International Monetary System

Exchange Rate System

• A nation’s exchange rate system is the set

of rules that determine the international
value of a nation’s currency.
• The exchange rate system evolves from the
monetary order.
 Currency Terminology
• A foreign currency exchange rate, or exchange rate,
is the price of one country’s currency in units of
another currency or commodity
– The system, or regime, is classified as a fixed,
floating, or managed exchange rate regime
– The rate at which the currency is fixed, or pegged,
is frequently referred to as its par value
– If the government doesn’t interfere in the valuation
of its currency, the currency is classified as floating
or flexible
 Currency Terminology
• Spot exchange rate is the quoted price for
the foreign exchange to be delivered at
once, or in two days for interbank
transactions
– Example: ¥114/$ is quote for 114 yen to buy
one US dollar for immediate delivery
• Devaluation of a currency refers to a drop
in foreign exchange value of a currency
that is pegged to gold or to another
currency. The par value is reduced, the
opposite of devaluation is revaluation
 Currency Terminology
• Weakening, deteriorating, or depreciation of a
currency refers to a drop in foreign exchange value a
floating currency. The opposite of weakening is
strengthening or appreciating, which refers to a gain
in the exchange value of a floating currency
• Soft or weak describes a currency that we expect to
devalue or depreciate relative to major currencies;
hard or strong is the opposite
• Eurocurrencies are another type of money although in
reality they are domestic currencies of a country
deposited in another country.
– Example: a Eurodollar is a US dollar denominated deposit in
a bank outside of the United States
 The Gold Standard

• Came into effect around 1880 as most of

the major economies unilaterally pegged to
gold.
• Nations fixed the value of their currency
relative to gold via a mint parity rate.
• They also established convertibility. That is,
the ability to exchange the currency for
gold.
 The Gold Standard

• As each currency was pegged to gold, it

established an exchange rate system by
indirectly establishing an exchange rate.
• The mint parity rates could be used to
determine the exchange rates between
currencies.
The Gold Standard

G old
A t C en ter of S ys tem

U S D ollar U K P ou n d
2 0 .6 4 6 4 .2 5 2

4 .8 5 6 $ /p ou n d
 The Gold Standard

• Period characterized by long-run price stability,

since supply of money limited by the supply of
gold, which increased only slowly over time
• Short-run price instability, since balance of
payments problems were remedied by gold flows
between countries, which caused changes in
money supply and prices in different countries
 International Settlements
Under the Gold Standard I
• A country that had balance of payments deficit
would have to redeem foreigners’ excess holdings
of the domestic currency with gold, draining
domestic gold reserves, reducing domestic money
supply and reducing inflation/prices
• This would reduce imports and increase exports,
correcting the imbalance
 International Settlements
Under the Gold Standard II
• A country that had balance of payments surplus
could use its excess foreign currency holdings to
purchase other countries’ gold, increasing
domestic gold reserves, thereby increasing
domestic money supply and increasing
inflation/prices
• This would increase imports and reduce exports,
correcting the imbalance
 End of the Gold Standard

• Suspended in 1914 at the beginning of

WWI

• Depression (1930s) was period when

countries were at economic war with each
other
The Bretton Woods Conference, 1944

• Forty-four nations participated in the

conference.
• Primary architects were Harry White of the
U.S. and John Maynard Keynes of the U.K.
The Bretton Woods Conference
Organizations Created

In tern ation al M on etary F u n d

IM F

In tern ation al B an k for R ec on s tru c tion an d D evelop m en t

IR B D
W orld B an k

G en eral A g reem en t on Tariffs an d Trad e

G A TT
 Bretton Woods Monetary System
(1944-1971)
• System of adjustable pegged exchange
rates
• U.S. dollar was the anchor of the system as
it was pegged to gold.
• All other nations pegged to the dollar,
therefore, a dollar-standard exchange rate
system was created.
 Bretton Woods System
• Currencies could be devalued, revalued if
necessary
– Devaluation: an abrupt reduction in the pegged value
of a currency
– Revaluation: an abrupt increase in the pegged value of
a currency
• U.S. dollar was the reserve currency – used to
settle international debts and express the exchange
value of other currencies
• U.S. dollar was convertible to gold by official
holders (central banks and treasuries) only
– The Special Drawing Right (SDR) is an
international reserve assets created by the IMF to
supplement existing foreign exchange reserves
• It serves as a unit of account for the IMF and is
also the base against which some countries peg
their exchange rates
• Defined initially in terms of fixed quantity of
gold, the SDR has been redefined several times
• Currently, it is the weighted average value of
currencies of 5 IMF members having the largest
exports
• Individual countries hold SDRs in the form of
deposits at the IMF and settle IMF transactions
through SDR transfers
The Dollar-Standard System

G old

U .S . D ollar
$ 3 5 .0 0

P ou n d M ark
2 .8 0 $ /p ou n d 4 .2 0 D M /$

1 1 .7 6 D M /p ou n d
 Adjustments to Disequilibrium in
Foreign Exchange Market

• Gold Standard
– Gold flows between countries
• Flexible (Floating) Exchange Rates
– Market forces
• Pegged Exchange Rates
– Central bank intervention to maintain peg
– Devaluation and revaluation, if necessary
 Central Bank Intervention
In the Foreign-Exchange Market
$/£
S

S’
A B
1.60
1.50
C

£1 £2 £3 £
To maintain exchange rate at $1.60 after increase in
supply, central bank buys AB pounds in market.
 Central Bank Intervention
In the Foreign-Exchange Market
$/£
S
C
1.70
A B
1.60

D’
D

£1 £2 £3 £
To maintain exchange rate at $1.60 after increase in
demand, central bank sells AB pounds in market.
 Parity Band

• Under Bretton Woods, each nation pegged the

value of its currency to the U.S. dollar
• Each nation was obligated to maintain the value of
its currency within a band one percent above or
below the pegged value. This was the parity
band.
• How? By buying or selling dollars with its
currency in the foreign exchange market (central
bank intervention)
 Meaning of “Run on the Pound”
• Suppose U.K. has balance of payments problems –
e.g., because imports > exports
• Foreign exchange markets flooded with surplus
pounds which Bank of England must buy up to
maintain pegged value of pound
• When investors, traders, speculators begin to
doubt ability of Bank of England to maintain
current pegged value, they rush to sell pounds
• This may force U.K. to devalue the pound – it
doesn’t have unlimited foreign exchange reserves
with which to buy pounds
 The 1960s
Trouble for the Dollar
• Glut (excess supply) of dollars in foreign hands
due to U.S. trade deficits
• Dollar believed overvalued relative to the
currencies of Japan and some Western European
economies, e.g., Germany.
• Dollar becomes target of foreign exchange
speculators who believed it would be devalued
relative to gold
 The 1960s
Trouble for the Dollar

• U.S. and European countries intervene in the gold

market, selling gold for dollars (the gold pool,
1960-68)
• Pound also under pressure
• Britain devalues pound in 1967 and holders of the
pound experience a 15 percent capital loss.
 The Dollar and the Mark

• On May 4, 1971, the Bundesbank buys $1 billion

on the exchange market to maintain the parity
value of the mark.
• On the next day they buy $1 billion in the first
hour of trading.
• Bundesbank abandons the parity rate and lets the
mark float upward relative to the dollar.
• Austria, Belgium, the Netherlands, and
Switzerland follow suit.
 End of Bretton Woods System

• Faced with a major run on the dollar, President

Nixon suspends convertibility of the dollar
(August 1971).
• The dollar-exchange system falls into disarray.
• Foreign exchange markets are closed on extremely
volatile days
 Emerging Markets & Regime
Choices
Emerging Market High capital mobility is forcing emerging market
Country nations to choose between two extremes

Free-Floating Regime Currency Board or

Dollarization

•Currency value is free to

float up and down with •Currency Board fixes the
international market forces value of the local currency or
basket; Dollarization replaces
•Independent monetary policy currency with the US dollar
and free movement of capital
allowed, but at the loss of •Independent monetary policy
stability is lost; political influence on
monetary policy is eliminated
•Increased volatility may be
more than what a small •Seignorage, the benefits
financial market can accruing to a government
withstand from the ability to print its
own money, is lost
 The Birth of a European Currency: The Euro
• 15 Member nations of the European Union are also members
of the European Monetary System (EMS)
– Maastricht Treaty specified timetable and plan for replacing
currencies for a full economic and monetary union
– Convergence criteria called for countries’ monetary and fiscal
policies to be integrated and coordinated
• Nominal inflation should be no more than 1.5% above average for the
three members of the EU with lowest inflation rates during previous
year
• Long-term interest rates should be no more than 2% above average for
the three members of the EU with lowest interest rates
• Fiscal deficit should be no more than 3% of GDP
• Government debt should be no more than 60% of GDP
– European Central Bank (ECB) was established to promote
price stability within the EU
 The Euro & Monetary
Unification
• The euro, €, was launched on Jan. 4, 1999 with 11 member
states
• Effects for countries using the euro currency include
– Cheaper transaction costs,
– Currency risks and costs related to exchange rate
uncertainty are reduced,
– All consumers and businesses, both inside and outside of
the euro zone enjoy price transparency and increased
price-based competition
 The Euro & Monetary
Unification
• Successful unification of the euro relies on two
factors:
– Monetary policy for the EMU has to be coordinated
via the ECB
• Focus should be on price stability of euro and inflationary
pressures of economies
– Fixing the Value of the euro
• On 12/31/1998, the national exchange rates were fixed to
the Euro
• On 1/4/1999 the euro began trading on world currency
markets and value has slid steadily since its introduction