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Chapter 10 The International Monetary System. 10-2 Introduction The institutional arrangements that countries adopt to govern exchange rates are known.

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Presentation on theme: "Chapter 10 The International Monetary System. 10-2 Introduction The institutional arrangements that countries adopt to govern exchange rates are known."— Presentation transcript:

1 Chapter 10 The International Monetary System

2 10-2 Introduction The institutional arrangements that countries adopt to govern exchange rates are known as the international monetary system When a country allows the foreign exchange market to determine the relative value of a currency, a floating exchange rate system exists When a country fixes the value of its currency relative to a reference currency, a pegged exchange rate system exists

3 10-3 Introduction When a country tried to hold the value of its currency within some range of a reference currency, dirty float exists Countries that adopt a fixed exchange rate system fix their currencies against each other Prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

4 10-4 The Gold Standard The gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value Payment for imports was made in gold or silver Later, as trade grew, payment was made in paper currency which was linked to gold at a fixed rate

5 10-5 Mechanics Of The Gold Standard Pegging currencies to gold and guaranteeing convertibility is known as the gold standard In the 1880s, most of the worlds trading nations followed the gold standard Under the gold standard one U.S. dollar was defined as equivalent to grains of "fine (pure) gold The amount of a currency needed to purchase one ounce of gold was called the gold par value

6 10-6 Strength Of The Gold Standard The great strength of the gold standard was that it contained a powerful mechanism for achieving balance-of- trade equilibrium (when the income a countrys residents earn from its exports is equal to the money its residents pay for imports) by all countries

7 10-7 The Period Between The Wars: The gold standard worked fairly well from the 1870s until the start of World War I in 1914 During the war, many governments financed their war expenditures by printing money, and in doing so, created inflation People lost confidence in the system and started to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility By 1939, the gold standard was dead

8 10-8 The Bretton Woods System In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system that would facilitate postwar economic growth Under the new agreement: a fixed exchange rate system was established all currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold devaluations could not to be used for competitive purposes a country could not devalue its currency by more than 10% without IMF approval

9 10-9 The Bretton Woods System The Bretton Woods agreement also established two multinational institutions: the International Monetary Fund (IMF) to maintain order in the international monetary system the World Bank to promote general economic development

10 10-10 The Role Of The IMF The IMF was charged with executing the main goal of the Bretton Woods agreement - avoiding a repetition of the chaos that occurred between the wars through a combination of discipline and flexibility Discipline mean that: the need to maintain a fixed exchange rate put a brake on competitive devaluations and brought stability to the world trade environment a fixed exchange rate regime imposed monetary discipline on countries, thereby curtailing price inflation

11 10-11 The Role Of The IMF Flexibility meant that: while monetary discipline was a central objective of the agreement, a rigid policy of fixed exchange rates would be too inflexible the IMF was ready to lend foreign currencies to members to tide them over during short periods of balance-of- payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment

12 10-12 The Role Of The World Bank The World Bank is also called the International Bank for Reconstruction and Development (IBRD) There are two ways to borrow from the World Bank: 1. under the IBRD scheme, money is raised through bond sales in the international capital market borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses. 2. through the International Development Agency, an arm of the bank created in 1960 IDA loans go only to the poorest countries

13 10-13 The Collapse Of The Fixed Exchange Rate System Bretton Woods worked well until the late 1960s It collapsed when huge increases in welfare programs and the Vietnam War were financed by increasing the money supply and causing significant inflation Other countries increased the value of their currencies relative to the dollar in response to speculation the dollar would be devalued However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point

14 10-14 The Floating Exchange Rate Regime In 1976, following the collapse of Bretton Woods, IMF members formalized a new exchange rate system at a meeting in Jamaica The rules that were agreed on then, are still in place today

15 10-15 The Jamaica Agreement Under the Jamaican agreement: floating rates were declared acceptable gold was abandoned as a reserve asset total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion

16 10-16 Exchange Rates Since 1973 Since 1973, exchange rates have become more volatile and less predictable than they were between 1945 and 1973 Volatility has increased because of: The 1971 oil crisis The loss of confidence in the dollar that followed the rise of U.S. inflation in 1977 and 1978 The 1979 oil crisis The unexpected rise in the dollar between 1980 and 1985 The partial collapse of the European Monetary System in 1992 The 1997 Asian currency crisis

17 10-17 Exchange Rates Since 1973 Figure 10.1: Major Currencies Dollar Index,

18 10-18 Fixed Versus Floating Exchange Rates The merit of a fixed exchange rate versus a floating exchange rate system continues to be debated Many countries today are disappointed with the floating exchange rate system

19 10-19 The Case For Floating Exchange Rates The case for floating exchange rates has two main elements: 1. monetary policy autonomy 2. automatic trade balance adjustments

20 10-20 The Case For Floating Exchange Rates Supporters of floating exchange rates argue that removing the obligation to maintain exchange rate parity restores monetary control to a government Under a fixed system, a country's ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity So, under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would have to agree to a currency devaluation

21 10-21 The Case For Fixed Exchange Rates Supporters of fixed exchange rates focus on monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates Having to maintain a fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates They also claim that speculation that is associated with floating exchange rates can cause uncertainty Advocates of floating exchange rates also argue that floating rates help adjust trade imbalances

22 10-22 Who Is Right? There is no real agreement as to which system is better We know that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work A different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment

23 10-23 Exchange Rate Regimes In Practice Various exchange rate regimes are followed today Currently: 14% of IMF members follow a free float policy 26% of IMF members follow a managed float system 28% of IMF members have no legal tender of their own the remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs

24 10-24 Exchange Rate Regimes In Practice Figure 10.2: Exchange Rate Policies, IMF Members, 2006

25 10-25 Pegged Exchange Rates A country following a pegged exchange rate system, pegs the value of its currency to that of another major currency Pegged exchange rates are popular among the worlds smaller nations There is some evidence that adopting a pegged exchange rate regime does moderate inflationary pressures in a country

26 10-26 Currency Boards Countries using a currency board commit to converting their domestic currency on demand into another currency at a fixed exchange rate To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued

27 10-27 Crisis Management By The IMF Since many of the original reasons for the IMF no longer exist, the organization has redefined its mission The IMF now focuses on lending money to countries experiencing financial crises However, critics claim that IMF policies in these countries have actually made the situation worse

28 10-28 Financial Crises In The Post-Bretton Woods Era A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates A banking crisis refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt

29 10-29 Mexican Currency Crisis Of 1995 The Mexican currency crisis of 1995 was a result of: high Mexican debts a pegged exchange rate that did not allow for a natural adjustment of prices To keep Mexico from defaulting on its debt, a $50 billion aid package was created

30 10-30 The Asian Crisis The 1997 Southeast Asian financial crisis was caused by a series of events that took place in the previous decade: huge increases in exports that helped fuel a boom in commercial and residential property, industrial assets, and infrastructure investments that were made on the basis of projections about future demand conditions that were unrealistic and created significant excess capacity Investments made on the basis of unrealistic projections about future demand conditions created significant excess capacity investments were often supported by dollar-based debts

31 10-31 The Asian Crisis when inflation and increasing imports put pressure on the currencies, the resulting devaluations led to default on dollar denominated debts by the mid 1990s, imports were expanding across the region by mid-1997, it became clear that several key Thai financial institutions were on the verge of default foreign exchange dealers and hedge funds started to speculate against the Baht, selling it short after struggling to defend the peg, the Thai government abandoned its defense and announced that the Baht would float freely against the dollar

32 10-32 The Asian Crisis With its foreign exchange rates depleted, Thailand lacked the foreign currency needed to finance its international trade and service debt commitments, and was in desperate need of the capital the IMF could provide Following the devaluation of the Baht, speculation caused other Asian currencies including the Malaysian Ringgit, the Indonesian Rupaih and the Singapore Dollar to fall These devaluations were mainly driven by similar factors to those that led to the earlier devaluation of the Baht-- excess investment, high borrowings, much of it in dollar denominated debt, and a deteriorating balance of payments position

33 10-33 Evaluating The IMFs Policy Prescriptions By 2006, the IMF was committing loans to some 59 countries in economic and currency crisis All IMF loan packages require a combination of tight macroeconomic policy and tight monetary policy However, critics worry: the one-size-fits-all approach to macroeconomic policy is inappropriate for many countries the IMF is exacerbating moral hazard (when people behave recklessly because they know they will be saved if things go wrong) The IMF has become too powerful for an institution without any real mechanism for accountability As with many debates about international economics, it is not clear who is right

34 10-34 Corporate-Government Relations Managers need to recognize that businesses can influence government policy towards the international monetary system So, companies should promote an international monetary system that facilitates international growth and development


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