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Assingnment On Monetary System
Assingnment On Monetary System
PROJECT REPORT
ON
SUBMITTED TO:
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CONTENT
1. INTRODUCTION 1
2. HISTORY OF IMS 2
a. BIMETALLISM 2
b. CLASSICAL GOLD 3
STANDARD
c. INTERWAR PERIOD 4
d. BRETTON WOODS 5
SYSTEM
e. FLEXIBLE 6
EXCHANGE RATES
3. EURO CURRENCY 7
4. CURRENCY CRISES 8
5. BIBLIOGRAPHY 9
Introduction
1. What “system”? The phrase “international monetary system” (IMS) refers to the rules and
institutions for international payments. Less abstractly, it refers to the currency/monetary regimes of
countries, the rules for intervention if an exchange rate is fixed or managed in some way, and the
institutions that back those rules if there is a problem (through official credits, controls, or parity
changes). With the world divided into a camp of major currencies that float freely and permit the
free flow of capital, and another camp with varying degrees of control over exchange rates and
cross-border flows, today’s IMS is something of a “non-system.” A key notion in this setup is that
of reserve asset: so long as a country fixes or manages its exchange rate, it needs a liquid
international asset of stable value to intervene with. Since the demise of real assets like gold as
monetary anchors, the U.S. dollar has been the world’s principal reserve asset. For the most part,
that system has worked reasonably well—except when it has not.
2. What is the issue? In a nutshell, the concern brought to the fore by the crisis is the tension
between (1) the scale and volatility of global capital flows, which motivates ever larger reserve
buffers, and (2) questions about the desirability of anchoring the IMS on one country’s currency
(the U.S. dollar), given the origins of this crisis in the U.S. heart of the global financial system. As
discussed below, these tensions are not new, and to some extent reprise the difficulties experienced
by the previous—and also dollar-based—Britton Woods Monetary System. The goal of this paper is
to shed some light on the underlying tensions and touch on the reform proposals that have been
floated.
3. Outline. In offering perspectives on tensions in the IMS and possible avenues for resolving
these, this paper does not attempt definitive conclusions and remedies
—not least because many of the ideas discussed require dramatic changes in the scale of global
policy coordination, and amendments to the IMF’s Articles of Agreement. Section II begins by
outlining the problem with current arrangements for meeting the world’s demand for reserve assets
(e.g., the lack of adjustment by the reserve issuer and its “exorbitant”—if earned— privilege of low-
cost access to foreign capital). Section III asks how the demand side can be ameliorated by reducing
incentives for reserve accumulation. Although some of the proposed remedies could be
implemented quickly, they would only address part of the problem. Thus, section IV looks at the
alternatives on the supply side, ranging from competing reserve currencies to multilateral assets like
the SDR or a really new global currency. These remedies share a longer timeframe of
implementation, but present difficult trade-offs in terms of stability, efficiency, sovereignty, and
practicality. All this suggests that the current system, suitably strengthened, may endure for some
time longer.
1. BIMETALLISM (pre-1875)
Commodity money system using both silver and gold (precious metals) for int'l payments
(and for domestic currency). Why silver and gold? (Intrinsic Value, Portable, Recognizable,
Homogenous/Divisible, Durable/Non-perishable). Why two metals and not one (silver
standard or gold standard vs. bimetallism)? Some countries' currencies in certain periods
were on either the gold standard (British pound) or the silver standard (German DM) and
some on a bimetallic (French franc). Pound/Franc ex-rate was determined by the gold
content of the two currencies. Franc/DM was determined by the silver content of the two
currencies. Pound (gold) / DM (silver) rate was determined by their ex-rates against the
Franc.
Under a bimetallic standard (or any time when more than one type of currency is acceptable
for payment), countries would experience "Gresham's Law" which is when "bad" money
drives out "good" money.
The more desirable, superior form of money is hoarded and withdrawn from circulation, and
people use the inferior or bad money to make payments. The bad money circulates, the good
money is hoarded. Under a bimetallic standard the silver/gold ratio was fixed at a legal rate.
When the market rate for silver/gold differed substantially from the legal rate, one metal
would be overvalued and one would be undervalued. People would circulate the
undervalued (bad) money and hoard the overvalued (good) money.
Examples: a) From 1837-1860 the legal silver/gold ratio was 16/1 and the market ratio was
15.5/1. One oz of gold would trade for 15.5 oz. of silver in the market, but one oz of gold
would trade for 16 oz of silver at the legal/official rate. Gold was overvalued at the legal
rate, silver was undervalued. Gold circulated and silver was hoarded (or not minted into
coins), putting the US on what was effectively a gold standard.
b) France went from a bimetallic standard to effectively a gold standard after the discovery
of gold in US and Australia in the 1800s. The fixed legal ratio was out of line with the true
market rate. Gold became more abundant, lowering its scarcity/value, silver became more
valuable. Only gold circulated as a medium of exchange.
For about 40 years most of the world was on an international gold standard, ended with
WWI when most countries went off gold standard. London was the financial center of the
world, most advanced economy with the most int'l trade.
Under a gold standard, ex-rates would be kept in line by cross-country gold flows. Any
mis-alignment of ex-rates would be corrected by gold flows. Payments could in effect be
made by either gold or banknotes. If market ex-rates ever deviated from the official ex-rate,
it would be cheaper to pay in gold than in banknotes.
Example: Suppose that the U.K. Pound is pegged to gold at: £6/oz., and the French franc is
pegged to gold at FF12/oz., then the ex-rate should be FF2/Pound. If the market rate was
FF1.80/£, then the pound is undervalued in the market (one pound should buy 2 FF, it only
buys 1.8 FF). Arbitrage would re-align the ex-rate:
When WWI started, countries abandoned the gold standard, suspended redemption of
banknotes for gold, and imposed embargoes on gold exports (no gold could leave the
country). After the war, hyperinflationary finance followed in many countries such as
Germany, Austria, Hungary, Poland, etc. Price level increased in Germany by 1 trillion
times!! Why hyperinflation then?? What are the costs of inflation??
US (1919), UK (1925), Switzerland, France returned to the gold standard during the 1920s.
However, most central banks engaged in a process called "sterilization" where they would
counteract and neutralize the price-specie-flow adjustment mechanism. Central banks
would match inflows of gold with reductions in the domestic MS, and outflows of gold with
increases in MS, so that the domestic price level wouldn't change. Adjustment mechanism
would not be allowed to work. If the US had a trade surplus, there would be a gold inflow
which should have increased US prices, making US less competitive. Sterilization would
involve contractionary monetary policy to offset the gold inflow.
In the 1930s, what was left of the gold standard faded - countries started abandoning the
gold standard, mostly because of the Great Depression, bank failures, stock market crashes.
Started in US, spread to the rest of the world. Also, escalating protectionism (trade wars)
brought int'l trade to a standstill. (Smoot-Hawley Act in 1930), slowing int'l gold flows. US
went off gold in 1933, France lasted until 1936.
Between WWI and WWII, the gold standard never really worked, it never received the full
commitment of countries. Also, it was period of political instability, the Great Depressions,
etc. So there really was no stable, coherent IMS, with adverse effects on int'l trade, finance
and investment.
At the end of WWII, 44 countries nations met at Bretton Woods, N.H. to develop a postwar
IMS. The International Monetary Fund (IMF) and the World Bank were created as part of a
comprehensive plan to start a new IMS. The IMF was to supervise the rules and policies of a
new fixed ex-rate regime; the World Bank was responsible for financing development
projects for developing countries (power plants, roads, infrastructure investments).
1. Economizes on scarce resources (gold) by allowing foreign reserves ($s) to be used for
IMS payments. Easier to transfer dollars vs. shipping gold overseas under pure gold std.
2. By holding $ instead of gold as reserves, foreign central banks can earn interest vs. non-
interest bearing gold.
3. Ex-rate stability reduced currency risk, provided a stable IMS, and facilitated int'l trade
and investment, led to strong economic growth around the world in 50s and 60s.
In long run, Bretton Woods (gold-exchange system) was unstable. There was no way to:
1) devalue the reserve currency ($) even when it became overvalued or
2) force a country to revise its ex-rate upward (appreciate its currency). A country could
agree, or be pressured into devaluation, but there was no way to "revalue" a currency
upward (appreciate through contractionary policy). In the 1960s, US pursued expansionary
monetary policy (printed money) to reduce unemployment, resulting in the dollar being
overvalued and foreign currencies being undervalued according to the fixed ex-rate system.
There was no way to devalue the $, and other countries were not willing to revalue their ex-
rates upward (appreciate). Why?
a. Flexible ex-rates allowed, central banks could intervene in currency markets. (Under
fixed ex-rates, you lose control over your monetary policy. Monetary policy must be
committed to maintaining the fixed ex-rate, and cannot be used to pursue other
macroeconomic goals)
b. Gold was abandoned as a reserve asset.
c. Developing countries were to get more assistance from IMF.
Disadvantages:
Major currencies like $, £ Yen, etc. are freely floating ex-rates, changing daily to reflect
market forces. Most of the rest of the world is under some type of system of "pegged ex-
rates" or "managed floating," where central bank intervention is required to maintain a
certain level of ex-rates. One system results in trading 1:1 with the dollar (Panama,
Bahamas, Belize 2:1, and Liberia), other systems trade within a certain band (range).
Currencies pegged to $, FF, SDRs, others. 36 are independently floating, no pegging or
targeting. More than 40 have "managed floating" systems that combine market forces with
pegging.
European Monetary System has been replaced by the Euro, the single currency in Europe (1
ECU = 1 Euro). To qualify for euro, countries had to meet certain economic criteria:
1) Deficits/GDP less than 3%,
2) Price level stability - low and stable inflation, etc. Of the 15 countries in the European
Union, three countries decided not to join (UK, Denmark, and Sweden).
As of Jan 1, 1999:
1) the 12 countries fixed their ex-rates against each other and against the Euro, and
2) the Euro became a unit of account. For example, 3.35FF/DM. 6.55 FF/Euro. FF and DM
will float against the $, £ and Yen, but will be fixed against each other and against the Euro.
Fixed ex-rate system for the 12 countries.
Euro currency (euro as a medium of exchange) started to circulate on Jan. 1, 2002. Old
currency and Euros BOTH circulated for the first 6 months, then old currency was taken out
of circulation and only Euros now exist.
Changes:
1) Stores now quote prices in Euros.
2) Payment in Euros can be made with charge cards and checking accounts
3) Euro currencies options are now traded
4) Stock prices/indexes are quoted in Euros.
5) European Central Bank (ECB) established to conduct monetary policy in Europe.
Governing Council made up of 12 ECB governors, one from each country, and 6 member
Executive Board.
Loss of control over domestic monetary policy and exchange rate determination.
Suppose that the Finnish economy is not well-diversified, and is dependent on exports of
paper/pulp products, it might be prone to "asymmetric shocks" to its economy. If there is a
sudden drop in world paper/pulp prices, the Finnish economy could go into recession,
unemployment could increase. If independent, Finland could use monetary stimulus to
lower interest rates and lower the value of its currency, to stimulate the domestic economy
and increase exports. As part of EU, Finland no longer has those options, it is under the EU
Central Bank, which will probably not adjust policy for the Eurozone to accommodate
Finland's recession. Finland may have a prolonged recession. There are also limits to the
degree of fiscal stimulus through tax cuts, since budget deficits cannot exceed 3% of GDP, a
requirement to maintain membership in EMU (to discourage irresponsible fiscal behavior).
General Consensus: Euro has been a success, and will likely emerge as the second global
currency, with the Yen as a junior partner. The success of the Euro may encourage other
areas to explore cooperative monetary arrangements (Asia, S. America). Three world
currencies at some point (¥, €, $)?
CURRENCY CRISES
Trilema: A country can attain only 2 of the following 3 conditions at one time: a) fixed
exchange rate, b) free international flows of capital, and c) independent monetary policy.
If you have an independent monetary policy and free capital flows (U.S., U.K., Euro), then
you can't maintain a fixed exchange rate, it will float.
To maintain a fixed ex-rate and allow free capital flows, you cannot have independent
monetary policy, like Hong Kong (7.8 HK$ to one USD) or Argentina (used to be 1:1) with
currency boards.
If you maintain a fixed ex-rate and pursue independent monetary policy, then you have to
impose capital controls, like China.
To avoid currency crises, a country can have: a) a really fixed ex-rate or b) a flexible ex-
rate, but NOT a fixed yet adjustable ex-rate when int'l. capital markets are integrated. See
Friedman article.
BIBLIOGRAPHY
WWW.BUSINESSWORLD.COM
WWW.WHEREISDOC.COM
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INTERNATIONAL FINANCIAL MANAGEMENT