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CHAPTER 3

The InternationalMonetary System



PART I. ALTERNATIVE EXCHANGERATE SYSTEMS

I. FIVE MARKET MECHANISMS A. Freely Floating (Clean Float)1. Market forces of supply

and demand determine

rates.2. Forces influenced bya. price levelsb. interest rates

c. economic growth3. Rates fluctuate over time

randomly.



ALTERNATIVE EXCHANGE RATE

SYSTEMS

B. Managed Float (Dirty Float)

1. Market forces set rates unless

excess volatility occurs.

2. Then, central bank determinesrate.




SYSTEMS

C. Target-Zone Arrangement1. Rate Determination

a. Market forces constrainedto upper and lower range of

rates.

b. Members to the arrangementadjust their national economicpolicies to maintain target.




SYSTEMS

D.Fixed Rate System1. Rate determination

a. Government maintainstarget rates.

b. If rates threatened, centralbanks buy/sell currency.

c. Monetary policies coordinated.




SYSTEMS

D. Fixed Rate System (con’t)2. Some Government Controls:

a. On global portfolio

investments.b. Ceilings on direct foreign

direct insurance.

c. Import restrictions.




SYSTEMS

E. Current System

1. A hybrid system

a. Major currencies:usefreely-floating method

b. Others move in and outof various fixed-rate systems.



PART II. A BRIEF HISTORY OF THE

INTERNATIONAL MONETARY SYSTEM

I. THE USE OF GOLD A. Desirable properties

B. In short run: High production costs limitshort-run changes.

C. In long run: Commodity money insuresstability.



A BRIEF HISTORY OF THEINTERNATIONAL MONETARY SYSTEM

II.The Classical Gold Standard(1821-1914) A. Major currencies on gold standard.

1. Involved commitment bynations to fix the price of domestic currency in terms of aspecific amount of gold.




2. Maintenance involved the buying

and selling of gold at that price.3. Disturbances in Price Levels:

Would be offset by the price-

specie*-flow mechanism.

* specie refers to gold coins




a. Price-specie-flow mechanism

had automatic adjustments:1.) When a balance of payments surplus

led to a gold inflow;

2.) Gold inflow led to higher prices whichreduced surplus;

3.) Gold outflow led to lower prices and

increased surplus.



A BRIEF HISTORY OF THE


III. The Gold Exchange Standard

(1925-1931) A. Only U.S. and Britain allowed to

hold gold reserves.

B. Others could hold both gold, dollarsor pound reserves.





C. Currencies devalued in 1931

- led to trade wars.

D. Bretton Woods Conference

- called in order to avoid futureprotectionist and destructiveeconomic policies





IV. The Bretton Woods System(1946-71)

A. The Bretton Woods Agreement

1. U.S.$ was key currency;

valued at $1 = 1/35 oz. of gold.2. All currencies linked to that price in

a fixed rate system.

3. Exchange rates allowed to fluctuateby 1% above or below initially setrates.





B. Collapse, 1971

1. Causes:a. U.S. high inflation rate

b. U.S.$ depreciated sharply.





V. Post-Bretton Woods System

(1971-Present) A. Smithsonian Agreement, 1971

US$ devalued to 1/38 oz. of gold.By 1973: World on a freelyfloating exchange rate system.





B. OPEC and the Oil Crisis (1973-1974)

1. OPEC raised oil prices four fold;2. Exchange rate turmoil resulted;3. Caused OPEC nations to earn

large surplus B-O-P.4. Surpluses recycled to debtor nations

which set up debt crisis of 1980’s.





C. Dollar Crisis (1977-78)

1. U.S. B-O-P difficulties

2. Result of inconsistent monetary

policy in U.S.3. Dollar value falls as confidence

shrinks.





D. The Rising Dollar (1980-85)1. U.S. inflation subsides as the Fed

raises interest rates

2. Rising rates attracts global capital toU.S.

3. Result: Dollar value rises.





E. The Sinking Dollar:(1985-87)

1. Dollar revaluated slowly downward;

2. Plaza Agreement (1985)

G-5 agree to depress US$ further.3. The Louvre Agreement (1987)

G-7agree to support the falling US$.





F. Recent History (1988-Present)1. 1988 US$ stabilized2. Post-1991 Confidence resulted in

stronger dollar

3. 1993-1995 Dollar value falls



PART III.

THE EUROPEAN MONETARYSYSTEM

I. INTRODUCTION

A. The European Monetary System(EMS)

1. A target-zone method (1979)2. Close macroeconomic policy

coordination required.



THE EUROPEAN MONETARY

SYSTEM

B. EMS Objective:

to provide exchange rate stability to all

members by holding exchange rateswithin specified limits.




SYSTEM

C.European Currency Unit(ECU)

a “cocktail” of European currencies with

specified weights as the unit of account.1. Exchange rate mechanism (ERM)

each member determines mutually agreed

upon central cross-rate for its currency.




SYSTEM

2. Member Pledge:

to keep within 15% margin above or belowthe central rate.

D. EMS ups and downs1. Foreign exchange interventions failed due

to lack of support by coordinated monetarypolicies.




SYSTEM

2. Currency Crisis of Sept. 1992

a. System breaks down

b. Britain and Italy forced to withdraw fromEMS.

G. Failure of the EMS

members allowed political priorities

to dominate exchange rate policies.




SYSTEM

H. Maastricht Treaty

1. Called for Monetary Union by 1999(moved to 2002)

2. Established a single currency: the

euro3. Calls for creation of a single central EU

bank

4. Adopts tough fiscal standards




SYSTEM

I. Costs / Benefits of A Single

Currency A. Benefits

1. Reduces cost of doing business2. Reduces exchange rate risk

B. Costs

1. Lack of national monetary flexibility.

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