International Monetary Arrangements

1. International Monetary Arrangements MSFI535 Week #1 International Monetary Arrangements Week 1 Lecture Slides

2. International Monetary Arrangements Lecture Outline • Monetary systems • The gold standards 1880 – 1914 & 1944 - 70 • The interwar period 1918 – 1939 • Floating exchange rates 1973 – present • The transition years 1971 - 1973 • Foreign exchange systems • Floating system • International reserve currencies • The Greenback (US Dollar) • The European Monetary System (EMS) & the Euro International Monetary Arrangements Week 1 Lecture Slides

3. Monetary Systems Lecture Outline • Introduction • Like most areas of public policy, international monetary systems are subject to frequent proposal for change. In response to the current global economic crisis, there are loud (and angry) calls for the rejection of “capitalism” and its free financial markets. • Many are now calling for more government regulations to rein in the free financial markets. Some even suggest we consider implementing a fixed or managed financial system to help control international capital flows and exchange rates to minimize their “boom and bust” effects on economies. International Monetary Arrangements Week 1 Lecture Slides

4. Monetary Systems Lecture Outline • Introduction • However, before we study the merits of alternative international monetary systems to help us better understand how financial markets around the world interconnect and affect real economic activities, we should first try to understand the background of the international monetary systems. • Perhaps, by understanding the past, we can better understand the forces which are affecting and shaping today’s financial markets. International Monetary Arrangements Week 1 Lecture Slides

5. Monetary Systems The Gold Standard: 1880 - 1914 • Stability (and Low Inflation) • From the 1870s until World War I, the United Kingdom served as the leading financial and banking center of the world, while gold ruled as the monetary standard of all the major trading countries. Each country pegged its currency to gold at a constant and unchanging rate. The international gold standard system ushered in a period of unprecedented stability and prosperity - at least for the middle and upper classes in the industrial countries. • The gold standard provided monetary discipline. Because governments were required to convert domestic currency into gold on request, the amount of currency they could print was limited by the amount of gold in their reserves. International Monetary Arrangements Week 1 Lecture Slides

6. Monetary Systems The Gold Standard: 1880 - 1914 • Stability (and Low Inflation) • Exchange rate never varied in the classical gold system. This made exchanging money much easier for travelers. American Express even printed the exact amount of foreign currency exchange right on its traveler's cheques. International Monetary Arrangements Week 1 Lecture Slides

7. Monetary Systems The Gold Standard: 1880 - 1914 • How did it work? • Gold was used as the primary form of money to facilitate and support the global economic activities (e.g. exchange and investments). • Therefore, gold stock was equivalent to money supply. Hence: • Exports increase the domestic money supply • Imports reduce the domestic money supply International Monetary Arrangements Week 1 Lecture Slides

8. Monetary Systems The Gold Standard: 1880 - 1914 • How did it work? • Under the system with the fixed exchange rates, there was no lasting current account deficits (e.g. US & UK) and surpluses (e.g. China & Korea). Why? • The system will automatically restore global capital equilibrium. • How was the equilibrium restored? • Trade deficit exports < imports  outflow of gold  reduction in money supply  relatively lower domestic prices (vs. higher foreign prices)  exports > imports  trade balances! • Trade surplus  exports > imports  inflow of gold increase in money supply  higher relative domestic prices (vs. foreign prices)  exports < imports  trade balances! International Monetary Arrangements Week 1 Lecture Slides

9. Monetary Systems The Gold Standard: 1880 - 1914 • How well did it work? • The standard produced global financial stability (e.g. US/UK Exchange Rates). This in turn supported global investments and thus, economic growth. • Since the standard prevented the emergence lasting current account deficits/surpluses, it also minimized formations of financial bubbles and subsequent busts (which we are experiencing today). • Note that many economists believe that the U.S. current account deficits (from mostly trade balance) generated large inflow of capitals (from China) and contributed to the build up of the recent housing/asset bubbles. International Monetary Arrangements Week 1 Lecture Slides

10. Monetary Systems The Gold Standard: 1880 - 1914 • Thought questions • Why is the development of U.S. current account deficit not possible under the gold standard? • Why is the U.S. current account balance deficit getting smaller? • How this development may affect the availability of capital for investment in the U.S.? • How would increased personal savings may affect the availability of capital? • Why governments do not prefer the gold standard? (Hint: next slide) International Monetary Arrangements Week 1 Lecture Slides

11. Interwar Period 1918-1939 Meltdown • Why the gold standard fall apart? • World War I marked the end of an economic era. Faced with an urgent need for more liquidity, the combatant countries took their currencies off the stabilizing gold standard and printed more money. This triggered high inflation, which persisted after the war • The cost of the "World War" was staggering when compared with the costs of earlier hostilities. Governments were forced to stop redeeming their currencies for gold, since they had to print so much paper money to pay for the war which resulted in run away inflation in many countries International Monetary Arrangements Week 1 Lecture Slides

12. Interwar Period 1918-1939 Global Depression • Bad public policies prevailed • Normalcy returned with the reestablishment of the gold standard in the mid-1920s, but imbalances plagued the monetary system. The prewar fixed exchange rates no longer reflected the relative economic strengths of the major countries: • The U.K. pound was greatly overvalued. • The U.S. dollar and French franc were undervalued. • By the end of the decade, economic and financial troubles had spread around the world. • The (possible) cause of the Great Depression is discussed in the optional reading assignment – DeLong) International Monetary Arrangements Week 1 Lecture Slides

13. The Gold Exchange System 1944 - 1970 Economic Cooperation • The Bretton Woods System • The desire for economic cooperation stemmed from fear of repeating the post-World War I mistakes that had led to inflation, financial instability, and the Great Depression. While World War II still raged, Allied policy makers debated several plans for international monetary stability. • Representatives from 44 countries managed to gather for a conference at Bretton Woods in New Hampshire. Their goal - to design the framework for postwar international economic cooperation. • Note that D-Day had taken place three weeks previously. International Monetary Arrangements Week 1 Lecture Slides

14. The Gold Exchange System 1944 - 1970 Economic Cooperation • The Bretton Woods System • The Bretton Woods meeting was a success. The delegates agreed on the fundamental principles of a new monetary system – fixed but adjustable exchange rates - to encourage economic stability and prosperity. • Moreover, the delegates established two intergovernmental institutions to further these principles: The International Monetary Fund and the World Bank International Monetary Arrangements Week 1 Lecture Slides

15. The Transition Years 1971 - 1973 The Collapse • Monetary revolution • On August 15, 1971, the United States stunned the world by declaring that it would cease redeeming dollars for gold from its reserves. Why? • There are many reasons. However, the main underlying reason is for the government to enjoy “Seigniorage” or real resources earned (or seized) by a government when it prints money that it spends on goods and services • With this move, the dollar's link to gold was severed, dismantling the foundation of Bretton Woods. The financial system that had helped bring a quarter century of prosperity to the industrial world had finally collapsed International Monetary Arrangements Week 1 Lecture Slides

16. The Transition Years 1971 - 1973 The Collapse • Monetary revolution • Note that for thousands of years, "money" had been based on a tangible, valuable commodity such as gold or silver. • In the early 1970s, the international community abandoned the security and discipline of a fixed-rate metal standard. In its place, the world adopted a system of "floating" exchange rates: each currency’s value moved up or down depending on international demand and the amount of confidence in its country’s economy. International Monetary Arrangements Week 1 Lecture Slides

17. The Transition Years 1971 - 1973 The Collapse • Thought questions • With the collapse of the Bretton Woods fixed exchange rate system, governments are now more able to print money or increase their money supply • What may be possible affects on financial markets as results of this development? • Why is an independent central bank important in promoting investments? International Monetary Arrangements Week 1 Lecture Slides

18. Floating Exchange Rates 1973 - Present Free Financial Markets • Supply and demand • The currency's value is determined solely by supply and demand in the market, rather than official policy. • More on exchange rate determination in Week 4 Lecture discussion • Countries generally permit a free float only as a temporary solution, because it could result in excessive fluctuations. Such fluctuations disrupt international transactions by constantly altering the cost of goods and value of payments between companies in different countries International Monetary Arrangements Week 1 Lecture Slides

19. Floating Exchange Rates 1973 - Present Free Financial Markets • Supply and demand • On the other hand, export oriented countries like China and Japan are accused of actively managing their currency valuation by affecting the forces of supply and demand in the foreign exchange market to achieve their political and economic policy objectives • For some countries, their currency's value is pegged to a basket of currencies or to another country's currency. Many developing countries pegged their exchange rates to the currency of an industrial country with which they traded heavily (e.g. Aruba, Jordan, Oman, Saudi Arabia and etc.) International Monetary Arrangements Week 1 Lecture Slides

20. Floating System Supply and Demand • What are the system’s pros and cons? • The benefits of floating system are: • The currency’s value respond to external shocks and help the economy adjust quickly (e.g. Argentina). Additionally, the effect of monetary policy actions can be amplified. For example, when the Fed lowers short term interest rates to create more credit and thus help to stimulate economic activities of consumption and investment (and shift the aggregate demand curve), the lower interest rates may also depreciate the currency (e.g. US dollar) and help promote exports. This will further simulate economic activities. International Monetary Arrangements Week 1 Lecture Slides

21. Floating System Supply and Demand • What are the system’s pros and cons? • The disadvantages of floating system are: • The effectiveness of fiscal policy may be eroded. Why? Government spending and tax cuts may increase consumer spending and business investment. Increased economic activities may increase interest rates (e.g. cost of funding), and this may attract global capital inflow and appreciating the home currency value. The currency appreciation may hurt exports while fueling imports. Therefore, the simulative effects of the fiscal policy action may be eroded International Monetary Arrangements Week 1 Lecture Slides

22. Floating System International Reserve Currencies • Is the U.S. dollar still commanding respect? • International reserves are the means of settling international debts. Under the gold standard, gold was the major component of international reserves. Now, the U.S. dollar is widely used as the dominant reserve currency. • Today, about 60 percent of official holdings of foreign exchange are in dollars • Since the U.S. international position (e.g. current account) has been eroded dramatically in the past decade, the question arises as to why we do not need the major currencies such as the Euro emerge as the dominant reserve currency. • Recently, China and Russia have called for a global currency which is composed on a basket of currencies International Monetary Arrangements Week 1 Lecture Slides

23. Floating System U.S. NATIONALDEBTCLOCK The Outstanding Public Debt as of 19 Jul 2009 at 08:45:54 PM GMT is: The estimated population of the United States is 306,578,179so each citizen's share of this debt is $37,869.77. The National Debt has continued to increase an average of$3.94 billion per day since September 28, 2007!Concerned? Then tell Congress and the White House! International Reserve Currencies • Thought questions • Why Chinese and Russian governments are calling for a global currency (to replace the dollar)? International Monetary Arrangements Week 1 Lecture Slides

24. Floating System International Reserve Currencies • What about the Euro? • The new European currency, the euro, made its debut on January 1, 1999. Euro notes and coins began to circulate on January 1, 2002. • Why was the euro created? The participating EU countries wanted to eliminate inefficiencies generated by managing currency risks and conversions to increase their productivity. Additionally, the euro may challenge the U.S. dollar as a viable international reserve currency. • How is it doing? The euro is doing well. This surprised many who thought it may not survived the first year. However, as discussed previously, when exchange rates are fixed then fiscal policy actions are less effective in stimulating the economy during its downturn. International Monetary Arrangements Week 1 Lecture Slides

25. Floating System International Reserve Currencies • What was given up to get the Euro? • In addition to eroding one’s fiscal policy, the participating countries had to also give up their central bank. Note that one money requires one central bank, and the euro is no exception. • The European Central Bank (ECB) began operations on June 1, 1998 in Frankfurt, Germany and now conducts monetary policy for the euro-area countries. • The ECB is challenged to set one “best fit” monetary policy prescription given that it has 16 varying countries with their unique economic issues (e.g. Italy with high deficits & Spain with record unemployment rates) International Monetary Arrangements Week 1 Lecture Slides

26. Floating System International Reserve Currencies • Which currency will emerge as the dominant one? • Under the free market system, its participants will determine via supply and demand International Monetary Arrangements Week 1 Lecture Slides