1. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–1 Chapter 11 The international monetary system

2. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–2 Lecture plan Brief history of the international monetary system – gold standard; the Bretton Woods system; the floating exchange rate system Fixed exchange rates vs floating exchange rates European Monetary System Issues related to the IMF

3. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–3 The international monetary system The gold standard The Bretton Woods system (1944); fixed exchange rate system The floating exchange rate system

4. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–4 The gold standard system Under the gold standard, countries pegged their currency to gold. At one time, for example, the US government would agree to exchange one dollar for 23.22 grains of gold (1 ounce = 480 grains). The exchange rate between currencies was determined based on how much gold a unit of each currency would buy. The gold standard worked fairly well until the inter-war years and the Great Depression. Following competitive devaluations (e.g. for export support), people lost confidence in the system and started to demand gold for their currency.

5. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–5 The Bretton Woods system (1944) Provided for two multinational institutions – the IMF and World Bank. The US dollar was to be pegged and convertible to gold, and other currencies would set their exchange rates relative to the dollar. A country could not devalue the currency by more than 10% without IMF approval. Fixed exchange rates were to force countries to have greater monetary discipline. Some flexibility through the use of short-term funds from the IMF to help support currencies during temporary pressures for revaluation.

6. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–6 The collapse of the fixed exchange rate system The fixed exchange rate system established in Bretton Woods collapsed mainly due to economic management of USA (Vietnam war fiscal crisis). Speculation that the dollar would have to be devalued relative to most other currencies forced other countries to increase the value of their currency relative to the dollar. The Bretton Woods system relied on an economically well managed US. When US began to print money, run high trade deficits, the system was strained to breaking point.

7. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–7 Fixed vs floating exchange rates Floating rates are claimed to – give countries autonomy regarding their monetary policy – facilitate smooth adjustment of trade imbalances Fixed exchange rates are claimed to – impose monetary discipline on a country – avoid speculative pressures – provide more stability to international trade and investment – promote more stable prices

8. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–8 Foreign exchange arrangements of IMF members, % of total Source: adapted from IMF Annual Report, 2004

9. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–9 CASE: The Australian exchange rate system Fixed exchange rates – pegged to pound sterling (before Dec. 1971) – pegged to US dollar (Dec. 1971–Sept.1974) – pegged to a TWI* (Sept. 1974–Nov. 1976) Managed float (TWI + Government) – Nov.1976–Dec.1983 Independently floating exchange rates – since Dec. 1983, with some RBA intervention (‘the dirty float’) * TWI = Trade Weighted Index

10. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–10 Exchange rates in practice – pegged exchange rates Pegged exchange rates are popular among the world’s smaller nations, as they peg their exchange rate to that of other major currencies. There is some evidence that a pegged exchange rate regime does moderate inflationary pressures in a country.

11. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–11 Exchange rates in practice – currency boards A currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate. To make this commitment credible, the currency board holds reserves of foreign currency equal, at the fixed exchange rate, to at least 100% of the domestic currency issued. Examples: Hong Kong, Argentina, Estonia

12. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–12 ‘Dollarisation’ Involves completely replacing the local currency with a foreign currency (e.g. US dollar). Disadvantage: Monetary conditions are almost completely controlled by the foreign central bank (e.g. the US Federal Reserve). Examples: Ecuador, Panama, Micronesia, and the Marshall Islands.

13. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–13 The European Monetary System Objectives 1. create a zone of monetary stability in Europe 2. control inflation 3. coordinate exchange rate policies with third currencies The ECU: a basket of currencies that served as the unit of account for the EMS. Each national currency was given a central rate vis-à-vis the ECU. From this central rate flows a series of bilateral rates. Currencies were not allowed to depart by more than 2.25% from their bilateral rate with another EMS.

14. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–14 The EURO Benefits –significant savings for businesses and individuals –easier comparability of prices; more competition –boost to development of highly liquid pan- European capital market –more investment options Drawbacks –national authorities lose control over monetary policy –EU is not an ‘optimal currency area’

15. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–15 The European Central Bank (ECB) Implements monetary policy in Euro-zone. In January 1999, the ECB assumed responsibility for union-wide monetary policy in the 11 countries of the euro-zone forming the European Monetary Union (Greece joined later). Conflicts between member countries with low inflation and members with high inflation. Second major concern: whether each member country will be able to use its national fiscal policy effectively to improve its performance.

16. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–16 Changes in the role of the International Monetary Fund (IMF) With the introduction of the floating rate system and the emergence of global capital markets, much of the original reason for the IMF's existence has disappeared. New role: helping third world countries out of their debt crises. –1995: Mexico –1997: Thailand, Indonesia, South Korea

17. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 11–17 Criticism of the IMF A ‘one size fits all’ policy –E. Asia is not the same as Mexico. Debt in E. Asia was mainly private; in Mexico it was mainly government. The IMF creates a moral hazard. –Since people and governments believe that the IMF will bail them out, they undertake overly risky investments. The IMF has become too big and does not have enough accountability for its actions. –Overall, still extremely helpful to many countries.