1. The International Monetary System
International Monetary System is a set of:
Agreements, Rules and Institutions
Relating to Exchange rates, International Payments and the flow of capital across national borders
Current system is based on a system of floating exchange rates - came about after the decline of the Bretton Woods system
Historical review of the international monetary systems
How do differing monetary systems affect currency values?

2. Historical overview of the systems of payment
Classical gold standard ( )
Rules under the gold standard:
Fix an official gold price of the local currency e.g. $20.67 = one ounce of gold in 1879
Money supply should be backed by gold
Prices worldwide would depend on the demand and supply of gold

3. Exchange rate between 2 countries was determined by the gold content of the respective currencies
E.g. 1 ounce of gold sold for DM 20 in Germany
1 ounce of gold sold for £ 10 in U.K.
This implied that DM 20 = £ 10
i.e. DM 1 = £ 0.5 (=10/20)
£ 1 = DM 2 (=20/10)
Domestic price level in a country was linked to the supply of gold through money supplies
Money was fully backed by gold
Governments need to find more gold to increase money supply

4. One motivation of the gold standard is price stability
Since currencies are tied to gold, prices depend on the cost of producing gold
Hence the long-run cost of gold production would determine price levels

5. How exactly does the gold standard work?
Starting from equilibrium assume that productivity increases in the U.S.
The cost of production declines
The price level declines (since prices are set based on how much gold is needed to produce a bundle of goods)
Prices of exports from the U.S. decline relative to imports
Demand for U.S. exports increases
Gold flows into the U.S. hence increasing money supply and prices
Relative to the initial equilibrium prices everywhere will be slightly lower than before since the cost of production has declined everywhere
Converse is true if prices increase in the U.S.

6. Imbalances in exports and imports was self-correcting
E.g. Consider a situation where Germany exported more to the U.K. than what it imported:
Net payment from U.K. To Germany
Gold flows from U.K. To Germany
Supply of gold declines in the U.K.
Price level in the U.K. Declines
Imports from the U.K. Are relatively more attractive
The imbalance changes

7. Period of was indeed characterized by price stability, stable exchange rates, expansion of international trade and economic growth worldwide
While the average inflation rate during the gold standard was lower than in the post-World war era, the variability of inflation in the U.S. was higher under the gold standard

8. Problems with the gold standard
World trade was hampered by the availability of gold
Inflation rates across countries would have to be equalized
Required co-ordination of domestic monetary policies with international policies
This is especially true during periods of inflation

9. Bretton Woods Agreement 1945-1972
Most countries abandoned the gold standard after the Great Depression
Bretton Woods Agreement:
Articles of agreement led to the birth of the International Monetary Fund (IMF)
Rules of conduct of international monetary policy
Birth of the International Bank for Reconstruction and Development (IBRD)
Financing development projects

10. Each country established a par value of its currency vis-a-vis the U.S. Dollar
The exchange rate was allowed to fluctuate within 1%
1 ounce of gold = (set) $35
Countries had the option to change the parity rate in response to “fundamental disequilibrium”
Countries were allowed to pursue their own domestic macroeconomic goals
Temporary imbalances in balance of payments would be covered using a buffer stock of reserves and borrowing from the IMF
If the demand for the £ increases versus the $, the Bank of England must be willing to supply extra pounds so that the exchange parity is maintained

11. Problem:
Requires official intervention in the foreign exchange markets
Assume inflation in the U.K.
This would lead to an increase in prices of their exports
Hence exports would decline and imports increase
Supply of pounds would have to increase on the world’s foreign exchange markets
This supply would reduce the value of the pound
To reduce the excess supply the U.K. would have to “buy” back using its reserves
This would reduce domestic money supply and prices
Problems arise if governments are not willing to do this

12. In reality most countries kept their exchange rates pegged to the dollar and kept changes to a minimum
Hence the exchange rate of the dollar was also fixed in this process
As the war ravaged economies outside the U.S. rebuilt , the stability of fixed rates helped
Soon however, the U.S. liabilities held by foreigners was more than that could be supported by the gold reserves held in the U.S. (using the fact that $35 = one ounce of gold

13. U.S. Had to supply dollars continuously to finance world trade
Dollars were moving from the U.S. To other countries
U.S. Had to be willing to run Balance of Payments deficits continuously
Gradually this led to loss of confidence in the dollar
The basis of the system (confidence in the dollar) collapsed

14. 1963: President Kennedy levied the Interest Equalization Tax (IET)
Tax on U.S. purchases of foreign securities
Dollars would less likely leave the U.S.
1965: Foreign Credit Restraint Program
Regulated the amount of U.S. Dollars that banks could lend to multinational corporations
1970: IMF introduced Special Drawing Rights (SDR)
SDR: is a basket of currencies allotted to IMF members
Could be used to finance transactions (in lieu of the $)

15. During the late 1960s with the Vietnam wars, inflation in the U. S
During the late 1960s with the Vietnam wars, inflation in the U.S. increased to 3.5% based on producer prices (compared to 1% from ) -
Dollar lost credibility
All these factors strained the system
1971: President Nixon suspended the dollar to gold convertibility
Smithsonian Agreement:
1 ounce of gold = $38 (dollar devalued)
Currencies revalued
Flexible exchange rates - band of %

16. Even this agreement collapsed a year later
1973 -
1.Flexible, free floating exchange rate system:
Advantages and disadvantages of the freely floating system of exchange rates:
E.g. Inflation in the U.S.:
U.S. Consumers shift to imports (say from U.K.)
Demand for imports increases
Demand for foreign currency (£) increases
Under fixed exchange rates:
Value of (£) does not change
Price of imports increases (given unchanged value of the pound)
Inflation in U.K. also

17. With flexible exchange rates,
Increased demand for imports
Increased demand for pounds
Value of the pound would increase
Hence imports would become more expensive to the U.S. Consumer (even if the prices of the goods in pounds are unchanged)
Inflation in the U.S. Does not lead to inflation abroad
However, if inflation in the U.S. Continues, this would lead to increase in the price of U.S. Materials which will increase the price of U.S. Goods and hence further reduce demand for them abroad

18. 2. Managed float exchange rate system:
Exchange rates float freely
However governments sometimes intervene
Managed or “dirty” float
Government manipulation

19. 3. Pegged exchange rate system:
Some currencies are pegged to other currencies or a basket of currencies
Home currency’s value is fixed in terms of the foreign currency to which it is pegged
Moves in line with the foreign currency against other currencies
So the exchange rate is fixed vis-a vis the currency to which it is pegged but floats with other currencies

20. E.g. Argentinian currency is pegged to the US dollar - so a unit of Argentinian currency = $0.2
If $1 = £0.5 this would imply for instance that a unit of Argentinian currency = £0.10
If the U.S. Dollar moves then the Argentinian currency moves with it, however it is fixed in terms of the U.S. Dollar
So if the dollar pound exchange rate changes to
$1 = £0.15 then one unit of Argentininan currency is now worth:
$0.20
0.20 x 0.15 = £ 0.03

21. E.g. Consider a world with 3 countries:
1. The U.S.
2. A country called FLOAT whose currency fluctuates against the U.S. Dollar and
3. A country called PEG whose currency is pegged to the U.S. Dollar , 1 PEG = $1.20
The current exchange rate for FLOAT is 1 FLOAT = $0.50
Hence 1 FLOAT = ?? PEGs
1 FLOAT = $0.50 and hence $1 = 2 FLOATS
1 PEG = $1.20 and hence $1 = 0.83 PEGS
2 FLOATS = 0.83 PEGS,
1 FLOAT = 0.83/2 = 0.42 PEGS
1 PEG = 1/ 0.42 = 2.38 FLOATS

22. Assume now that in the next 6 months, FLOAT depreciates against the dollar and 1 FLOAT = $0.40
How will trade between these countries be affected?
Since FLOAT depreciates against the dollar, it also depreciates against PEG
1 FLOAT = ?? PEGS
$1 = 1/0.4 = 2.5 FLOATS
$1 = 0.83 PEGS
Hence 2.5 FLOATS = 0.83 PEGS
Or 1 FLOAT = 0.83/2.5 = PEGS
Or 1 PEG = 3 FLOATS

23. Effect on trade
Hence consumers in FLOAT reduce their demand for PEG’s goods (more expensive now)
Consumers in PEG will substitute goods made in FLOAT for goods made in the U.S.
Similarly consumers in the U.S. Will substitute goods made in FLOAT for goods made in PEG
Overall FLOAT’s economy gets a boost
Korean won is pegged to the dollar, while the Japanese yen floats against the dollar. Following the dollar’s decline in 1986, Japanese products became more expensive in the US. Hence some US importers switched to Korean products

24. 1971- Present (Post Bretton Woods)
OPEC Crisis
Some nations like the U.S. tried to counter increasing oil prices through expansionary monetary policies and trying to control the price of oil leading to BOP deficits
Others like Japan allowed oil prices to increase
Dollar crisis
Enter Paul Volcker who announced a major change in monetary policy
The Fed would concentrate on controlling money supply
Rising dollar
inflation declined and the dollar appreciated

25. Sinking dollar
Dollar peaked in March 85
September 85, Group of Five or G-5 nations met and drafted the Plaza Agreement to bring down the value of the dollar to keep it competitive
Feb 87- G-7 nations (G-5 + Canada and Italy) met to stop the decline in the dollar - Louvre Accord
Dollar however, continued to fall despite this

26. Plaza-Louvre Intervention Accord
1981: Expansive fiscal policy and tight monetary policy in the U.S.
Led to prolonged appreciation in the dollar (appreciated by almost 50% in 1985 relative to 1980)
On Sept. 22, 1985, officials from the G-5 countries - Britain, France, West Germany, Japan and the U.S. met at the Plaza Hotel in NY
Pledged to support a depreciation of the dollar
Dollar fell sharply and kept declining till 1986
Dollar kept declining till 1987 so much so that it prompted the Louvre Accord on Feb. 22, 1987
Countries pledged to keep exchange rates around target zones

27. Target zones were never publicly announced but it is believed that the zones were bands of +/- 5% around the value of DM / $ and ¥ / $ (these were the rates that prevailed on the Friday before the meeting)
At the same time the European community was getting together to limit exchange rate fluctuations

28. European Economic Community (EEC) 1972
Currencies were to be set within a band of each other (Snake system)
Problems when all countries do not abide by it
European Monetary System (EMS) 1979
Countries’ exchange rates are tied together within specified limits
Also linked to the European Currency Unit (ECU)

29. The European Monetary System (EMS)
EMS was established in 1979 to foster monetary stability in the EC (European community
ECU (European currency unit) is a weighted average of different currencies in the EC (exhibit 3.9)
Individual currencies are determined based on the ECU
Problems of political enforcement
Monetary union - EMU (European monetary union) and the Euro
Conditions for entry
Pros and cons
e.g. a tourist in Paris that left with 1,000 francs and traveled to 11 EC countries without spending anything came back with 500 francs

30. 1988- Present
Fell in against the yen and DM
Rally in 1996