1. The International Monetary System International Finance Dr. A. DeMaskey

2. Learning Objectives  What different exchange rate systems are used by various governments?  What are the characteristics of an ideal currency?  What currency regime choices do emerging market countries have?  How was the euro created and what are its effects?  What are the origins and proposed mechanisms to deal with various emerging market currency crises?

3. The International Monetary System (IMS)  Official Part of the International Financial System  Presents a Structure within which Exchange rates are determined Trade and capital flows are accommodated Balance of payments adjustments are made  Operates under a set of policies, institutions, practices and regulations.

4. Alternative Exchange Rate Systems  Fixed Rates  Freely Floating  Managed Float  Pegged Exchange Rates  Target Zone Arrangement

5. Fixed Exchange Rate Systems  Gold Standard (1821-1914)  Gold Exchange Standard (1925-1931)  Fixed Rates with Narrow Bands - Bretton Woods System (1944-1971)  Fixed Rates with Wider Bands - Smithsonian Agreement (1971-1973)

6. Gold Standard (1821-1914)  Gold is the dominant international money  Currencies are valued in terms of a gold equivalent  All players had to adhere to the rules of the game  Government intervention  International reserves  Limited growth of the money supply  Automatic balance of payment adjustments.

7. Gold Exchange Standard (1925-1931)  Each currency is freely convertible into gold at a fixed rate but also into other currencies at relatively stable prices.  Greater convenience for international traders and investors.

8. Bretton Woods System (1944-1971) Fixed Rates with Narrow Bands  A dollar based system  Maintain a fixed, or pegged, exchange rate in terms of gold or the U.S. dollar  Dollar per gold value of $35.00  Allow currencies to fluctuate within a narrow band of ±1%.  Government intervention  International reserves

9. Smithsonian Agreement (1971-1973) Fixed Rates with Wider Bands  Dollar per gold value was changed to $38.02  Allow currencies to fluctuate within a wider band of ±2.25%.

10. Floating Exchange Rate Systems  Free or Clean Float (March 1973)  Managed or Dirty Float (January 1976)  Joint Float - European Monetary System (March 1979)

11. Freely Floating Exchange Rate System  Market forces determine the exchange rate  No government intervention  No need for international reserves  Independent monetary and fiscal policies  No capital flow restrictions  Price instability

12. Managed Floating Rate System  Market forces determine the exchange rate  Some government intervention  Jamaica Agreement (January 1976)  Plaza Agreement (September 1985)  Louvre Accord (February 1987)

13. Contemporary Currency Regimes  IMS (national currencies, artificial currencies, composite currency)  Exchange Rate Regimes (8) Rigidly fixed system (euro area) Independently floating (developed and emerging market countries)

14. Fixed vs. Flexible Exchange Rates Systems  Preference for fixed exchange rates  Anti-inflationary  Large international reserves  Inconsistency with economic fundamentals

15. Attributes of the Ideal Currency  Fixed value  Convertibility  Independent monetary policy

16. Emerging Markets and Regime Choices  A currency board is a system for maintaining the value of the local currency with respect to some other specified currency.  Dollarization refers to the replacement of a local currency with U.S. dollars

17. Currency Board System  Argentina (1991)  Fixed Rate System  100% Reserve System  Monetary Policy and Money Supply  Dollar-Denominated Accounts (interest differential)  End of Argentine Currency Board (2002) More…

18. Currency Board System  Characteristics No Central Bank No Discretionary Monetary Policy  Advantages Promotes price stability Responsible fiscal policy  Disadvantages Sharp contraction in money supply High interest rates

19. Dollarization  Use of U.S. dollar as the official currency Panama, Ecuador, Liberia  Requires change in structure and responsibilities of monetary policy authorities  Arguments for: Removes currency volatility against dollar Expectations of greater economic integration  Argument against: Loss of sovereignty over monetary policy Loss of power of seignorage Loss of role of lender of last resort

20. The Birth of a European Currency: The Euro  European Monetary System Target Zone Arrangement Pegged Exchange Rate System Joint Float Agreement  European Monetary Union Why Monetary Unification? Launch of the Euro How to Achieve Monetary Unification?

21. Target Zone Arrangement  Member countries maintain fixed exchange rates within a flexible range, called target zone, among themselves.  Each member’s currency is pegged to all the other members’ currencies.  The group as a whole floats jointly against the rest of the world.

22. The EMS: A Joint Float Agreement  EMS members peg their currencies to each other.  Exchange outside the EMS is subject to a managed float.  Objective: Exchange rate stability.

23. Summary of Historical Events Leading Up to EMU Treaty of Rome EEC 1957 Treaty of Rome - EEC the “monetary Snake” 1972 the “monetary Snake” the European Monetary System begins 1979 the European Monetary System begins Maastricht Treaty 1991Maastricht Treaty Madrid confirms timetable 1995 Madrid confirms timetable conversion 1/1/99 conversion

24. Maastricht Treaty (December 1991)  Common European Currency - Euro Fixed rate system Replaces individual national currencies  European Central Bank (ECB) Issues common currency Conducts monetary policy

25. The Maastricht Treaty Criteria  Inflation not to exceed that in three EU states with the lowest rate by more than 1.5%.  Long-term interest rates not to exceed that in three EU states with the lowest inflation rates by more than 2%.  The annual fiscal deficit not to exceed 3% of GDP.  Cumulative public debt not to exceed 60% of GDP.  A country must have maintained its membership in the EMS for two years without having initiated a devaluation.

26. Milestones on the Road to Monetary Union  Dec. 31, 1999 Euro exchange rates are fixed. ECB takes over monetary policy for all eleven EMU nations.  Jan. 4, 1999 Stock and bond markets convert to euro.  1999-2001 Foreign exchange transactions denominated in euros.  Jan. 1, 2002 (E-Day) Euro notes and coins must be in circulation in all EMU member states.  July 1, 2002 National currencies no longer legal tender.

27. Monetary Unification  Why Monetary Unification? A single currency area called euro zone Competing globally  How to Achieve Monetary Unification Fiscal policy Monetary policy Fixing the value of the euro  Performance of The Euro

28. Useful Websites  A table showing the currencies of the world and their exchange rate arrangements can be found at: http://pacific.commerce.ubc.ca/xr/currency_table.html  For more information on the euro, visit: http://www.euro.ecb.int/en.html http://www.ecb.int/ http://pacific.commerce.ubc.ca/xr/euro/

29. Emerging Market Currency Crises  Currency Crises Mexican crisis of 1994-1995 Asian crisis of 1997 Russian crisis of 1998 Brazilian crisis of 1998-1999  Transmission Mechanisms Trade Links Financial System More…

30. Emerging Market Currency Crises  Origins Moral Hazard Fundamental Policy Conflict  Policy Proposals Currency Controls Free Float Fixed Exchange Rates