1. Chapter X: The international financial system
Evolution of the international financial system
The gold standard
The Bretton-Woods System and the IMF
The ECU, the ERM and the euro
Nominal anchoring (dollarization, currency boards, and managed float)
Globalization and stability of the international financial system

2. Evolution of the international financial system
Before World War I, the world economy operated under the gold standard
It means that most world currencies were backed by, and convertible into gold.
For currencies whose unit is permanently tied to a certain quantity of gold, the gold standard represents a fixed-exchange rate regime
To see how it works we take an example:

3. Operation of the gold standard (1)
The exchange rate between the $ and the £ is effectively fixed at $5:£1 via the common denominator gold
As the £ appreciates beyond $5 in financial markets, an American importer importing goods for £100 from the UK would have to pay more than $500
This importer could arbitrage against the “financial” £ by exchanging $500 for gold, shipping it to the UK, and converting it into £100 at the fixed gold parity

4. Operation of the gold standard (2)
An appreciation of the £ leads to British gains in international reserves, and an equal loss in international reserves in the United States
It entails a commensurate expansion of base money in Great Britain, and a contraction of base money in the United States
This must raise the British price level, and provoke a deflation in the US
It causes a depreciation of the £ against the $ until the former parity is reinstalled

5. “Price-species-flow” mechanism
Price adjustments under fixed exchange rates work through symmetries in the supply of base money between two countries
One country loses international reserves, the other gains international reserves
This mechanism will ultimately entail a countervailing adjustment of price levels for goods and services in each country
This “price-species-flow” mechanism was first described by David Hume

6. Example: The U.S. during the 1870s
During the Civil War in the US, the gold standard had been abandoned and the government had issued significant amounts of paper money to finance the war
In the end, this had lead to an almost doubling of the price level
After the war, the US returned to the gold standard at the parity that had reigned before.
This (“shock”) contraction of the money supply caused the depression of

7. Return to the gold standard after WW I
After World War I most countries tried to return to the gold standard
International trade was mainly carried out in British pounds, French francs, US dollars, all (partially) covered by gold
Payments were made in gold certificates (promissory notes denominated in gold), the volume of which increased by credit expansion
The Great Depression caused insolvencies in gold, which brought the gold standard to an end

8. The Bretton-Woods System
In 1944, the post-war international economic order was conceived in the little town of Bretton Woods (New Hampshire)
The three international institutions created are
the International Monetary Fund (IMF);
the Bank for Reconstruction and Development (Worldbank);
the General Agreement on Tariffs and Trade (GATT), now World Trade Organization (WTO)

9. The Bretton-Woods System
The international financial system (Bretton-Woods System) was based on gold and the US dollar
The parity between the dollar and gold was fixed at $35 for an ounce of gold
The exchange rates of other countries adhering to the system were pegged to the dollar
Discretionary exchange-rate adjustments were possible in the case of “fundamental balance-of-payments disequilibria”

10. Forex interventions by central banks
If the domestic currency was undervalued, the central bank must sell domestic currency to keep the exchange rate fixed (within limits of ± 1 percent), but as a result it had to take international reserves (US dollars) on board
If the domestic currency was overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result it lost international reserves

11. The role of the IMF
Surplus countries faced a strengthening of their currencies (revaluation)
Deficit countries experienced a weakening (devaluation)
The IMF took (and takes) the role of an international lender under certain conditions
Loans are given to member countries with balance-of-payment difficulties
The IMF has now close to 190 members

12. IMF as “lender of last resort”
A “lender-of-last-resort” operation by the IMF is a two-edged sword:
central bank lending during a financial crisis could stabilize the currency and strengthen domestic balance sheets; and it could
fend off speculation and prevent contagion
But it could also
arouse fears of inflation spiraling out of control, and hence cause a further depreciation; and it could
increase moral hazard and adverse selection problems and make the crisis worse

13. The operation of the system
As for any fixed-exchange-rate regime, the “price-species-flow” mechanism was also working under the BW-system
However, revaluations and devaluations were devices to “let out steam” and to ease economic pressures, and hence to avoid the full price adjustment
This was in particular helpful for deficit countries, because internal prices are typically rigid downwards (in particular wages), and a painful deflation could thus be avoided

14. Problems of the BW system
The US-dollar became an international trading and reserve currency, for which the Fed held a monopoly
As more and more dollars would be issued (US gold reserves remaining constant), trust in the world currency was expected to weaken (“Triffin Dilemma”)
However, initially there was a shortage of international reserves worldwide, although this changed later

15. Special Drawing Rights (SDR)
In order to overcome the apparent shortage of international reserves in the 1960s, the US and other key IMF members had allowed the IMF to issue a paper substitute for gold: “special drawing rights” (SDRs)
SDRs function as international reserves, but -- unlike gold -- they can (within limits) be issued by the IMF through credit creation
SDRs are only being used for official payments among central banks

16. The end of Bretton Woods
The Bretton-Woods agreement lasted until 1971, when it broke down due to institutional and economic asymmetries
When the US pursued an inflationary policy during the 1960s and early 1970s, the “low-inflation” Deutsche Mark became an increasingly attractive speculative asset
Prices for gold in the free market provided opportunities for arbitrage gains; there were mounting incentives for currency speculation

17. The end of Bretton Woods
One option of surplus countries would have been to follow US inflationary policies (and take on board US dollars without limits!)
This opens up unlimited seignorage gains for the issuer of the reserve currency, the US
The other option was to revalue
For countries that use the dollar as a reserve instrument, their relative wealth position is tied to the exchange rate of international reserves
A revaluation of the DM implies a devaluation of the acquired claims in US dollars

18. Forex market and monetary policy
Moreover, an appreciation of the currency entails an increase in export prices for foreigners, and a fall of import prices at home
This could trigger higher unemployment
“Because surplus countries were not willing to revise their exchange rates upward, adjustment .. did not take place and the BW System collapsed in 1971.” (F. Mishkin)
“The ability to conduct monetary policy is easier when a country’s currency is a reserve currency” (F. Mishkin)

19. The ECU and the ERM
The ECU was a weighted average of the currencies of all (initially 9, then 12) member states of the (now) European Union
The ERM (“exchange-rate mechanism”) was an arrangement that compelled governments to keep the exchange rate of their currencies within predetermined corridors (± 2.25% or ± 6%) relative to the ECU rate
Participation in the ERM was voluntary

20. The composition of the ECU (1989)

21. The exchange-rate mechanism (ERM)
The national currency is fixed to the ECU
A variation of the exchange rate within the pre-defined “corridor” is allowable
Once the exchange rate tends toward the margins of the “corridor”, the central bank is encouraged to intervene (“infra-marginal interventions”)
Once the exchange rate moves out of the “corridor”, a central bank intervention is mandatory to bring it back into the “corridor”

22. International monetary policy coordination
There were two (failed) attempts to coordinate exchange-rate policies to stabilize the US dollar in the 1980s: the “Plaza” and the “Louvre” accords

23. Capital controls
Capital controls (particularly those on outflows) are typically rejected by economist
Controls on capital inflows receive some support and have also been used rather successfully in some countries (Chile and Colombia)
Reason: Capital inflows can cause an excessive lending boom, … entailing a painful reversal
But controls of capital inflows could also block funds for economic development. It calls for differential treatment according to maturity

24. The international policy focus is now on …
.. improving banking regulation and supervision, and on greater transparency.

25. The role of a nominal anchor
Adherence to a nominal anchor forces a monetary authority to conduct “disciplined” monetary policy
A priori publicized self-binding rules
imply a strong auto-commitment;
can relieve from short-term political pressures;
contribute to the predictability of policy and hence stabilize economic behavior;
foster confidence building in monetary authorities

26. The time-consistency problem
Economic behavior is influenced by what economic agents expect monetary authorities to do in the future
If expectations were to remain unchanged there is the temptation to abuse this fact by attempting to boost the economy through discretionary expansionary monetary policy
If expectations will incorporate the expected outcome of such a policy, output will not be higher, but inflation will!
A monetary anchor acts as self-binding rule

27. Exchange-rate targeting
Exchange-rate targeting has a long history, including the fixing of the exchange rate to the price of gold
Exchange-rate targeting has clear advantages
it links the price of traded goods to that found in the anchor country; this might contain inflation;
time-inconsistent monetary becomes less of an option; this stabilizes price expectations;
it is a simple and transparent rule (“franc fort”)
Exchange-rate targeting has been widely used in Europe and world-wide

28. Disadvantages of exchange-rate targeting
Exchange-rate targeting might be create serious problems because
the country tying its currency to that of an anchor currency can no longer respond to shocks to its own economy;
there could also be shocks applying to the anchor country; these are fully transmitted (the case of Germany after unification);
if the anchor country opts for inflation, countries with pegged currencies will “import inflation”
it may present opportunities of a one-way bet for speculators (crisis of the EMS of September 1992)

29. The 1992 ERM crisis: the UK and France
The UK did devalue
France did not!

30. The “cost” of pegging The UK had higher growth and less unemployment
But its inflation rate increased
France had lower growth and more unemployment
But its inflation rate was lower

31. Exchange-rate targeting: For whom?
Industrialized countries might have more to lose by exchange-rate targeting than to win
In some industrialized countries the central banks is subject to political pressure
In this case exchange-rate targeting may prove to be beneficial
It also encourages economic integration
Contrary to industrialized countries, emerging market countries may not lose much by giving up an independent monetary policy, but it leaves them open to speculative attacks

32. Can speculation be averted?
The currency-board approach:
One approach is to back the domestic currency by 100% by a foreign currency (euros, dollars)
It means
the money supply can only expand when international reserves of a country increase.
a strong commitment of monetary policy, which may therefore work instantly in controlling inflation.
Currency boards are however not immune against speculation

33. Currency boards: Examples
Recent examples of currency boards include
Hong Kong (1983)
Argentina (1991)
Estonia (1992) and Lithuania (1994)
Bulgaria (1997)
Bosnia and Herzegovina (1998)
Argentina had to abandon the scheme in December with painful social and economic repercussions

34. The CFA-zone
The CFA franc is the common currency of 14 countries in West and Central Africa, 12 of which are former French colonies
The CFA franc has been pegged to the French franc since Only one devaluation has occurred during the history of the currency peg (January 1994)
The French Treasury has the sole responsibility for guaranteeing convertibility of CFA francs into euros, without any monetary policy implication for the ECB

35. Can speculation be averted?
Dollarization:
Another approach is to abandon a national currency altogether and to adopt a foreign currency (e.g. US dollars) instead
It means
a euro or dollar remains a euro or dollar, whether inside or outside the respective currency area.
that the country adopting a foreign currency loses potential income through seignorage.
However a reversal to a domestic currency always remains an option

36. “Dollarization”: Examples of countries

37. “Dollarization”: Exits
Even dollarization does not guarantee a permanent monetary anchoring
There is need to a continuing inflow of foreign denominated capital to satisfy domestic demand for money
This puts severe strains on the economy
There is a large number of exits from a currency zone during recent years:
Numerous exits from the ruble zone after the breakdown of the Soviet Union
the secession of Slovakia from Czechoslovakia
the breakdown of Yugoslavia

38. Foreign exchange arrangements

39. Inflation targeting
A number of countries has adopted inflation targeting following the lead of New Zealand (1990)
Canada (from 1991)
the UK (from 1992)
Australia (1994)
Brazil (1995)
In 1990 the Reserve Bank of NZ became fully independent and was committed to the sole objective of price stability
The governor of the central bank is held accountable for achieving a predefined inflation goal

40. Inflation targeting: strategy
The strategy consists of
publicly announcing a medium-term numerical target for inflation that is well defined;
committing the central bank to price stability as the primary (if not sole) policy goal;
an information strategy that includes several indicators, not just monetary aggregates
increased communication with the public to render monetary policy more transparent; and
an increased accountability of the central bank for attaining its inflation target.

41. Inflation targeting: advantages
enables the central bank to focus on domestic policy objectives, but a stable relationship between money and the price level is not critical for its success;
is highly transparent and easily understood;
increases the accountability of the central bank because of a numerical target as a benchmark;
seems to ameliorate the effects of inflationary shocks (introduction of a GST in Canada; exit of the British pound from the ERM in 1992). There was a one-time price adjustment, but no spiraling up of inflation.

42. Inflation targeting: disadvantages
Inflation targeting is not without problems because
inflation cannot be controlled directly and policy outcomes occur only with a time lag;
therefore the policy cannot send immediate signals to economic agents;
may be too rigid and limit the policy discretion to respond to unforeseen events;
it will even out inflation, but might increase output fluctuations

43. The two pillar strategy of the ECB
The strategy of the ECB appears to reconcile monetary targeting with inflation targeting by scrutinizing both monetary growth and a bundle of economic indicators to assess the medium-term impact on the HICP
Contrary to the NZ approach, the ECB may be criticized as being less responsive to public demands for information
Less transparency goes hand in hand with less accountability

44. Reading 10-1: “Wrestling for influence”, The Economist, July 3rd, 2008

45. That’s it ! Thank you for attending this course I hope you enjoyed it
All the best for you private and professional future, and …
… good luck for the final exam !