Unit 5 International Monetary System

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Sanjay Ghimire

KUSOM

Unit 5

International Monetary System

1



International Monetory System

The international monetary system consists of laws,rules, institutions, instruments, and procedures, all ofwhich are involved in the international transfers ofmoney

The IMS refers to the institutional arrangements thatcountries adopt to govern exchange rates

The elements above affect foreign exchange rates,international trade and capital flows, and balance-of-payments adjustments.

Thus IMS ensure Liquidity, Adjustment and Stablity of

the international trade2



Evolution of IMS

Pre 1875 Bimetalism

1875-1914: Classical Gold Standard 1915-1944: Interwar Period

1945-1972: Bretton Woods System

1973-Present: Flexible (Hybrid) System

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Bimetalism

A “double standard” in the sense that bothgold and silver were used as money.

Both gold and silver were used asinternational means of payment and theexchange rates among currencies weredetermined by either their gold or silvercontents.

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The classical gold standards

Gold is freely transferable between countries

Countries fix parity price of gold

Essentially a fixed rate system (Suppose the USannounces a willingness to buy gold for $200/oz andGreat Britain announces a willingness to buy gold for£100. Then £1=$2)

They allow arbitrage between two markets parity price of gold at Central Bank

free market price of gold

– single currency the ounce of gold

– Balance of Payments deficits settled with gold5



Interwar Period

Periods of serious chaos such as German

hyperinflation and the use of exchange rates as a

way to gain trade advantage.

Disturbed supply of gold.

Britain and US adopt a kind of gold standard.

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Bretton Woods System

Allied powers met in Bretton Woods and created apost-war international monetary system

Established a US dollar based monetary systemand created the IMF and World Bank U.S.$ was key currency;

– valued at $1 - 1/35 oz. of gold. All currencies linked to that price in a fixed rate

system. Exchange rates allowed to fluctuate by 1% above or

below initially set rates. Collapse, 1971

a. U.S. high inflation rate

b. U.S.$ depreciated sharply.7



Current Exchange rate regimes

Free Float – The largest number of countries, about 48, allow market forces

to determine their currency’s value. Managed Float

– About 25 countries combine government intervention withmarket forces to set exchange rates.

Pegged to (or horizontal band around) another currency No national currency (Dollarization)

– Some countries do not bother printing their own, they just usethe U.S. dollar. For example, Ecuador, Panama, and ElSalvador have dollarized .

Monetary unification8



Fixed vs. Flexible Exchange Rate

Arguments in favor of flexible exchange rates: – Easier external adjustments.

– National policy autonomy.

Arguments against flexible exchange rates: – Exchange rate uncertainty may hamper international trade.

– No safeguards to prevent crises.

Currencies depreciate (or appreciate) to reflect theequilibrium value in flexible exchange rates

Governments must adjust monetary or fiscal policiesto return exchange rates to equilibrium value in fixedexchange rate regimes

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Suppose the exchange rate is $1.40/£ today.

In the next slide, we see that demand forBritish pounds far exceed supply at thisexchange rate.

The U.S. experiences trade deficits.

Under a flexible exchange rate regime, thedollar will simply depreciate to $1.60/£, theprice at which supply equals demand and the

trade deficit disappears.10




11 11S D Q of £

Dollar price per

£ (exchangerate)

$1.40

Trade deficit

Demand

(D)

Supply(S)

$1.60




Instead, suppose the exchange rate is “fixed”

at $1.40/£, and thus the imbalance betweensupply and demand cannot be eliminated bya price change.

The government would have to shift the

demand curve from D to D* – In this example this corresponds to monetary and

fiscal policies intervention.

12




13

Supply(S)

Demand(D)

Demand (D*)

* =

Contractionarypolicies

(fixed regime)

Q of £

D o l l a r p r i c e

p e r £

( e x c h a n g e

r a t e )

$1.40



Some terms

Depreciation: Decline in currency value in a

flexible exchange rate regime Devaluation: Decline in currency value in a

flexible exchange rate regime

Appreciation: Increases in currency value in

a flexible exchange rate regime

Revaluation: Increase in currency value in afixed exchange rate regime

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European Monetary System (EMS)

EMS was created in 1979 by EEC countries tomaintain exchange rates among their currencies

within narrow bands, and jointly float against outsidecurrencies. Objectives:

– Establish zone of monetary stability – Coordinate exchange rates vis-à-vis non-EMS countries –

Develop plan for eventual European monetary union Exchange rate management instruments:

– European Currency Unit (ECU) Weighted average of participating currencies Accounting unit of the EMS

– Exchange Rate Mechanism (ERM) Procedure by which countries collectively manage exchange

rates15



What Is the Euro ( €)?

The euro is the single currency ofthe EMU which was adopted by 11

Member States on 1 January 1999. These original member states

were: Belgium, Germany, Spain,France, Ireland, Italy, Luxemburg,Finland, Austria, Portugal and the

Netherlands. Prominent countries initially

missing from Euro :

– UK

– Greece ?????

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1 Euro is Equal to:

40.3399 BEF Belgian franc

1.95583 DEM German mark

166.386 ESP Spanishpeseta6.55957 FRF French franc

.787564 IEP Irish punt

1936.27 ITL Italian lira

40.3399 LUF Luxembourgfranc2.20371 NLG Dutch guilder

13.7603 ATS Austrianschilling200.482 PTE Portuguese

escudo5.94573 FIM Finnishmarkka



Benefits and Costs of the

Monetary Union

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Transaction costs reducedand FX risk eliminated

Creates a Eurozone –

goods, people and capitalcan move withoutrestriction

Compete with the U.S. – Approximately equal in

terms of population andGDP

Price transparency and

competition

Loss of national monetaryand exchange rate policy

independence Country-specific

asymmetric shocks canlead to extendedrecessions



The Long-Term Impact of the Euro

If the euro proves successful, it will advance

the political integration of Europe in a majorway, eventually making a “United States of

Europe” feasible.

It is likely that the U.S. dollar will lose its

place as the dominant world currency. The euro and the U.S. dollar will be the two

major currencies.

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Unit 5 International Monetary System

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