International monetary system IMS refers to the institutional arrangements that govern exchange rates. Floating exchange rates : when foreign exchange markets determine the relative value of a currency. Pegged exchange rate : means value of the currency is fixed relative to a reference currency Dirty float : the value of the currency is determined by the market forces and the value can alter within a range, but the central bank of the country will intervene to make sure value remains within the specified range. Fixed exchange rate : values of a set of currencies are fixed against each other at some mutually agreed on exchange rate.
European Monetary System For a quarter of a century after WWII, the world’s major industrial nations participated in a fixed exchange rate system.
Gold Standard Gold standard : pegging currencies to gold and guaranteeing convertibility Gold per value : amount of currency needed to purchase one ounce of gold
Strength of Gold Standard Balance –of-trade equilibrium : when income its residents earn from exports is equal to the money its residents pay to other countries for imports.
Wars, depression an death of gold standard Due to world war I, governments financed parts of their military expenditure by abandoning gold standard and printing money. Resulted in high inflation. US returned to gold in 1919 GB in 1925 France in 1928
Wars, depression an death of gold standard GB pegged gold to pre-war levels despite inflation between 1914 – 1925 Forced British goods out of the foreign markets GB in depression Foreign holders of pound lost confidence in Pound and began to convert to Gold. British government could not satisfy demand of gold so abandoned gold standard in 1931
Wars, depression an death of gold standard US raised dollar price from 20 to 35$ in 1934 Implication that dollar was worth less. By devaluing in this manner, US was trying to reduce price of US exports and increase price of US imports to help boost output during its recession. Resulted in devaluation wars. 1939, gold standard was dead
Bretton Woods System 1944 – 44 representatives from different countries met to overcome problems of dead gold standard and recent depression Wanted to avoid senseless devaluation wars and saw gold standard could not be relied upon. US Dollar was termed the only currency convertible to Gold and the reference currency for the rest. Established two multinational institutions: International Monetary Fund World Bank
IMF Fixed exchange rate benefits: Puts brake on competitive devaluations and brings stability to world trade environment Curtails price inflation by imposing monetary constraints
World Bank It’s establishment was seen in context of destroyed Europe Initial mission to help finance Europe with low-interest loans Overshadowed by the ‘Marshal Plan’ so bank turned to funding third world nations
Collapse of fixed exchange rate Collapsed in 1973 To finance Vietnam war, Johnson did not raise taxes, but through raising money supply (MS). Cause price inflation Rise in government spending raised appetite for more goods – imports – by the US consumer US trade balance deteriorated Inflation and worsening trade position gave rise to speculation that US Dollar would be devalued.
Floating Exchange Rate regime 1976 IMF members met in Jamaica to formalize the floating exchange rate regime Floating exchange rates termed acceptable Gold abandoned as a reserve asset. Total annual IMF quotas – the amount member countries contribute to IMF – were increased
Exchange rates since 1973 Volatility in exchange rates: Oil crisis in 1971 when OPEC quadrupled prices of oil (resulted in inflation and decline in value of dollar) Sharp rise in US inflation Oil crisis of 1979 – OPEC doubled prices Rise in the USD despite deteriorating a balance-of-payment 1997 Asian currency crisis Managed float system : frequency of government intervention in foreign exchange markets
Case for floating exchange rates Monetary policy autonomy Trade balance adjustment
Case for fixed exchange rates Monetary discipline Speculation Uncertainty Trade Balance Adjustments
Crisis Management Currency crisis : occurs when speculative attack on the exchange value of a currency results in a sharp-depreciation in the value of the currency or forces authorities to expend large volumes of international currency serves and sharply increase interest rates to defend the prevailing exchange rate. Banking crisis : refers to loss of confidence in the banking system that leads to a run on banks as individuals or companies withdraw their deposits Foreign debt crisis : situation in which a country cannot service its foreign debt obligations
Asian Crisis The heavy export lead economies of SE Asia went on an investment spree spurred on by their governments. Many of these investments were based on positive projections and forecasts. When prices of goods from these large ventures went down, it hurt business. Property prices tanked due to excess capacity (due to positive projections).
Asian crisis Much of borrowing for investment was in DOLLARS which had lower interest rates than local currency Banks lent to local projects in local currencies – at higher interest rates [property supply > property demand, local constructors can’t sell, they default on loans, which prompts banks who borrowed dollars, to default on their loans]