CHAPTER 3

Defining and Analyzing the

International Monetary System
PART I. ALTERNATIVE EXCHANGE
RATE SYSTEMS

I. FIVE MARKET MECHANISMS

A. Freely Floating (Clean Float)
1. Market forces of supply
and demand determine
rates.
2. Forces influenced by
a. price levels
b. interest rates
c. economic growth
3. Rates fluctuate over time
randomly.
ALTERNATIVE EXCHANGE RATE
SYSTEMS
B. Managed Float (Dirty Float)
1. Market forces set rates unless
excess volatility occurs.
2. Then, central bank determines
rate.
ALTERNATIVE EXCHANGE RATE
SYSTEMS
C. Target-Zone Arrangement
1. Rate Determination
a. Market forces constrained
to upper and lower range of
rates.

b. Members to the arrangement

adjust their national economic
policies to maintain target.
ALTERNATIVE EXCHANGE RATE
SYSTEMS
D. Fixed Rate System
1. Rate determination
a. Government maintains
target rates.
b. If rates threatened, central
banks buy/sell currency.
c. Monetary policies coordinated.
ALTERNATIVE EXCHANGE RATE
SYSTEMS
D. Fixed Rate System (con’t)
2. Some Government Controls:
a. On global portfolio
investments.
b. Ceilings on direct foreign
direct insurance.
c. Import restrictions.
ALTERNATIVE EXCHANGE RATE
SYSTEMS
E. Current System
1. A hybrid system
a. Major currencies:use
freely-floating method
b. Others move in and out
of various fixed-rate systems.
 PART II. A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM

I. THE USE OF GOLD

A. Desirable properties
B. In short run: High production costs limit
short-run changes.
C. In long run: Commodity money insures
stability.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM

II.The Classical Gold Standard

(1821-1914)
A. Major currencies on gold standard.
1. Involved commitment by
nations to fix the price of
domestic currency in terms of a
specific amount of gold.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
2. Maintenance involved the buying
and selling of gold at that price.
3. Disturbances in Price Levels:
Would be offset by the price-
specie*-flow mechanism.

* specie refers to gold coins

 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
a. Price-specie-flow mechanism
had automatic adjustments:
1.) When a balance of payments surplus
led to a gold inflow;
2.) Gold inflow led to higher prices which
reduced surplus;
3.) Gold outflow led to lower prices and
increased surplus.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
III. The Gold Exchange Standard
(1925-1931)
A. Only U.S. and Britain allowed to
hold gold reserves.
B. Others could hold both gold, dollars
or pound reserves.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
C. Currencies devalued in 1931
- led to trade wars.

D. Bretton Woods Conference

- called in order to avoid future
protectionist and destructive
economic policies
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
IV. The Bretton Woods System(1946-71)
A. The Bretton Woods Agreement
1. U.S.$ was key currency;
valued at $1 = 1/35 oz. of gold.
2. All currencies linked to that price in
a fixed rate system.
3. Exchange rates allowed to fluctuate
by 1% above or below initially set
rates.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
B. Collapse, 1971
1. Causes:
a. U.S. high inflation rate
b. U.S.$ depreciated sharply.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
V. Post-Bretton Woods System
(1971-Present)
A. Smithsonian Agreement, 1971
US$ devalued to 1/38 oz. of gold.
By 1973: World on a freely
floating exchange rate system.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
B. OPEC and the Oil Crisis (1973-1974)
1. OPEC raised oil prices four fold;
2. Exchange rate turmoil resulted;
3. Caused OPEC nations to earn
large surplus B-O-P.
4. Surpluses recycled to debtor nations
which set up debt crisis of 1980’s.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM

C. Dollar Crisis (1977-78)

1. U.S. B-O-P difficulties
2. Result of inconsistent monetary
policy in U.S.
3. Dollar value falls as confidence
shrinks.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM

D. The Rising Dollar (1980-85)

1. U.S. inflation subsides as the Fed
raises interest rates
2. Rising rates attracts global capital to
U.S.
3. Result: Dollar value rises.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM

E. The Sinking Dollar:(1985-87)

1. Dollar revaluated slowly downward;
2. Plaza Agreement (1985)
G-5 agree to depress US$ further.
3. The Louvre Agreement (1987)
G-7agree to support the falling US$.
 A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM

F. Recent History (1988-Present)

1. 1988 US$ stabilized
2. Post-1991 Confidence resulted in
stronger dollar
3. 1993-1995 Dollar value falls
 PART III.
THE EUROPEAN MONETARY
SYSTEM
I. INTRODUCTION
A. The European Monetary System
(EMS)
1. A target-zone method (1979)
2. Close macroeconomic policy
coordination required.
 THE EUROPEAN MONETARY
SYSTEM
B. EMS Objective:
to provide exchange rate stability to all
members by holding exchange rates within
specified limits.
 THE EUROPEAN MONETARY
SYSTEM

C. European Currency Unit

(ECU)
a “cocktail” of European currencies with
specified weights as the unit of account.
1. Exchange rate mechanism (ERM)
each member determines mutually agreed
upon central cross-rate for its currency.
 THE EUROPEAN MONETARY
SYSTEM
2. Member Pledge:
to keep within 15% margin above or below
the central rate.
D. EMS ups and downs
1. Foreign exchange interventions failed due
to lack of support by coordinated monetary
policies.
 THE EUROPEAN MONETARY
SYSTEM
2. Currency Crisis of Sept. 1992
a. System breaks down
b. Britain and Italy forced to withdraw from
EMS.
G. Failure of the EMS
members allowed political priorities
to dominate exchange rate policies.
 THE EUROPEAN MONETARY
SYSTEM
H. Maastricht Treaty
1. Called for Monetary Union by 1999
(moved to 2002)
2. Established a single currency: the
euro
3. Calls for creation of a single central EU
bank
4. Adopts tough fiscal standards
 THE EUROPEAN MONETARY
SYSTEM
I. Costs / Benefits of A Single
Currency
A. Benefits
1. Reduces cost of doing business
2. Reduces exchange rate risk
B. Costs
1. Lack of national monetary flexibility.