2. The International Monetary System Start by looking at a typical domestic monetary system
Domestic Monetary Systems Central Bank Government Retail Banks Typically, the government establishes a central bank to…. Control the money supplyRegulate the banking system Act as the bank for the government and for private retail banks people And ultimately, of course, money flows between the government, retail banks, people and businesses. businesses
Domestic Monetary Policy The objective(s) of monetary policy may be… Low inflation (steady prices).High GDP growth.To fund (pay for) a government deficit.To support a particular domestic retail interest rate.To support a particular international exchange rate against another currency. Monetary policy determines how, and how much money, the central bank inserts into, or takes out of, the economy. The central bank typically does this by raising or lowering the interest rate it charges retail banks; and/or buy buying or selling government debt.
Exchange Rates An exchange rate is simply the price of one currency against another. For example… Exchange rates are necessary to fund international trade and investment. = 30 30 Thai baht per 1 US dollar 1 Or, 1 Thai baht = 1/30 US dollar 30 1 0.0333
Trade Flows Example: A Thai exported sells some shoes to an American customer for Bt 3,000. The exchange rate is 30 baht per dollar. $100 Bt 3,000 / (Bt30/$) = $100 Bt 3,000 Depending upon the payment method, the dollars could be changed into Thai baht in the USA, in Thailand, or through the Bank of International Settlements (BIS) in Switzerland.
Discussion Questions Consider the baht/dollar exchange rates $1 = ThB 25; $1 = ThB 30, $1 = ThB 40 Q1: Which exchange rate above indicates a stronger baht? A stronger dollar? Q2: From Thailands point of view, which is the best exchange rate? A1: $1 = ThB 25 makes the dollar weak and therefore the baht strong. Rewriting the exchange rates as ThB 1 = $.04, ThB 1 = $0.0333, ThB 1 = $.025, we can see that the first exchange rate $1 = ThB 25 makes the baht the strongest. A2: Generally, a weak currency benefits exporters and the economy; but a strong currency benefits importers and lowers inflation. But what is also important is the volatility of the exchange rate. Generally, a stable exchange rate is better than a volatile one.
History of Monetary Regimes Bimetallism (pre-1875) Gold Standard (1875- 1914) Interwar Period (1915- 1944) Bretton Woods (1945- 1972) Flexible Exchange Rates (after 1973) How exchange rates are determined depends in large part upon the international monetary regime under which it operates.
Gold Standard 1875-1914 1. Each countrys central bank holds gold reserves. Bank of England gold reserves Bank of France 2. Each country sets its own domestic convertibility ratio between gold and its own currency. £6 = 1 ounce gold FFr12 = 1 ounce gold 3. Exchange rates are determined by the currencies convertibility into gold. 1 ounce gold = £6 = FFr12…. so £6 = FFr12 or £1 = FFr2. Importantly, trade imbalances are funded indirectly by flows of gold reserves! If England exports goods to France… …gold reserves will flow from France to England.
Discussion Questions Q1: What is the equillibriating (adjusting) mechanism here for trade imbalances? A1: Flows of gold reserves between countries….causing domestic prices to adjust which should restore trade balances. Q2: Whats good about this system? A2: Stability. A2: Legitimacy of currency & low inflation. Q3: Whats bad about this system? A3: For net importers (gold reserve exporters), a temptation to adjust downward the currency/gold exchange rate. A3: Systemic problems if equillibriating mechanisms dont work and reserves get too low. Generally speaking, well see below that fixing a currency to gold – or to anything else, including another currency – can lead to trouble for net importing countries.
Bretton Woods 1945-72 The post-WWII international monetary system, created along with the International Monetary Fund (IMF) and the World Bank.
A dollar-based gold standard Participating countries wanted… stable exchange rates. a gold-based system without the need for gold reserves. The eventual solution was….
A dollar-based gold standard Gold pegged at $35/ounce German D-mark UK pound sterling French franc Par value Bretton Woods System: The US Dollar fixed to gold; and other currencies fixed at par to the US dollar. As a result, the US dollar became the defacto world reserve currency.
A dollar-based gold standard German D-mark UK pound sterling French franc To increase their reserves, other countries exported heavily to the US, getting dollars in return. Persistent trade deficits weakened faith in the dollar, and encouraged exchanging dollars for gold. Eventually, falling demand for US$, coupled with expansionary US monetary policy, forced the US Government to suspend convertibility of dollars for gold…. …and the free- floating, flexible exchange rate regime was born.