The document discusses the international monetary system and different exchange rate systems. It begins by describing freely floating and managed float systems where market forces primarily determine exchange rates. It then outlines target zone arrangements, fixed rate systems, and the current hybrid system used by major and smaller currencies. The document also provides a historical overview of international monetary systems including the gold standard, Bretton Woods system, and European Monetary System.

1. International Finance
International Monetary System

2. 2
Objective
Understand
(a) what the international monetary system is and
(b) how the choice of system affects currency value.
also
(c) provide a historical background of the international monetary system
We will describe how exchange rates are determined under five different
mechanisms--free float, managed float, fixed-rate system, target-zone system and
the current hybrid system.

3. 3
PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS
A. Freely Floating (Clean Float)
1. Market forces of supply
and demand determine
rates.
2. Forces influenced by
a. price levels
b. interest rates
c. economic growth
3. Rates fluctuate over time
randomly (participants will react to new information).

4. 4
PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float
0.785
0.79
0.795
0.8
0.805
0.81
0.815
0.82
0.825
0.83
0.835
0 10 20 30 40
Price
of
US
dollar
Price of US dollar in terms of Euro is plotted below
- September 1st to October 22nd 2004.

5. 5
PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float
EUR/USD - Sep012003 to Oct222004
0.76
0.78
0.8
0.82
0.84
0.86
0.88
0.9
0.92
0.94
0 50 100 150 200 250 300 350
Volatility of EUR/USD exchange rate is
much lower now than before as indicated by
standard errors.

6. 6
PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float
USD/DM 5-minute rates for November 25th 1996.
USD/DM
0.719
0.72
0.721
0.722
0.723
0.724
0.725
0 10 20 30 40 50 60 70 80
Variance of EUR/USD exchange rate is 0.0018

7. 7
ALTERNATIVE EXCHANGE RATE SYSTEMS
B. Managed Float (Dirty Float) – It is difficult to resist
to intervene in the market to reduce the economic uncertainty associated with a clean
float. An brupt change can negatively impact the export industry (ıf appreciation) or
lead to higher inflation (depreciation).
1. Market forces set rates unless
excess volatility occurs.
2. Then, central bank determines
rate.

8. 8
ALTERNATIVE EXCHANGE RATE SYSTEMS
Three categories of intervention
(1) Smoothing out daily fluctuations
intervene to preserve an orderly pattern of exchange rate changes. For
example, Brazilian Peso is allowed to depreciate monthly by about 0.6 percent
against the dollar.
(2) Leaning against the wind
designed to prevent short and medium term fluctuations brought about by
temporary random events. It delays the impacts. Determination of temporary or
fundamental effects.
(3) Unofficial pegging
Involves resisting any fundamental upward or downward exchange rate
movements –

9. 9
ALTERNATIVE EXCHANGE RATE SYSTEMS
C. Target-Zone Arrangement
Countries adjust their national economic policies to maintain their exchange rates
within a specific margin around agreed-upon, fixed exchange rates.
1. Rate Determination
a. Market forces constrained
to upper and lower range of rates.
b. Members to the arrangement adjust their
national economic policies to maintain target.

10. 10
ALTERNATIVE EXCHANGE RATE SYSTEMS
D. Fixed Rate System
1. Rate determination
a. Government maintains target
rates.
b. If rates are threatened, central
banks buy/sell currency.
c. Monetary policies coordinated – all
have the same inflation rate. No control over monetary policy.

11. 11
ALTERNATIVE EXCHANGE RATE SYSTEMS
2. Some Government Controls – the most drastic
occurs when all foreign exchange earnings must be
surrendered to the central bank:
a. On global portfolio investments.
b. Ceilings on direct foreign direct insurance.
c. Import restrictions.
d. Imposition of taxes and limitations on
foreign-owned bank deposits.
e. Limitations on prepayments for imports.

12. 12
ALTERNATIVE EXCHANGE RATE SYSTEMS
E. Current System
1. A hybrid system
a. Major currencies: use
freely-floating method
b. Others move in and out
of various fixed-rate systems.

13. 13
PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
I. THE USE OF GOLD
A. Desirable properties – durable, storable,
portable, easily recognized, divisible and easily
standardized.
B. In short run: High production costs limit
short-run changes.
C. In long run: Commodity money insures
stability.

14. 14
PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
The Gold Standard involved a commitment to fix the
prices of their domestic currencies in terms of a
specified amount of gold. They are willing to buy or
sell gold to anyone at that price.
For example, Great Britain maintained a fixed price of gold at 4.2474 per ounce. The
US maintained the price of gold at $20.67 per ounce. Hence, dollar-pound exchange
rate can easily determined as:
($20.67 per ounce of gold)/(pound 4.2474 per ounce of gold)=$4.8665 per one pound

15. 15
PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
Fiat money is nonconvertible paper money backed only
by faith that the monetary authorities will not cheat by
issuing more money (100% profit margin). By contrast,
the net profit margin on issuing more money under gold
standard is zero.
Under the classical gold standard, disturbances in Price
Levels would be wholly or partly offset by automatic
balance of payments adjustment mechanism called the
price- specie*-flow mechanism.
* specie refers to gold coins

16. 16
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
a. Price-specie-flow mechanism
had automatic adjustments :
1.) When a balance of payments
surplus led to a gold inflow;
2.) Gold inflow led to higher prices which
reduced surplus;
3.) Gold outflow led to lower prices and
increased surplus.

17. 17
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
II. The Classical Gold Standard
(1821-1914)
- Major currencies on gold standard.
Characterized by: free international trade, stable
exchange rates and prices, rapid economic growth, free
flow of labor and capital across borders and world peace.

18. 18
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
III. The Gold Exchange Standard (1925-1944)
Gold standard broke down during WWI
A. Only U.S. and Britain allowed to
hold gold reserves.
B. Other countries could hold both
gold, dollars or pound reserves.

19. 19
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
C. Currencies devalued in 1931
- “beggar-thy-neighbor” devaluations - led to
trade wars.
D. Bretton Woods Conference
- called in order to avoid future protectionist and
destructive economic policies
- created two new institutions: IMF and World Bank.
- IMF was created to promote monetary stability.
- WB to lend money to countries so that they can build their infrastructure

20. 20
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
Role of IMF evolve over time.
- oversees exchange rate policies
- advises developing countries how to turn their economies around
It has become lender of last resort which creates a moral hazard problem.
IMF bailouts causes (a) governments persist with bad policies and (b)
investors to underestimate the risks
In theory, IMF makes short term loans conditional on the borrower’s
implementation of policy changes. Conditionality has little credibility.

21. 21
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
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.

22. 22
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
3. Exchange rates allowed to fluctuate by 1%
above or below initially set rates.
Fixed exchange rates were maintained by official intervention in the foreign exchange
market.
Withot price stability, balance of payment deficits was the result.
Experienced foreign exchange crisis as governments were reluctant to adjust their
economic policies.
B. Collapse, 1971
1. Causes:
a. U.S. high inflation rate (by
printing money)
b. U.S.$ depreciated sharply.

23. 23
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
V. Post-Bretton Woods System (1971-Present)
A. Smithsonian Agreement, 1971
US$ devalued to 1/38 oz. of gold.
By 1973: World on a freely
floating exchange rate system.

24. 24
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
NEER - USD
80
85
90
95
100
105
110
115
0 50 100 150 200 250
Time
NEER
January 1973
NEER: Nominal Effective Exchange Rate

25. 25
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
Volatility is calculated as the rolling standart deviation over the past 24 months
using NEER
Volatility
0
1
2
3
4
5
6
0 50 100 150 200 250
Time
Volatility
January 1973

26. 26
PART III.
THE EUROPEAN MONETARY SYSTEM
I. INTRODUCTION
A. The European Monetary System (EMS) –
goal was to foster monetary stability in the European
Community
1. A target-zone method (1979)
2. Close macroeconomic policy
coordination required.

27. 27
THE EUROPEAN MONETARY SYSTEM
B. EMS Objective:
to provide exchange rate stability to all
members by holding exchange rates within
specified limits.

28. 28
THE EUROPEAN MONETARY SYSTEM
C. European Currency Unit (ECU)
A “cocktail” of European currencies (composite
currency) with specified weights as the unit of account.
1. Exchange rate mechanism (ERM)
each member determines mutually agreed
upon central cross rate for its currency.

29. 29
THE EUROPEAN MONETARY SYSTEM
National currency weights to the ECU value
Currency 13.03.1979-
16.09.1984
17.09.1984-
21.09.1989
21.09.1989-
31.12.1998
BEF 9.64% 8.57% 8.183%
DEM 32.98% 32.08% 31.955%
DKK 3.06% 2.69% 2.653%
ESP - - 4.138%
FRF 19.83% 19.06% 20.316%
GBP 13.34% 14.98% 12.452%
GRD - 1.31% 0.437%
IEP 1.15% 1.20% 1.086%
ITL 9.49% 9.98% 7.840%
LUF - - 0.322%
NLG 10.51% 10.13% 9.98%
PTE - - 0.695%

30. 30
THE EUROPEAN MONETARY SYSTEM
2. Member Pledge:
To keep within 15% margin above or below the
central rate.
D. EMS ups and downs
1. Foreign exchange interventions failed due to lack of
support by coordinated monetary policies.

31. 31
THE EUROPEAN MONETARY SYSTEM
2. Currency Crisis of Sept. 1992 –
Bundesbank’s decision to tighten the monetary policy (high R); high cost of
intervention by other countries (R was 500% in Sweden)
a. System broke down
b. Britain and Italy forced to
withdraw from EMS.
G. Failure of the EMS
members allowed political priorities
to dominate exchange rate policies.
EMS has succeeded to lower inflation in Europe.

32. 32
THE EUROPEAN MONETARY SYSTEM
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.

33. 33
THE EUROPEAN MONETARY SYSTEM
I. Costs / Benefits of A Single Currency
A. Benefits
1. Reduces cost of doing business (e.g. Philips
saves a $300 million a year from a single currency transactions cost; easier
corporate planning, pricing and invoicing).
2. Reduces exchange rate risk
B. Costs
1. Lack of national monetary flexibility.
It can also impose high costs if wages and prices are inflexible.
- What happens if demand for French goods fall sharply?

34. 34
Emerging Market Currency Crisis
Currency crisis tend to be contagious. Two major
contagion channels.
(1) Trade links: can sperad from one nation to another through trade. For example,
when Argentina is in crisis, it imports less from Brazil.
(2) Financial System: Trouble in one market as a wake-up call for similar
countries. Investors seek to exit these similar countries. For example, Asian currency
crisis in 1997. Financial contagion can also occur if investors start selling their assests
in other countries to cover their losses.

35. 35
Emerging Market Currency Crisis
Sources:
(1) Moral Hazard - IMF
(2) Fundamental policy conflict among policy objectives

36. 36
Emerging Market Currency Crisis
Possible ways to avoid currency crisis
(1) Currency controls
(2) Freely floating currency
(3) Permanently fixed exchange rate (money supply adjusts to the
balance of payments)

37. 37
Official Currency Conversion rates
Country Currency Currency Units per euro
Austria schilling 13.7603
Belgium franc 40.3399
Finland markka 5.94573
France franc 6.55957
Germany mark 1.95583
Greece drachma 340.75
Ireland punt 0.787564
Italy lira 1936.27
Luxembourg franc 40.3399
Netherlands guilder 2.20371
Portugal escudo 200.482
Spain peseta 166.386
Currency units per euro