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International Finance FINA 5331 Lecture 4: History of Monetary Institutions Read: Chapters 2 Aaron Smallwood Ph.D. PowerPoint Presentation
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International Finance FINA 5331 Lecture 4: History of Monetary Institutions Read: Chapters 2 Aaron Smallwood Ph.D. Review. The international gold standard has two advantages: Prices are very stable since the money supply is directly connected to the amount of gold.

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International Finance

FINA 5331

Lecture 4:

History of Monetary Institutions

Read: Chapters 2

Aaron Smallwood Ph.D.

review
Review
  • The international gold standard has two advantages:
    • Prices are very stable since the money supply is directly connected to the amount of gold.
    • There are not any major distortions associated with the balance of payments.
      • PRICE SPECIE FLOW MECHANISM
the international gold standard 1879 1913
The International Gold Standard, 1879-1913
  • There are shortcomings:
    • The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves.
    • Even if the world returned to a gold standard, any national government could abandon the standard.
the relationship between money and growth
The Relationship Between Money and Growth
  • Money is needed to facilitate economic transactions.
  • MV=PY →The equation of exchange.
  • Assuming velocity (V) is relatively stable, the quantity of money (M) determines the level of spending (PY) in the economy.
  • If sufficient money is not available, say because gold supplies are fixed, it may restrain the level of economic transactions.
  • If income (Y) grows but money (M) is constant, either velocity (V) must increase or prices (P) must fall. If the latter occurs it creates a deflationary trap.
  • Deflationary episodes were common in the U.S. during the Gold Standard.
interwar period 1918 1941
Interwar Period: 1918-1941
  • Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market.
  • Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”.
  • The result for international trade and investment was profoundly detrimental.
  • Smoot-Hawley tariffs
  • Great Depression
bretton woods system 1945 1971
Bretton Woods System: 1945-1971
  • Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire.
  • The purpose was to design a postwar international monetary system.
  • The goal was exchange rate stability without the gold standard.
  • The result was the creation of the IMF and the World Bank.
bretton woods system 1945 19717
Bretton Woods System: 1945-1971
  • Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar.
  • Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary.
  • The U.S. was only responsible for maintaining the gold parity.
  • Under Bretton Woods, the IMF was created.
  • The Bretton Woods is also known as an adjustable peg system. When facing serious balance of payments problems, countries could re-value their exchange rate. The US and Japan are the only countries to never re-value.
the fixed rate dollar standard 1945 1971
The Fixed-Rate Dollar Standard, 1945-1971
  • In practice, the Bretton Woods system evolved into a fixed-rate dollar standard.

Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, and keep the exchange rate within 1% of this par value indefinitely.

United States : Remain passive in the foreign change market; practice free trade without a balance of payments or exchange rate target.

bretton woods system 1945 19719

German mark

British pound

French franc

Par Value

Par Value

Par Value

Bretton Woods System: 1945-1971

U.S. dollar

Pegged at $35/oz.

Gold

purpose of the imf
Purpose of the IMF

The IMF was created to facilitate the orderly adjustment of Balance of Payments among member countries by:

  • encouraging stability of exchange rates,
  • avoidance of competitive devaluations, and
  • providing short-term liquidity through loan facilities to member countries
collapse of bretton woods
Collapse of Bretton Woods
  • Triffin paradox – world demand for $ requires U.S. to run persistent balance-of-payments deficits that ultimately leads to loss of confidence in the $.
  • SDR was created to relieve the $ shortage.
  • Throughout the 1960s countries with large $ reserves began buying gold from the U.S. in increasing quantities threatening the gold reserves of the U.S.
  • Large U.S. budget deficits and high money growth created exchange rate imbalances that could not be sustained, i.e. the $ was overvalued and the DM and £ were undervalued.
  • Several attempts were made at re-alignment but eventually the run on U.S. gold supplies prompted the suspension of convertibility in September 1971.
  • Smithsonian Agreement – December 1971
the floating rate dollar standard 1973 1984
The Floating-Rate Dollar Standard, 1973-1984
  • Without an agreement on who would set the common monetary policy and how it would be set, a floating exchange rate system provided the only alternative to the Bretton Woods system.
the floating rate dollar standard 1973 198414
The Floating-Rate Dollar Standard, 1973-1984

Industrial countries other than the United States : Smooth short-term variability in the dollar exchange rate, but do not commit to an official par value or to long-term exchange rate stability.

United States : Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target. No need for sizable official foreign exchange reserves.

the plaza louvre intervention accords and the floating rate dollar standard 1985 1999
The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999
  • Plaza Accord (1985):
    • Allow the dollar to depreciate following massive appreciation…announced that intervention may be used.
  • Louvre Accord (1987) and “Managed Floating”
    • G-7 countries will cooperate to achieve exchange rate stability.
    • G-7 countries agree to meet and closely monitor macroeconomic policies.
imf classification of exchange rate regimes
IMF Classification of Exchange Rate Regimes
  • Independent floating
  • Managed floating
  • Exchange rate systems with crawling bands
  • Crawling peg systems
  • Pegged exchange rate systems within horizontal bands
  • Conventional pegs
  • Currency board
  • Exchange rate systems with no separate legal tender
independent floating
Independent Floating
  • Exchange rate determined by market forces, with intervention aimed at minimizing volatility:
  • Example: United States
managed floating
Managed Floating
  • There is no pre-announced path for the exchange rate, although intervention is common. Policy makers will try to influence the “level” of the exchange rate: example: India
crawling band
Crawling Band
  • The currency is maintained within bands around a central target for the domestic currency against another currency (or group of currencies). The bands themselves are periodically adjusted, sometimes in response to changes in economic indicators.
  • Example: Costa Rica
crawling pegs
Crawling pegs
  • The domestic currency is pegged to another currency or basket of currencies at an established target rate. The target rate is periodically adjusted, perhaps in response to changing economic indicators.
  • Example: Bolivia
exchange rates within horizontal bands
Exchange rates within horizontal bands
  • The domestic currency is pegged to another currency or group of currencies. The exchange rate is maintained within bands that are wider than 1% of the established target:
  • Example: Any ERM II country, including Denmark
conventional pegs
Conventional pegs
  • The country pegs its currency at a fixed rate to another currency (or group of currencies). The currency cannot fluctuate by more than 1% relative to the established target:
  • Example: Saudi Arabia, formerly China
currency boards
Currency boards
  • Currency board countries are sometimes called “hard peggers”. Example: Hong Kong….
  • The currency board is a separate government institution whose only responsibility is to buy and sell foreign currency at an established price. The country will typically maintain foreign currency reserves equivalent to 100% of the total amount of outstanding domestic money and credit.Currency boards
hong kong
Hong Kong
  • Jim Rogers a famed currency trader has noted: “If I were the Hong Kong government, I would abolish the Hong Kong dollar. There's no reason for the Hong Kong dollar. It's a historical anomaly and I don't know why it exists anymore…. You have a gigantic neighbor who is becoming the most incredible economy in the world.”
no separate legal tender
No separate legal tender
  • The country uses another country’s (or group of countries’) currency as its own:
  • Example: Ecuador (US dollar)