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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. • There are not any major distortions associated with the balance of payments. • PRICE SPECIE FLOW MECHANISM
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 • 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 • 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 • 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: 1945-1971 • Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. • Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. • The U.S. was only responsible for maintaining the gold parity. • Under Bretton Woods, the IMF was created. • The Bretton Woods is also known as an adjustable peg system. When facing serious balance of payments problems, countries could re-value their exchange rate. The US and Japan are the only countries to never re-value.
The Fixed-Rate Dollar Standard, 1945-1971 • In practice, the Bretton Woods system evolved into a fixed-rate dollar standard. Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, 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.
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 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 • 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 • 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, 1973-1984 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 • 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 • 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 • Exchange rate determined by market forces, with intervention aimed at minimizing volatility: • Example: United States
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 • 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 • 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 • 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 • 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 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 • 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 • The country uses another country’s (or group of countries’) currency as its own: • Example: Ecuador (US dollar)