International EconomicsPart International financial relationsⅡ

Feb.15,2011~Jun.10,2011

Lecture 7 BOP in Open Economy Lecture 8 Market-Determined Exchange Rates

Lecture 9 The International Currency SystemLecture 10 Domestic Policy to Adjust the Balance of Payments

Lecture 11 Effects of Exchange Rate Adjustment on the Current Account and the Domestic Economy

International Economics

Lecture 9 The International Currency System

Feb.15,2011~Jun.10,2011

Syllabus

• Fixed Exchange Rates • The Contemporary International

Currency System • The Incompatible Trinity • Indices of Trade-Weighted (Effective)

Exchange Rates • The International Monetary Fund • Summary

1. Fixed Exchange Rates Under a fixed exchange-rate system the government fixes the exchange rate at a given level by buying or selling foreign currencies when market forces push the exchange rate away from that predetermined level.

Devaluation and revaluation describe discrete decrease or increase in the exchange value of the currency, by government decree.

Figure 9-1 A hypothetical fixed exchange-rate system

Devaluation: the lowering of the exchange value of a currency.

Revaluation: an increase in the exchange value of a currency.

Spread

Figure 9-2 Excess supply of dollars (or excess demand for euros)

When the ECB buys dollars in exchange for euros, its official reserve rise, and Euro-Zone money supply expands.

Unsterilized intervention

Sterilized intervention

Revaluation

Figure 9-3 Excess demand for dollars (or excess supply of euros)

Devaluation

History of Fixed Exchange Rates • The Gold standard:1880-1914

ü Under the gold standard the external value of all currencies was maintained by fixing their prices in terms of gold.

ü Gold was the common denominator and official reserve.

• The Gold Exchange Standard:1944-1973,Bretton Woods system

ü Dollar instead the gold as the “core” of the system.ü All currencies were pegged to the dollar.

2. The Contemporary International Currency System

• Fluctuating Currencies • The Euro-A Currency of 17 Countries • Fixed Exchange Rates. • Summary of Exchange Regimes. • The Role of the U.S. Dollar • [Eurodollars]

(1)Fluctuating Currencies

• Two differences between free and managed floats should be noted.p228

l Managed floats are floating exchange rates subjects to government intervention.

l $, ￡ , ¥, €, and CAN$ are under managed float.

l Most floating currencies are on a managed float regime with sterilized intervention.

Under a free float, an external deficit (surplus) is reflected in depreciation (appreciation) of the currencies; under a fixed exchange rate, an external imbalance causes a change in international reserves, and the accumulation or depletion of reserves constitutes a measure of the surplus or deficit respectively; under a managed float system an external imbalance results in a combination of variations in the exchange rate and a change in international reserve.

（ 2） The Euro-A Currency of 17 Countries

AustriaBelgiumFinlandFranceGermanyIrelandItalyLuxemburgNetherlandsPortugalSpainGreece

Slovenia

The Republic of Malta

the Republic of Cyprus

The Slovak Republic

Estonia

European monetary union

They establish the ECB to determine monetary policy for the entire Euro-Zone.

(3)Fixed Exchange Rates• Pegged rate: numerous developing

countries peg their exchange rates either to a single currency or to a basket of currencies.

• A credible way of pegging the exchange rate is by establishing a currency board

• Another way is to abandon the countries own currency in favor of another currency.

China H.K. 1983

Argentina 1991

Ecuador & El Salvador

(4)Summary of Exchange Regimes

Fixed rate

(“hard peg”)

Pegged rate

Floating rate

408

4840

54

496

424189

Exchange arrangement with no separate legal tenderCurrency board arrangements

Conventional fixed arrangementsPegged exchange rates within horizontal bandsCrawling pegs

Exchange rate within crawling bandsManaged floating with no pre-announced path for exchange rateIndependently floating

Exchange rate regime Number of countries

ChinaDenmark HungaryCosta Rica

Israel

India and Thailand

• Dollar position: although somewhat redu

ced in importance from Bretton Woods er

a, the U.S. dollar still occupies a central r

ole as a transaction, reserve, vehicle, a

nd intervention currency.

(5)The Role of the U.S. Dollar

3. The Incompatible Trinity • Incompatible trinity

Fixed exchange rate

Independent monetary policy

Free capital movements

• These three features cannot coexist for a long period. (1992 European exchange crisis)

4. Indices of Trade-Weighted (Effective) Exchange Rates

• Bilateral exchange rate: is the exchange of value of a currency relative to another single currency.

• A trade-weighted exchange rate: is an index showing variations in the weighted average of the bilateral exchange rates of a given currency, where the weights can be the bilateral imports, exports, or total trade.

• Real Bilateral exchange rate: is the nominal bilateral rate adjusted for the inflation deferential between the two countries.

• Real trade-weighted exchange rate: is the (nominal) trade-weighted rate adjusted for the inflation deferential between the country and that of its trading partners.

E$/€=(E$/€)(PE/PU.S.)

Figure 9-4 Real effective exchange rate index of the dallar

5. The International Monetary Fund

• Regular IMF Procedures

• Special Drawing Rights Procedures

• Special Facilities

• International Reserves

The IMF is a Washington based organization of 185 countries, charged with overseeing the international financial system. It offers financial assistance and advice to countries in need.

(1)Regular IMF ProceduresQuota : Each member country is assigned a quota, of which it must contribute to the IMF 25% in gold or widely used convertible foreign currencies and 75% in its own currency.

Conditionality provisions : IMF requires a “borrowing” country to follow certain fiscal and monetary polices that would ensure its return to economic health.

Voting power

The amount of loans it is eligible to receive

(2)Special Drawing Rights ProceduresSDRs : is an asset that the IMF creates and alloc

ates to its members. SDRs is a reserve asset.

Its value is a weighted average of $,€, ￡ and ¥.

The attractiveness of SDRs as a reserve asset derives from the obligation of all members to accept them from each other.

(3)Special Facilities Compensatory finance facilitySystem transformation facility

(4)International Reserves• The combined demand of all countries indic

ates the amount of reserves needed by the international community.

• A country’s official reserves consist of gold; SDRs; Reserves Position in the IMF; and convertible foreign currencies—mainly dollars.

5.Summary

• A fixed exchange rate system requires the use of reserves, which are bought or sold on the home market to maintain the value of the currency within a prescribed spread or band.

• Effects of exchange intervention on the domestic money supply are neutralized with sterilization.

• The contemporary monetary system consists of a mixture of fixed and floating rates.

• A system of fixed exchange rates coupled with free capital movements requires coordinated monetary policy for sustainability in the long run.

• A trade-weighted average of bilateral exchange rate changes is required to determine changes in the exchange value of the U.S. dollar or any currency.

• Real exchange rates reflect changes in a country's competitive position. A real effective exchange rate is obtained by adjusting the effective nominal exchange rate for differences in the country's inflation rate and a weighted average of foreign inflation rates.

Suggested Further Reading • M. Bordo and Barry Eichengreen, eds., A Retrospective Hi

story of the Bretton Woods System: Lessons for International Monetary Reform, Chicago: University of Chicago Press, 1993.

• A. Giovanni and C. Mayer, eds. European Financial Integration, Cambridge: Cambridge University Press, 1991.

• A. W. Hooke, The International Monetary Fund: Its Evolution, Organisation, and Activities, 2nd ed., Pamphlet Series no. 37, Washington D.C.: IMF 1982.

• John Williamson, The Exchange Rate System, Washington D.C.: Institute for International Economics, 1985.