International Finance FINA 5331 Lecture 5 History of Monetary Institutions Read: Chapters 2 & 3 Aaron Smallwood Ph.D.

Additionally What exchange rate systems exist today? –The choice between a fixed system and a flexible system. How does another country’s exchange rate system affect you? How does China’s changing exchange rate system affect you? What are currency crises and how can they impact your business? What is the euro? Will the euro-zone expand? How does expansion of the euro-zone affect you?

Interwar Period: Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”. The result for international trade and investment was profoundly detrimental. Smoot-Hawley tariffs Great Depression

Economic Performance and Degree of Exchange Rate Depreciation During the Great Depression

Bretton Woods System: Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank.

Bretton Woods System: Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. The U.S. was only responsible for maintaining the gold parity. Under Bretton Woods, the IMF was created. The Bretton Woods is also known as an adjustable peg system. When facing serious balance of payments problems, countries could re-value their exchange rate. The US and Japan are the only countries to never re-value.

The Fixed-Rate Dollar Standard, In practice, the Bretton Woods system evolved into a fixed-rate dollar standard. Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, and keep the exchange rate within 1% of this par value indefinitely. United States : Remain passive in the foreign change market; practice free trade without a balance of payments or exchange rate target.

Bretton Woods System: German mark British pound French franc U.S. dollar Gold Pegged at $35/oz. Par Value

Purpose of the IMF The IMF was created to facilitate the orderly adjustment of Balance of Payments among member countries by: encouraging stability of exchange rates, avoidance of competitive devaluations, and providing short-term liquidity through loan facilities to member countries

Composition of SDR (Special Drawing Right)

Collapse of Bretton Woods Triffin paradox – world demand for $ requires U.S. to run persistent balance-of-payments deficits that ultimately leads to loss of confidence in the $. SDR was created to relieve the $ shortage. Throughout the 1960s countries with large $ reserves began buying gold from the U.S. in increasing quantities threatening the gold reserves of the U.S. Large U.S. budget deficits and high money growth created exchange rate imbalances that could not be sustained, i.e. the $ was overvalued and the DM and £ were undervalued. Several attempts were made at re-alignment but eventually the run on U.S. gold supplies prompted the suspension of convertibility in September Smithsonian Agreement – December 1971

The Floating-Rate Dollar Standard, Without an agreement on who would set the common monetary policy and how it would be set, a floating exchange rate system provided the only alternative to the Bretton Woods system.

The Floating-Rate Dollar Standard, Industrial countries other than the United States : Smooth short-term variability in the dollar exchange rate, but do not commit to an official par value or to long-term exchange rate stability. United States : Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target. No need for sizable official foreign exchange reserves.

The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, Plaza Accord (1985): –Allow the dollar to depreciate following massive appreciation…announced that intervention may be used. Louvre Accord (1987) and “Managed Floating” –G-7 countries will cooperate to achieve exchange rate stability. –G-7 countries agree to meet and closely monitor macroeconomic policies.

Value of $ since 1965

IMF Classification of Exchange Rate Regimes Independent floating Managed floating Exchange rate systems with crawling bands Crawling peg systems Pegged exchange rate systems within horizontal bands Conventional pegs Currency board Exchange rate systems with no separate legal tender