International Economics Part Ⅱ International financial relations Feb.15,2011~Jun.10,2011 Lecture 7 BOP in Open Economy Lecture 8 Market-Determined Exchange Rates Lecture 9 The International Currency System Lecture 10 Domestic Policy to Adjust the Balance of Payments Lecture 11 Effects of Exchange Rate Adjustment on the Current Account and the Domestic Economy

International Economics Lecture 9 The International Currency System Feb.15,2011~Jun.10,2011

Syllabus Fixed Exchange Rates The Contemporary International Currency System The Incompatible Trinity Indices of Trade-Weighted (Effective) Exchange Rates The International Monetary Fund Summary

1. Fixed Exchange Rates Under a fixed exchange-rate system the government fixes the exchange rate at a given level by buying or selling foreign currencies when market forces push the exchange rate away from that predetermined level. Devaluation and revaluation describe discrete decrease or increase in the exchange value of the currency, by government decree.

Figure 9-1 A hypothetical fixed exchange-rate system Devaluation: the lowering of the exchange value of a currency. Revaluation: an increase in the exchange value of a currency. Spread

Figure 9-2 Excess supply of dollars (or excess demand for euros) When the ECB buys dollars in exchange for euros, its official reserve rise, and Euro-Zone money supply expands. Unsterilized intervention Sterilized intervention Revaluation

Figure 9-3 Excess demand for dollars (or excess supply of euros) Devaluation

History of Fixed Exchange Rates The Gold standard: üUnder the gold standard the external value of all currencies was maintained by fixing their prices in terms of gold. üGold was the common denominator and official reserve. The Gold Exchange Standard: ,Bretton Woods system ü Dollar instead the gold as the “core” of the system. ü All currencies were pegged to the dollar.

2. The Contemporary International Currency System Fluctuating Currencies The Euro-A Currency of 17 CountriesThe Fixed Exchange Rates. Summary of Exchange Regimes. The Role of the U.S. Dollar [Eurodollars]

(1)Fluctuating Currencies Two differences between free and managed floats should be noted.p228 l Managed floats are floating exchange rates subjects to government intervention. l $, ￡, ¥, €, and CAN$ are under managed float. l Most floating currencies are on a managed float regime with sterilized intervention. Under a free float, an external deficit (surplus) is reflected in depreciation (appreciation) of the currencies; under a fixed exchange rate, an external imbalance causes a change in international reserves, and the accumulation or depletion of reserves constitutes a measure of the surplus or deficit respectively; under a managed float system an external imbalance results in a combination of variations in the exchange rate and a change in international reserve.

（ 2 ） The Euro-A Currency of 17 Countries Austria Belgium Finland France Germany Ireland Italy Luxemburg Netherlands Portugal Spain Greece Slovenia The Republic of Malta the Republic of Cyprus The Slovak Republic Estonia European monetary union They establish the ECB to determine monetary policy for the entire Euro-Zone.

(3)Fixed Exchange Rates Pegged rate: numerous developing countries peg their exchange rates either to a single currency or to a basket of currencies. A credible way of pegging the exchange rate is by establishing a currency board Another way is to abandon the countries own currency in favor of another currency. China H.K Argentina 1991 Ecuador & El Salvador

(4)Summary of Exchange Regimes Fixed rate (“hard peg”) Pegged rate Floating rate Exchange arrangement with no separate legal tender Currency board arrangements Conventional fixed arrangements Pegged exchange rates within horizontal bands Crawling pegs Exchange rate within crawling bands Managed floating with no pre-announced path for exchange rate Independently floating Exchange rate regime Number of countries China Denmark Hungary Costa Rica Israel India and Thailand

Dollar position: although somewhat reduced in importance from Bretton Woods era, the U.S. dollar still occupies a central role as a transaction, reserve, vehicle, and intervention currency. (5)The Role of the U.S. Dollar

3. The Incompatible Trinity Incompatible trinity Fixed exchange rate Independent monetary policy Free capital movements These three features cannot coexist for a long period. (1992 European exchange crisis)

4. Indices of Trade-Weighted (Effective) Exchange Rates Bilateral exchange rate: is the exchange of value of a currency relative to another single currency. A trade-weighted exchange rate: is an index showing variations in the weighted average of the bilateral exchange rates of a given currency, where the weights can be the bilateral imports, exports, or total trade.

Real Bilateral exchange rate: is the nominal bilateral rate adjusted for the inflation deferential between the two countries. Real trade-weighted exchange rate: is the (nominal) trade-weighted rate adjusted for the inflation deferential between the country and that of its trading partners. E $/€ =(E $/€ )(P E /P U.S. )

Figure 9-4 Real effective exchange rate index of the dallar

5. The International Monetary Fund Regular IMF Procedures Special Drawing Rights Procedures Special Facilities International Reserves The IMF is a Washington based organization of 185 countries, charged with overseeing the international financial system. It offers financial assistance and advice to countries in need.

(1)Regular IMF Procedures Quota : Each member country is assigned a quota, of which it must contribute to the IMF 25% in gold or widely used convertible foreign currencies and 75% in its own currency. Conditionality provisions : IMF requires a “borrowing” country to follow certain fiscal and monetary polices that would ensure its return to economic health. Voting power The amount of loans it is eligible to receive

(2)Special Drawing Rights Procedures SDRs : is an asset that the IMF creates and allocates to its members. SDRs is a reserve asset. Its value is a weighted average of $,€, ￡ and ¥. The attractiveness of SDRs as a reserve asset derives from the obligation of all members to accept them from each other. (3)Special Facilities Compensatory finance facility System transformation facility

(4)International Reserves The combined demand of all countries indicates the amount of reserves needed by the international community. A country’s official reserves consist of gold; SDRs; Reserves Position in the IMF; and convertible foreign currencies—mainly dollars.

5.Summary A fixed exchange rate system requires the use of reserves, which are bought or sold on the home market to maintain the value of the currency within a prescribed spread or band. Effects of exchange intervention on the domestic money supply are neutralized with sterilization. The contemporary monetary system consists of a mixture of fixed and floating rates.

A system of fixed exchange rates coupled with free capital movements requires coordinated monetary policy for sustainability in the long run. A trade-weighted average of bilateral exchange rate changes is required to determine changes in the exchange value of the U.S. dollar or any currency. Real exchange rates reflect changes in a country's competitive position. A real effective exchange rate is obtained by adjusting the effective nominal exchange rate for differences in the country's inflation rate and a weighted average of foreign inflation rates.

Suggested Further Reading M. Bordo and Barry Eichengreen, eds., A Retrospective History of the Bretton Woods System: Lessons for International Monetary Reform, Chicago: University of Chicago Press, A. Giovanni and C. Mayer, eds. European Financial Integration, Cambridge: Cambridge University Press, A. W. Hooke, The International Monetary Fund: Its Evolution, Organisation, and Activities, 2nd ed., Pamphlet Series no. 37, Washington D.C.: IMF John Williamson, The Exchange Rate System, Washington D.C.: Institute for International Economics, 1985.