of floating currency system
– Central bank is not required to constantly maintain
exchange rates within specified boundaries
– Country is more insulated from overseas economic
woes
 Disadvantages of floating currency system
– Currency volatility
– Pursue inflationary policies
1.B International Monetary System
 Gold Standard – participating countries fixed the prices of their
currencies in terms of a specified amount of gold.
– U.S. set the dollar exchange rate to gold at the rate $20.67 per troy
ounce.
– During the same period Great Britain set its currency at the rate
£4.2474 per troy ounce
 Because the value of gold is fairly stable over time, the gold
standard ensured long-run price stability for both individual
countries and groups of countries.
 During this period in most major countries:
– Gold alone was assured of unrestricted coinage
– There was two-way convertibility between gold and national
currencies at a stable ratio.
– Gold could be freely exported or imported.
Chapter 3: The International Monetary System 10
1.B International Monetary System
 Classical Gold Standard (1821-1914)
– Characterized by price-specie-flow mechanism
• Changes in the price level in one country were offset by an
automatic balance of payments (“BOP”) adjustment.
• What happens when there is a new gold discovery in the
U.S.?

Chapter 3: The International Monetary System 11

2.B International Monetary System
 Classical Gold Standard (1821-1914), continued
– 1821 – England returns to gold standard
– 1821-1880 – other countries join the gold standard
– 1880-1914
• Rapid expansion of virtually free international trade
• Stable exchange rates and prices
• Free flow of labor and capital
• Rapid economic growth
• World peace
• However, some negative economic conditions
– Major depression in 1890s
– Economic contraction in1907
– Repeated recessions

Chapter 3: The International Monetary System 12

4.B Classical Gold Standard: 1876-1914
 Highly stable exchange rates under the classical gold
standard provided an environment that was conducive to
international trade and investment.
 Countries had to maintain adequate gold reserves to back its
currency’s value.
 Money growth was limited to the rate at which official
authorities could acquire additional gold.
5.B International Monetary System
 Gold Exchange Standard (1925-1931)
– The U.S. and England could hold only gold reserves
– Other nations could hold both gold and dollars/pounds as reserves.
– In 1931, England departed from gold given massive gold and capital
flows stemming from an unrealistic exchange rate, ending the Gold
Exchange Standard.

 1931-1944
– Beggar thy neighbor devaluations – countries devalued their currencies
to maintain trade competitiveness, leading to a trade war.

Chapter 3: The International Monetary System 14

6.B International Monetary System
 Bretton Woods System (1946-1971)
– Bretton Woods Conference, 1944
• New postwar monetary system
– Allied nations pledged to maintain a fixed (pegged) exchange rate in
terms of the dollar or gold.
– 1 ounce of gold = $35
– Exchange rates could fluctuate only within 1% of their stated par
values.
– Fixed rates were maintained by central bank intervention in foreign
exchange markets.
– Any dollars acquired by foreign countries in the process of intervention
could then be exchanged at the U.S. Treasury at a fixed price of $35
per ounce.

Chapter 3: The International Monetary System 15

7.B International Monetary System

 Design of the gold-exchange system

British German French

pound mark franc
DM4.20/$
$2.80/₤ Par Value
Par Value Par Value
U.S. Dollar

Pegged at $35/oz …
Called the mint parity value

Gold
8.B International Monetary System
 Bretton Woods System (1946-1971)
– Imposed economic discipline
• Say, France followed policies leading to a new higher rate of inflation
– Exports would decrease; imports would increase; BOP deficit would get
larger
– Resulting increase in supply of currency would depress exchange value
of the franc
– Country would be obligated to buy francs with its dollar reserves,
effectively reducing domestic money supply
• It cannot afford to keep intervening … sooner or later it will
exhaust its reserves
– Therefore, it will be forced to change economic policies, which along
with lower money supply, will bring its inflation in line with the rest of the
world

– Devaluations were used only as a last resort

Chapter 3: The International Monetary System 17

9.B International Monetary System
 Bretton Woods System (1946-1971), continued
– Bretton Woods Conference, 1944, continued
• Two new institutions created
– International Monetary Fund (IMF) – created to promote monetary
stability
• Role has evolved over time
• Oversees exchange rate policies in about 182 member countries
• Advises developing countries on economic policy
• Lender of last resort
• Moral hazard – expectation of IMF bailouts leads investors to
underestimate risks of lending to governments that pursue
irresponsible policies
– International Bank for Reconstruction and Development (World Bank)
– created to lend money to countries to rebuild their war-damaged
infrastructures

Chapter 3: The International Monetary System 18

10.B International Monetary System
 Bretton Woods System (1946-1971), continued
– Fixed rate system in name only.
• Of 21 major industrial countries:
– Only the U.S. and Japan maintained their par values
– 12 countries devalued their currencies > 30% against the dollar
– 4 countries revalued their currencies
– 4 countries allowed their currencies to float
– Collapse of Bretton Woods system
• Inflation in the U.S. stemming from the Johnson Administration
printing money instead of raising taxes to finance Vietnam conflict.
• West Germany, Japan, and Switzerland would not accept the
inflation that a fixed exchange rate with the dollar would have
imposed on them.

Chapter 3: The International Monetary System 19

11.B International Monetary System
 Post-Bretton Woods System (1971-Present)
– Smithsonian Agreement
• Dollar was devalued to 1/38 of an ounce of gold.
• Other currencies revalued by agreed-on amounts in terms of the dollar.

– Attempts to set new fixed rates unsuccessful.

– International floating exchange rate system instituted in 1973.
• System supposed to reduce economic volatility and facilitate free trade.
– Floating rates would offset international differences in inflation.
– Real exchange rates would stabilize given gradual changes in
underlying conditions affecting trade and productivity of capital.
– Nominal exchange rates would stabilize if countries coordinated their
monetary policies to achieve inflation rate convergence.
• However, currency volatility has increased due to non-monetary global
economic shocks (e.g., changing oil prices) – see Exhibit 3.8, pg. 72

Chapter 3: The International Monetary System 20

1.C European Monetary System
 European Monetary System (EMS)
– Began operating in March 1979.
– Purpose: Foster monetary stability in the European Community (EC)
– Members established the European Currency Unit (ECU), a composite
currency consisting of fixed amounts of the 12 EC member currencies.
– The quantity of each currency reflected each country’s relative
economic strength within the ECU.

Chapter 3: The International Monetary System 21

2.C European Monetary System
 Exchange rate mechanism (ERM)
– Target zone system
– Allowed each EMS member to determine a mutually agreed-on currency
exchange rate.
– Each rate was denominated in central ECU currency units.
– Central rates established a grid of bilateral cross-exchange rates
between currencies.
– Participating countries pledged to maintain their currencies within a +/-
15% margin of cross-exchange rates.
– EMS crisis in 1992 because of divergence in countries economic
policies (read illustration on pg. 76)
– By 1993, the ERM created a two-tiered system
• One tier included currencies tightly anchored by the DM
• One tier included weaker currencies
– EMR abandoned in August 1993
Chapter 3: The International Monetary System 22
3.C European Monetary System
 European Monetary Union (EMU, or EU)
– Maastricht Treaty
• Failure of ERM hastened the need for the EC to move towards
monetary union – i.e., establish a single (European) central
bank with the sole power to issue a single European currency
called the euro
– On January 1, 1999, the euro became a currency and
conversion rates for the euro were locked in for member
countries.
– On January 1, 2002, member countries’ currencies were
replaced by euro bills and coins.
– Currently 27 member countries in the EU; 16 of them have
adopted the euro

Chapter 3: The International Monetary System 23

4.C European Monetary System
 European Monetary Union (EMU, or EU)
– To join the EU, countries were subjected to the Maastricht criteria
• Government debt ≤ 60% of GDP
• Budget deficit ≤ 3% of GDP
• Inflation ≤ 1.5 percentage points above the average rate of
Europe’s three lowest-inflation countries
• Long-term interest rates ≤ 2 percentage points above the
average interest rate in the three lowest-inflation countries

Chapter 3: The International Monetary System 24

5.C European Monetary System
 European Monetary Union (EMU, or EU), continued
– Consequences of EU
• Lower cross-border currency conversion costs
• Eliminated risk of currency fluctuations
• Facilitated cross-border price comparisons
• Encouraged flow of trade and investments among member
countries
• Greater integration of Europe’s capital, labor, and
commodity markets
• Increased Europe’s competitiveness
• Greater coordination of monetary policy

Chapter 3: The International Monetary System 25

1.D Emerging Market Currency Crises
 Currency crises spread from one country to another by
two means.
– Trade links – e.g., when Argentina is in crisis, it
imports less from Brazil, causing Brazil’s economy to
contract and its currency to weaken. Brazil’s
contraction will in turn affect other trade partners.
– The financial system – distress in one emerging
market causes investors to exit other countries with
similar risk profiles.
 Common denominator in promoting currency crises:
Countries issue too much short-term debt closely linked
to the dollar. When the dollar appreciates, the cost of
repaying dollar-linked bonds soars.
Chapter 3: The International Monetary System 26
2.D Emerging Market Currency Crises
 Circumventing emerging market crises
– Currency controls
• Abandoning free capital movement to insulate a country’s currency
from speculative attacks.
• However:
– Open capital markets channel savings to where they are most
productive;
– Developing nations need foreign capital and know-how; and
– Currency controls have led to corruption

– Freely floating currency – floating rates absorb the pressures created

in emerging countries that simultaneously peg their exchange rates
and pursue independent monetary policy.
– Permanently fix the exchange rate – through dollarization, use of a
currency board, or a monetary union, a country can permanently fix its
exchange rate.

Chapter 3: The International Monetary System 27