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Macroeconomics 1: Week 13The international Monetary system
1. Exchange Rate Systemsa) Freely floating flexible exchange rate regimesb) Fixed exchange rates
2. History of International Monetary Systemsa) The Gold Standardb) Bretton Woodsc) Managed floats
3. Australias Exchange rate history
Reading: Jackson & McIver pp. 95-98 Chapter 18
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Exchange rate systems
Two types of exchange rate system: Flexible or floating exchange rates
The exchange rate is determined by demandand supply Fixed exchange rates
Government intervention in the foreignexchange market offsets the changes inexchange rate caused by the demand andsupply factors
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Freely floating exchange rates Determined by the unimpeded forces of
supply and demand Depreciation and appreciation
Depreciation in the exchange rate is an increase
in the number of units of a countrys currencyrequired to buy a single unit of some foreigncurrency
Appreciation is a reduction in the number of unitsof a countrys currency required to buy a singleunit of some foreign currency
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Flexible rates and the balanceof payments
Flexible exchange rates automaticallyadjust so as to eliminate balance of payments deficits or surpluses
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Adjustments under flexible, fixed & the goldstandard
P
Q
Dollar price ofonepound
Pounds
3
2
1
S 1
D 0
D 1
D 0
D 1
S 1
C
B
A
X
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Flexible exchange rates (cont.)Disadvantages of floating exchange rates Instability in the macroeconomic environment
Destablising effects on the domestic economyarising from shifts in net exports brought aboutby changes in the exchange rate
Complicates the use of domestic monetary andfiscal policies
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Fixed exchange rates
Exchange rate for which the values aredetermined by government decision
Nations have often fixed or pegged theexchange rate to overcome thedisadvantages of floating exchange rates
Fixed exchange rates require adequatereserves to accommodate periodicbalance of payment deficits
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Fixed exchange rates (cont.) Trade policies
To maintain a fixed exchange rate, a countrymay enact protectionist trade policies to increasenet exports
Exchange controls: rationing Restricting imports to the amount of foreign
exchange earned by exports
Domestic macroeconomic adjustments Use fiscal and monetary policies to adjust GDPto a level consistent with the fixed exchange rate
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International monetary system:the gold standard
A system under which the value of a nationsmonetary unit was backed by gold rather thanfiat
Gold standard conditions Define the monetary unit in terms of a certain
quantity of gold
Fixed relationship between stock of gold and thedomestic currency
Allow gold to be freely exported and imported
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The gold standard (cont.) Gold flows
This would result in exchange rates that are fixed Domestic macro adjustments
The gold standard implies changes in the domestic
money supply of nations, which affects prices,real output and employment Advantages of gold standard
Stable exchange rates resulting from the goldstandard reduces uncertainty and risk The flow of gold between countries caused shifts
in the supply and demand curves and automaticallycorrects balance of payments deficits or surpluses
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The gold standard (cont.)
Disadvantages of gold standard Nations must accept domestic adjustments in
the form of higher unemployment or inflation Countries must have sufficient reserves of
gold Demise of the gold standard
During the Depression years of the 1930s
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Bretton Woods monetary system Bretton Woods conference 1944 Adjustable peg system of exchange rate
emerged A system by which members of the IMF were
obligated to define their monetary units in termsof gold (or US dollars), establishing par rates of exchange between the currencies of all other members, and to keep their exchange rates within 1per cent of these par values
US Dollar the main international currency Capital flows were believed to be destabilizing,
prewar controls were left in place.
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Bretton Woods monetary system
Fundamental imbalances: adjusting the peg Countries running persistent balance of payments
deficits ran out of reserves and were unable to
maintain its fixed exchange rate Demise of the Bretton Wood
Dilemma: dollars and the deficits Emergence of floating rates
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Managed float An exchange rate system where central banks
buy and sell foreign exchange to smooth outshort-run or day-to-day fluctuations in rates
Encourages international trade and finance,while allowing for trend or long-term exchange
rate flexibility to correct fundamental paymentsdisequilibria Liquidity and special drawing rights
Special drawing rights are bookkeeping entries
at the IMF, available to IMF members in proportionto their IMF quotas, that may be used to settle payments deficitsor satisfy reserve needs in place of foreign exchange or gold
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Managed float (cont.)
Demonetisation of gold Further reform of the international monetary
system led to the downgrading of the roleof gold
Gold has now ceased to function as aninternational money
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Managed float: an evaluation
Arguments for managed float Trade growth
Managing turbulenceArguments against Volatility and adjustment
Reinforcement of inflation
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Exchange rate history: AustraliaFrom 1931 to December 1971 the Australian currency
dollar was tied to the pound sterling. In 1971 major devaluation of the $US link between
the $Aus and Pound Sterling severed. $Aus pegged to
the US dollar 19711974 Was revalued in 1972 and 1973
Pegged to the trade-weighted index 19741976
An index of the average exchange rate comprisedof the basket of currencies of Australias major trading partners, weighted to reflect their share of trade
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Exchange rate history:Australia (cont.)
From 1976 till December 1983 operated on amanaged float with the exchange rate set bythe Governor of the Reserve Bank, theSecretary of the Treasury and the Secretaryof the Department of the Prime Minister andCabinet, rate announced every morning.
The floating of the exchange rate (1983) mostexisting exchange rate controls beingremoved, including controls on capital flows
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Exchange rate history: Australia
Floating and the current account crisis Recovery during the late 1980s
The early 1990s and the 1990 recession The late 1990s and the Asian crisis Into the 2000s