1. © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved PowerPoint® Presentation Prepared By Charles Schell International Monetary System Chapter 2

2. Slide 2-1 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Evolution of the International Monetary System Current Exchange Rate Arrangements European Monetary System Euro and the European Monetary Union Fixed versus Flexible Exchange Rate Regimes Chapter Two Outline

3. Slide 2-2 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973- Present 2.1Evolution of the International Monetary System

4. Slide 2-3 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved A “double standard” in the sense that both gold and silver were used as money. Some countries were on the gold standard, some on the silver standard, some on both. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. 2.2Bimetallism: Before 1875

5. Slide 2-4 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Bimetallism cursed by Gresham’s Law Gresham’s Law: Bad money (overvalued at the official rate) drives out good money (undervalued at the official rate). Official exchange rate: 3S = 1G or.33G = 1S Black Market rate: 2S = 1G or.5G = 1S due to gold discoveries. At official rate: S undervalued, G overvalued. Arbitrage: Buy low, sell high. Buy S at official rate, sell S at black market rate.

6. Slide 2-5 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved The curse of Gresham’s Law (cont’d) Buy S coins, melt down, turn to S ingots and sell. Silver disappears as money; gold is sole money that remains. Gold drives out silver. The overvalued money (at official rate) drives out the undervalued money (at official rate). Bimetallism is unstable: A deviation of official from black market rate causes one type of money to disappear.

7. Slide 2-6 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved During this period in most major countries: Gold alone was assured of unrestricted coinage There was two-way convertibility between gold and national currencies at a stable ratio. Gold could be freely exported or imported. The exchange rate between two country’s currencies would be determined by their relative gold contents. 2.1Classical Gold Standard: 1875-1914

8. Slide 2-7 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: Classical Gold Standard: 1875-1914 $30 = £6 $5 = £1

9. Slide 2-8 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism. Classical Gold Standard: 1875-1914

10. Slide 2-9 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Suppose Great Britain exported more to France than France imported from Great Britain. This cannot persist under a gold standard. Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France. Price-Specie-Flow Mechanism

11. Slide 2-10 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Price-Specie-Flow Mechanism under Gold Standard Provides a self-correcting mechanism for trade imbalances. Trade imbalances cannot persist due to price- specie-flow mechanism. A country with a trade deficit will, due to the mechanism, soon experience a reduction in that deficit.

12. Slide 2-11 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved There are shortcomings: The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. Even if the world returned to a gold standard, any national government could abandon the standard. Classical Gold Standard: 1875-1914

13. Slide 2-12 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 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. 2.4Interwar Period: 1915-1944

14. Slide 2-13 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 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. 2.5Bretton Woods System: 1945-1972

15. Slide 2-14 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 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 Bretton Woods system was a dollar-based gold exchange standard. Bretton Woods System: 1945-1972

16. Slide 2-15 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Bretton Woods System: 1945-1972 German mark British pound French franc U.S. dollar Gold Pegged at $35/oz. Par Value

17. Slide 2-16 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Triffin Paradox cursed Bretton Woods Triffin paradox: problem with the Gold Exchange Standard. To support the increase in world trade, the world must lose confidence in the USD: PARADOX! 1. Increase in international (USD) reserves required to sustain increase in world trade. 2. US must run BoP deficits to provide increase in international (USD) reserves. 3. But world loses confidence in USD if US persistently runs BoP deficits.

18. Slide 2-17 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 2.6The Flexible Exchange Rate Regime: 1973-Present. Flexible exchange rates were declared acceptable to the IMF members. Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities. Gold was abandoned as an international reserve asset. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

19. Slide 2-18 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 2.6The Flexible Exchange Rate Regime: 1973-Present.

20. Slide 2-19 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 2.7Current Exchange Rate Arrangements Free Float The largest number of countries, about 48, allow market forces to determine their currency’s value. Managed Float About 25 countries combine government intervention with market forces to set exchange rates. Pegged to another currency Such as the U.S. dollar or euro. No national currency Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

21. Slide 2-20 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 2.8European Monetary System Eleven European countries maintained exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives: To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis-à-vis non- European currencies. To pave the way for the European Monetary Union.

22. Slide 2-21 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved What Is the Euro? The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands. In between 2001 and 2004 Greece, Cyprus, Malta, Slovenia and Finland joined.

23. Slide 2-22 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Euro Conversion Rates

24. Slide 2-23 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Euro Conversion Rates

25. Slide 2-24 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved The Long-Term Impact of the Euro If the euro proves successful (NOT!), it will advance the political integration of Europe in a major way, eventually making a “United States of Europe” feasible. But a United States of Europe is required for the euro to survive! It is likely that the U.S. dollar will lose its place as the dominant world currency. The euro and the U.S. dollar will be the two major currencies (NOT!)

26. Slide 2-25 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Eurodämmerung (twilight of the euro) Monetary integration without fiscal integration is not sustainable. Fiscal integration: a unified central government with taxation and spending powers, i.e. a United States of Europe. Monetary integration: different countries share the same currency with a common central bank (e.g. European Central Bank)

27. Slide 2-26 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 2.10Fixed versus Flexible Exchange Rate Regimes Arguments in favor of flexible exchange rates: Easier external adjustments. National policy autonomy. Arguments against flexible exchange rates: Exchange rate uncertainty may hamper international trade. No safeguards to prevent crises.

28. Slide 2-27 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Fixed versus Flexible Exchange Rate Regimes Suppose the exchange rate is $1.40/£ today. In the next slide, we see that demand for British pounds far exceed supply at this exchange rate. The U.S. experiences trade deficits.

29. Slide 2-28 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Fixed versus Flexible Exchange Rate Regimes SD Q of £ Dollar price per £ (exchange rate) $1.40 Trade deficit Demand (D) Supply (S)

30. Slide 2-29 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Flexible Exchange Rate Regimes Under a flexible exchange rate regime, the dollar will simply depreciate to $1.60/£, the price at which supply equals demand and the trade deficit disappears.

31. Slide 2-30 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Fixed versus Flexible Exchange Rate Regimes Market for Sterling Supply (S) Demand (D) Demand (D*) D = S Dollar depreciates (flexible regime) Q of £ Dollar price per £ (exchange rate) $1.60 $1.40

32. Slide 2-31 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Fixed versus Flexible Exchange Rate Regimes Instead, suppose the exchange rate is “fixed” at $1.40/£, where there is an imbalance between supply and demand The government would have to shift the demand curve from D to D* via a contractionary fiscal policy (e.g. increase taxes) Alternatively, the Fed (US central bank) could reduce its £ reserves by (b-a)

33. Slide 2-32 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Fixed versus Flexible Exchange Rate Regimes: Market for Sterling Supply (S) Demand (D) Demand (D*) a Contractionary fiscal policy (fixed regime) Q of £ Dollar price per £ (exchange rate) $1.40 b

34. Slide 2-33 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Fixed vs Flexible: Yuan & USD Market for USDs from China’s perspective Effect of Wal-Mart, GM establish China based supply chains: Supply curve of USDs shifts to the right To hold exchange rate fixed at CNY7 = 1USD, People’s Bank of China (central bank) must accumulate large USD reserves derived from large US trade deficit with China

35. Slide 2-34 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved People’s Bank of China: maintains low value of the Yuan (Y7) in Market for $’s by accumulating $’s (b-a) Supply (S) Demand (D) Q of $ Yuan per $ (exchange rate) Y7 S’ b a Y6

36. Slide 2-35 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Central bank intervention in FX markets Under fixed FX rates and dirty floating Dirty floating: central bank influences but does not determine the FX rate Central bank increases (e.g. PBC increases it USD reserves) or reduces (e.g. Fed reduces its reserves of sterling) its international reserves Central bank activities not reflected in the FX supply and demand curves Central bank fills the gap between supply and demand at the stipulated FX rate

37. Slide 2-36 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Summary The international monetary system can be defined as the institutional framework within which international payments are made, the movements of capital are accommodated and exchange rates among currencies are determined. The international monetary system went through five stages of evolution: bimetallism, Classical gold standard, interwar period, Bretton Woods system and flexible exchange rate regime. Under the gold standard, the exchange rate between two currencies is determined by the gold content of the currencies

38. Slide 2-37 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Summary Under the Bretton Woods system, each country established a par value in relation to the US dollar (fully convertible to gold). In 1971- 73, the Bretton Woods system collapsed ushering in the current regime of flexible exchange rate. However, there have been periodic attempts to manage the floating exchange rate system, e.g. the 1985 Plaza Agreement to stop the rise in the USD and the 1987 Louvre Accord to stop the fall in the USD. In 1979, the EEC countries launched the European Monetary System (EMS) which featured the European Currency Unit (ECU, a portfolio of European currencies with fixed weights) and the Exchange Rate Mechanism (ERM, whereby major European currencies had controlled exchange rates vis-à-vis the ECU). In 1999 The Euro was introduced, a common currency managed by the European Central Bank (ECB).