Money facilitates exchange and increases productivity. A monetary system uses fiat currency controlled by a central bank, which faces a trade-off between controlling inflation and responding to economic crises. The foreign exchange market determines currency exchange rates under different exchange rate regimes like free floating or fixed rates. Central banks intervene in currency markets to influence exchange rates by buying or selling their own currencies.

1. Monetary System
and FX Market
Jaehoon Lee
DeepSearch, Inc.
Last Updated: 22 April 2019

2. What is Money?

3. "The most powerful forces in the world are fictional realities."
"Money in fact is the most successful story, ever invented and told by humans, because it is
the only story everybody believes. Not everybody believes in God, not everybody believes in
human rights, not everybody believes in nationalism, but everybody believes in money."
- Yuval Harari

4. • The only purpose of money is EXCHANGE
• You can exchange in two dimensions
• Exchange with others
=> consumption
• Exchange with yourself in the other time
=> saving / borrowing

5. Why is Exchange
important?

6. Market would have looked like...
Without Money (barter) With Money

7. Adam Smith's "Pin Factory"
• Pin factory employing 10 men who produced 48,000 pins per day
• Each man could have produced only 10 or 20 pins per day individually

8. Thus, money is important because
• Exchange becomes more efficient
• Labor becomes divided, and productivity increases

9. Monetary System

10. Monetary System
• Fiat money ⇔ Gold standard
(e.g.) Bretton Woods System
• Fiat money
• Central bank has the authority to print/withdraw money
• Gold standard
• Money supply is fixed

11. Inflation
• Fiat money ⇒ the difference between nominal and real
values
• Nominal price: price of real goods in monetary unit
(money)
• Real value: price of real goods in other real goods
• Nominal value increases while real value is fixed
⇒ inflation

12. Hyperinflation in Zimbabwe
• Zimbabwe’s government runs huge budget deficits
• Its central bank prints tons of money to fund the deficits
(seignorage)
• The reckless creation of money led to hyperinflation in
2008–2009
• In 2015, eventually, the Reserve Bank of Zimbabwe
abandoned its own currency and switched to US dollar as
Zimbabwe’s official currency (dollarization)

14. XR of Zimbabwean dollars per USD

15. Zimbabwe’s Latest Banknote

16. This is how Zimbabweans carried money...

17. Okay, fiat-money system
has the inflation problem.
Why don't countries switch
to gold standard?

18. Great Depression in 1929
This is what can happen with Gold Standard....

19. Under Fiat-Money System,
• If inflation is high,
• Reduce money supply
• Control inflation
• If recession happens (low growth or high unemployment),
• Print money and reduce interest rate
• Stabilize the economic growth

20. Under Gold Standard,
• You can't do anything

21. Argentina. Oh, Argentina...
• Peronism: populism policy that started in 1946 in
Argentina.
• The government printed a lot of money to pay for social
welfare.
• It led to hyperinflation and the economy totally collapsed.
Argentina’s peso became worthless.
• Argentina initiated a new currency based on the currency
board system.

22. Currency board worked!
Gold standard is the magic bullet for inflation control!

23. Wish it were a happy ending...
• Asian currency crisis and Russian Moratorium in 1998
• All emerging market currencies devalued and restored
competitiveness
• ... except Argentina

25. Argentine Great Depression in 1998-2002
• Currency board is abandoned in 2002
• Argentine peso lost 80% of its value
• Inflation followed, and then the economic growth

27. Trade-Off
• Fiat-money system can easily create inflation
• Gold-standard is not able to deal with business cycle or
economic crisis

28. Brief History of Monetary System
• 1821–1914: gold standard
• The purpose is to control the inflation after the
Napoleonic Wars
• 1914–1918: World War I, and the gold standard broke
down
• 1925–1931: gold standard was reinstated

29. Brief History of Monetary System
• 1929 until late 1930s: the Great Depression
• Gold standard broke down again due to the “beggar-
thy-neighbor” devaluations
• “Beggar-thy-neighbor” policy: countries devalue their
currencies to gain competitiveness and increase
exports
• 1939–1945: World War II

30. Brief History of Monetary System
• 1944–1971: Bretton Woods system
• USD was pegged to gold at $35/ounce
• Fixed exchange rates among currencies
• It also created IMF and World Bank
• Post 1971: floating exchange rate

31. Central Bank Independence
• Central bank's independence is critical to maintain the
fiat-money system
• Government can borrow money but they cannot print.
Only the central bank has the authority to print money.
• Without an independent central bank, it is extremely
tempting for a government to print money themselves

33. FX Market

34. Exchange Rate Mechanisms
• Free Floating
• Managed Floating
• Fixed Rate (or, pegged XR)

35. The Trilemma of Exchange Rate Systems
• Three goals of policy makers
• Stable exchange rate
• Independent monetary policy
• Capital market integration (free flow of capital)
• Impossible Trinity : one can achieve two of the three
goals, but it is impossible to achieve all three of them

37. Impossible Trinity
• Monetary independence & capital market integration
• (e.g.) US, UK
• Monetary independence & exchange rate stability
• (e.g.) China, Bretton Woods agreement
• Exchange rate stability & capital market integration
• (e.g.) Hong Kong, countries within the European Union

38. How can central banks
make interventions in the
currency market?

39. To make it cheaper...
• If PBOC (People’s Bank of China), for example, wants to
make RMB cheap,
• Print RMB, sell RMB and buy USD
• RMB depreciates relative to USD

41. To make it expensive...
• If PBOC wants to make RMB expensive,
• Sell foreign reserves (usually, US T-Bonds)
• Sell USD and receive RMB instead, withdraw the RMB
from circulation
• RMB appreciates relative to USD

43. Summary
1. What is Money?
2. Monetary System
3. FX Market