1. Ch 3. International Monetary System
I. Alternative exchange rate systems
II. A brief history of the international monetary
system
III. The European Monetary System and Monetary Union
IV. Emerging market currency crises

2. International Monetary Systems
Introduction:
1. Before 1971 (the Bretton Woods system), the international monetary system was mainly a relatively fixed exchange rate system (relative to the US dollar)
2. The current international monetary system is a system of rapidly fluctuating exchange rates (hybrid system)
3. The purpose of this chapter is to understand: what the international monetary system is and how the choice of system affects currency value.

3. International Monetary Systems
The international monetary system is the set of polices, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchanged for another.
There are five market mechanisms: (1) free float, (2) managed float, (3) target-zone arrangement, (4) fixed-rate system, and (5) the current hybrid system.

4. International Monetary Systems
I. Part I: Five market mechanisms
A. Freely Floating (“Clean Float”)
1. Market forces of supply and demand determine
exchange rates.
2. Forces are influenced by:
a. price levels
b. interest rates
c. economic growth
3. Rates fluctuate randomly over time when new
information arrives → economic uncertainty

5. Alternative Exchange Rate Systems
B. Managed Float (“Dirty Float”)
1. Market forces set rates unless excess volatility occurs
2. Then, central bank determines exchange rate
Types of managed float:
- smoothing out daily fluctuation, if volatility exceeds certain threshold
- “leaning against the wind” : prevent abrupt short- and medium-term fluctuations
- “unofficial pegging”: there is no publicly announced government commitment to a given exchange rate level

6. Alternative Exchange Rate Systems
C. Target-Zone Arrangement
1. Rate Determination
a. Market forces constrained to upper and lower range of exchange rates
b. Members to the arrangement adjust their national
economic policies to maintain target exchange rates
c. the precursor to the euro, European Monetary
System, is one of the systems

7. Alternative Exchange Rate Systems
D. Fixed Exchange Rate System (e.g., BW system)
1. Rate determination
a. Governments are committed to maintain target
rates.
b. If rates threatened, central banks buy/sell currency.
c. Monetary policies are coordinated or subordinated.
The problem is: monetary policy may be inconsistent with desirable goals on interest rate, economic growth and unemployment (domestic economic development)

8. Alternative Exchange Rate Systems
E. Current System - a hybrid system
a. Major currencies: use freely-floating method
b. Other currencies move in and out of various
fixed-rate systems.
G. Trade-off :
1. If prefer economic stability - fixed exchange rate system
is better. However, if nations can not follow a consistent
policy, it may lead to currency crisis
2. Economic shocks can be absorbed easily when exchange
rates are allowed to float freely. However, freely floating
rates may exhibit excessive volatility

9. Dynamics in an Economic System
Devaluing currency often leads to high inflation rate
Exchange rate
Inflation rate
High interest rate is often related to currency appreciation
Adjust money supply to intervene exchange rate
Loose money supply leads to high inflation rate
Monetary policy
Interest rate
Loose money supply results in lower interest rate
Economic growth, unemployment

10. Part II. A Brief History of the International Monetary System
I. The Use of Gold
A. Desirable properties
B. In the short run: High production costs limit changes.
C. In the long run: Commodity money insures stability.
II. The Classical Gold Standard ( )
A. Major global currencies on gold standard.
1. Nations fix the exchange rate in terms of a specific amount of gold.

11. A Brief History
2. Maintenance involved the buying and selling of gold at that price.
3. Disturbances in Price Levels:
- Would be offset by the price-specie*-flow mechanism.
* specie = gold coins

12. A Brief History
a. Price-specie-flow mechanism adjustments were automatic:
1.) When a balance of payments surplus led to a gold inflow;
2.) Gold inflow led to higher commodity prices which reduced surplus;
3.) Gold outflow led to lower commodity prices and increased surplus.
However, gold does have a cost. With low inflation, the reduced demand for gold has lowered its usefulness.

13. A Brief History III. The Gold Exchange Standard (1925-1944)
A. U.S. and Britain only allowed to hold gold reserves.
B. Others could hold both gold, dollars or pound reserves.
C. England currencies devalued in led to trade wars.
D. Bretton Woods Conference (1944)
- called in order to avoid future protectionist and
destructive economic policies

14. A Brief History V. The Bretton-Woods System (1946-1971)
1. U.S.$ was key currency;
valued at $1 - 1/35 oz. of gold.
2. All currencies linked to that price in a fixed rate system.
3. Exchange rates allowed to fluctuate by 1% above or below initially set rates.

15. A Brief History B. The B-W system collapse in 1971. Why?
a. U.S. high inflation rate - difficult to maintain the fixed price of gold
b. West Germany, Japan refuse to accept the inflation that the fixed exchange rate imposes
V. Post-Bretton Woods System (1971-Present)
A. Smithsonian Agreement, 1971: US$ devalued to 1/38 oz. of gold. By 1973, world is on a freely floating exchange rate system

16. A Brief History B. OPEC and the Oil Crisis (1973-1974)
1. OPEC raised oil prices four fold;
2. Resulted in exchange rate turmoil;
C. Dollar Crisis ( )
1. U.S. B-O-P difficulties
2. Result of inconsistent monetary policy in U.S.
3. Dollar value falls as confidence shrinks.
D. The Rising Dollar ( )
1. U.S. inflation subsides as the Fed raises interest rates
2. Rising rates attracts global capital to U.S.
3. Result: Dollar value rises.

17. A Brief History
Source Data: Reserve Bank of Australia

18. A Brief History E. The Sinking Dollar: (1985-87)
1. Dollar revaluated slowly downward;
2. Plaza Agreement (1985) : G-5 agree to depress US$ further.
3. Louvre Agreement (1987): G-7 support the falling US$.
F. Recent History (1988-Present)
US$ stabilized
2. Post-1991 Confidence resulted in stronger dollar
3. Trade deficit, Iraq war, US economy

19. Part III. The European Monetary System
I. Introduction
A. The European Monetary System (EMS)
1. A target-zone method (1979)
2. Close macroeconomic policy coordination required.
B. EMS Objective:
- to provide exchange rate stability to all members by holding exchange rates within specified limits.
C. European Currency Unit (ECU)
- a “cocktail” of European currencies with specified weights as the unit of account.

20. The European Monetary System
1. Exchange rate mechanism (ERM)
- each member determines mutually agreed upon central cross rate for its currency.
2. Member Pledge: to keep within 15% margin above or below the central rate.

21. The European Monetary System
D. EMS ups and downs
1. Foreign exchange interventions:
- failed due to lack of support by coordinated monetary policies.
2. Currency Crisis of Sept. 1992
a. System broke down
b. Britain and Italy forced to withdraw from EMS.

22. The European Monetary System
G. Failure of the EMS:
- members allowed political priorities to dominate exchange rate policies.
H. Maastricht Treaty
1. Called for Monetary Union by 1999 (moved to 2002)
2. Established a single currency: the euro
3. Calls for creation of a single central EU bank
4. Adopts tough fiscal standards

23. The Euro System I. Costs / Benefits of A Single Currency A. Benefits
1. Reduces cost of doing business
2. Reduces exchange rate risk
B. Costs
1. Lack of national monetary flexibility
Conflict of interest within EU

24. Part IV. Emerging Market Currency Crises
Crises in 1990s: e.g., Mexican ( ), Asian (1997), Russia (1998)
I. Transmission Mechanisms
A. Trade links
- contagion spreads through trade to trade partners
B. Financial System
- more important, serves as wakeup call to others
- investors sell off to make up for initial losses
C. Short-term debt linked to US Dollar

25. Emerging Market Currency Crisis
II. Origins of Emerging Market Crises
A. Moral hazard – e.g., IMF bailing out Asia ($118 B)
B. Fundamental Policy Conflict in fixed exchange rate, monetary policy, and free capital movement
III. Policy Proposals for Dealing with Emerging Market crises
A. Currency Controls
B. Freely Floating Currency
C. Permanently Fixed Exchange Rate - e.g. monetary union (EU, Panama, HongKong)

26. Study Questions
1. What are the main reasons for the collapse of Bretton-Woods System?
2. What are the benefits and costs from European Monetary Union?
Note that you don’t need to submit the answers for the study questions. These are to help you study the chapter. The answer key will be posted later.