18-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Chapter 18 The international monetary system

18-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Learning objectives Revisit the determination of the exchange rate by briefly examining the polar extremes of freely flexible and fixed exchange rates Explain and evaluate the various kinds of exchange rate systems that trading nations use Describe the gradual reform of the international monetary system, including the three different exchange rate systems used by the nations of the world Discuss the recent history of, and changes in, Australia's exchange rate

18-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Exchange rate systems Two types of exchange rate system: Flexible or floating exchange rates –The exchange rate is determined by demand and supply Fixed exchange rates –Government intervention in the foreign exchange market offsets the changes in exchange rate caused by the demand and supply factors

18-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Freely floating exchange rates Determined by the unimpeded forces of supply and demand Depreciation and appreciation –Depreciation in the exchange rate is an increase in the number of units of a country’s currency required to buy a single unit of some foreign currency –Appreciation is a reduction in the number of units of a country’s currency required to buy a single unit of some foreign currency

18-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Flexible rates and the balance of payments Flexible exchange rates automatically adjust so as to eliminate balance of payments deficits or surpluses

18-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Adjustments under flexible, fixed & the gold standard P Q Dollar price of one pound Pounds S1S1 D0D0 D1D1 D0D0 D1D1 S1S1 C B A X

18-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Flexible exchange rates Disadvantages of floating exchange rates Uncertainty and diminished trade –Uncertainty on prices due to movements in the exchange rate and discourage the flow of trade Terms of trade –A decline in the international value of a country’s currency will result in worsening terms of trade

18-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Flexible exchange rates (cont.) Disadvantages of floating exchange rates Instability in the macroeconomic environment –Destablising effects on the domestic economy arising from shifts in net exports brought about by changes in the exchange rate –Complicates the use of domestic monetary and fiscal policies

18-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Fixed exchange rates Exchange rate for which the values are determined by government decision Nations have often fixed or pegged the exchange rate to overcome the disadvantages of floating exchange rates Fixed exchange rates require adequate reserves to accommodate periodic balance of payment deficits

18-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Fixed exchange rates (cont.) Trade policies –To maintain a fixed exchange rate, a country may enact protectionist trade policies to increase net exports Exchange controls: rationing –Restricting imports to the amount of foreign exchange earned by exports Domestic macroeconomic adjustments –Use fiscal and monetary policies to adjust GDP to a level consistent with the fixed exchange rate

18-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal International monetary system: the gold standard A system under which the value of a nation’s monetary unit was backed by gold rather than fiat Gold standard conditions –Define the monetary unit in terms of a certain quantity of gold –Fixed relationship between stock of gold and the domestic currency –Allow gold to be freely exported and imported

18-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal The gold standard (cont.) Gold flows –This would result in exchange rates that are fixed Domestic macro adjustments –The gold standard implies changes in the domestic money supply of nations, which affects prices, real output and employment Advantages of gold standard –Stable exchange rates resulting from the gold standard reduces uncertainty and risk –The flow of gold between countries caused shifts in the supply and demand curves and automatically corrects balance of payments deficits or surpluses

18-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal The gold standard (cont.) Disadvantages of gold standard –Nations must accept domestic adjustments in the form of higher unemployment or inflation –Countries must have sufficient reserves of gold Demise of the gold standard –During the Depression years of the 1930s

18-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Bretton Woods monetary system Bretton Woods conference 1944 Adjustable peg system of exchange rate emerged –A system by which members of the IMF were obligated to define their monetary units in terms of gold (or US dollars), establishing par rates of exchange between the currencies of all other members, and to keep their exchange rates within 1 per cent of these par values

18-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal IMF and pegged exchange rates Stabilisation funds –Suppliers of both foreign and domestic moneys and gold held with the central bank or treasury for the purpose of intervention in the foreign exchange market to maintain the par value of the exchange rate IMF credit –Provided short-term loans to nations with temporary or short-term balance of payments deficits out of currencies and gold contributed by member nations

18-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Bretton Woods monetary system Fundamental imbalances: adjusting the peg –Countries running persistent balance of payments deficits ran out of reserves and were unable to maintain its fixed exchange rate Demise of the Bretton Wood –Dilemma: dollars and the deficits –Emergence of floating rates

18-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Managed float An exchange rate system where central banks buy and sell foreign exchange to smooth out short-run or day-to-day fluctuations in rates Encourages international trade and finance, while allowing for trend or long-term exchange rate flexibility to correct fundamental payments disequilibria Liquidity and special drawing rights –Special drawing rights are bookkeeping entries at the IMF, available to IMF members in proportion to their IMF quotas, that may be used to settle payments deficits or satisfy reserve needs in place of foreign exchange or gold

18-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Managed float (cont.) Demonetisation of gold Further reform of the international monetary system led to the downgrading of the role of gold Gold has now ceased to function as an international money

18-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Managed float: an evaluation Arguments for managed float Trade growth Managing turbulence Arguments against Volatility and adjustment Reinforcement of inflation

18-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Exchange rate history: Australia Setting exchange rates in the 1970s Pegged to the US dollar 1971–1974 –Was revalued in 1972 and 1973 Pegged to the trade-weighted index 1974–1976 –An index of the ‘average’ exchange rate comprised of the basket of currencies of Australia’s major trading partners, weighted to reflect their share of trade –From 1976 till December 1983 operated on a managed float

18-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Exchange rate history: Australia (cont.) The floating of the exchange rate (1983) Floating and the current account crisis Recovery during the late 1980s The early 1990s and the 1990 recession The late 1990s and the Asian crisis Into the 2000s