Chapter 8-9 International

Monetary System
• You should master:
(1) Features of a good international monetary
system;
(2) Rules of the games, and the advantages
and disadvantages of the three international
monetary systems;
(3) The fundamental and immediate cause for
the collapse of the Bretton Woods system;
(4) Some terms, like gold points,
 1.1. What is an international
monetary system?
• Narrowly speaking, it refers to
international exchange rate system.
• There are three international
exchange rate systems in history:
the gold standard, the Bretton
Woods, and the floating exchange
rate system.
 1.2. Features of a good
international monetary system
• Adjustment : a good system must be able to adjust
imbalances in balance of payments quickly and at a
relatively lower cost;
• Stability and Confidence: the system must be able to
keep exchange rates relatively fixed and people must
have confidence in the stability of the system;
• Liquidity: the system must be able to provide enough
reserve assets for a nation to correct its balance of
payments deficits without making the nation run into
deflation or inflation.
 1.3 Classification of international
monetary system
• gold standard,
gold exchange standard
fiduciary standard
Floating exchange rate system

Fixed exchange rate system

 II. The gold standard system(1880---
1914)
• Fixed Rate System
• The world economy operated under a
system of fixed dollar exchange
rates between the end of World War
II and 1973, with central banks
routinely trading foreign exchange to
hold their exchange rates at
internationally agreed levels.
 2.1 Rules of the game
• Fix an official gold price or “mint parity” and allow
free convertibility between domestic money and
gold at that price.
• Impose no restrictions on the import or export of
gold by private citizens, or on the use of gold for
international transactions.
• Issue national currency and coins only with gold
backing, and link the growth in national bank
deposits to the availability of national gold
reserves.
• In the event of a short-run liquidity crisis
associated with gold outflows, the central bank
should lend freely to domestic banks at higher
interest rates (Bagehot’s Rule).
• If Rule I is ever temporarily suspended, restore
convertibility at the original mint parity as soon as
practical.
 2.2 Factors that determine or
affect the exchange rates
• Factors that determine the exchange
rates: the mint parity
• E.g. US$1= British ￡

• Factors that influence the exchange

rates: gold points and the demand
for and supply of foreign exchange
 2.3 Adjustment of balance of
payments deficits or
surpluses
• Price-specie flow mechanism:
• Deficit gold flow out of the country
• gold reserve decrease
money supply decrease quantitytheoryof
money
price level decrease exchangerate
fixed
export go up, import go down, deficit
disappear
• The adjustment of surplus is the opposite.
 2.4 Remarks and
• An
comments
international gold standard avoids
the asymmetry inherent in a reserve
currency standard by avoiding the “Nth
currency” problem. Under a gold
standard, each country fixes the price of
its currency in terms of gold by standing
ready to trade domestic currency for
gold whenever necessary to defend the
official price.
 The collapse of the gold
standard system
• It is virtually a pound standard
system :
• Britain and British pound’s position
in the system
• Outbreak of World War I.
Advantage of the Gold
Standard
• Because there are N currency and N
prices of gold in terms of those
currencies, no single country occupies a
privileged position within the system:
each is responsible for pegging its
currency’s price in terms of the official
international reserve asset, gold. Gold
standard rules also require each country
to allow unhindered imports and exports
of gold across its borders.
 Benefits and drawbacks
of the Gold Standard
• Benefits:
1. Symmetry
2. Price level and value of
national money are more stable
and predictable
3. Enhance international
transactions
 Drawbacks:
1. Constraints on the use of monetary policy to
fight unemployment.
2. Tying currency values to gold ensures a stable
overall price level only if the relative price of gold
is stable.→gold discovery in South America
3. An international payments system based on gold
is problematic because central banks cannot
increase their holdings of international reserves
as their economies grow unless there are
continual new gold discoveries.
4. The gold standard gives gold-producing countries
power to influence the world economy
 The Gold Exchange
•
Standard
Halfway between the gold standard and a
pure reserve currency standard is the
gold exchange standard. Central banks’
reserves consist of gold and currencies
whose prices in terms of gold are fixed,
and each central bank fixes its exchange
rate to a currency with a fixed gold price.
• More flexibility in the growth of
international reserves.
 3. The Bretton Woods
System1944-1973
• 3.1 How this system came into being
• The harms and disasters that the two
Wars brought the world.
 3.2 Rules of the game
• Fix an official par value for domestic currency
in terms of gold or a currency tied to gold as a
numeraire.
• In the short run, keep the exchange rate
pegged within 1% of its par value, but in the
long-run leave open the option to adjust the
par value unilaterally if the IMF concurs.
• Permit free convertibility of currencies for
current account transactions, but use capital
controls to limit currency speculation.
 3.3 Features of the system
• IMF to see that this system runs on
smoothly
• More flexibility in exchange rates
• More channels to correct imbalances
in balance of payments
 3.4 Adjustment of balance of
payments imbalances
• Offset short-run balance of payments
imbalances by use of official reserves
and IMF credits, and sterilize the
impact of exchange market
interventions on the domestic money
supply
• Adjust fundamental imbalances by
change the par value permanently,
provided agreed by the IMF
3.4 Adjustment of balance of
payments imbalances
• Subordinate domestic monetary and fiscal
policies to maintain fixed exchange rate (use
monetary policy to keep price level and fiscal
policy---government expenditures minus tax
revenues--- to offset imbalances between
private savings and investment):
• Deficit contractionary monetary or fiscal
policy price level decrease exchangerate
fixed
export go up, import go down, deficit
disappear
• The adjustment of surplus is the opposite.
3.5 Remarks and comments
• Advantages
• Disadvantages: exchange rates are
not flexible, Triffin Paradox
 Triffin Paradox

liquidity

U.S. run deficits

U.S. run surplus

confidence
3.6 Collapse of the Bretton Woods
System: Process of dollar
devaluation
ounce of gold
Dollar value per

1
35

38
42.22

1944 1971 1973

Abandoned Gold Exchange
Standard
The post-World War II reserve currency system
centered on the dollar was, in fact, originally set
up as a gold exchange standard. While foreign
central banks did the job of pegging exchange
rates, the U.S. Federal Reserve was responsible
for holding the dollar price of gold at $35 an
ounce. By the mid-1960s, the system operated in
practice more like a pure reserve currency
system than a gold standard. President Nixon
unilaterally severed the dollar’s link to gold
in August 1971, shortly before the system of
fixed dollar exchange rates was abandoned.
 4. The present Floating
Exchange Rate System (1973-
• present)
4.1 How this system came into being
• “A system of no system” “An order of no
order”----Features of this system
1. No par values, between home currency
and foreign currency or gold
2. No upper or lower limits of exchange rate
fluctuations
3. The government has no obligation to maintain
exchange rate fixed, it can choose any kind of
exchange rate system, flexible rates are legal
 4.2 Rules of the game
• Smooth short-term variability in the dollar exchange
rate, but do not commit to an official par value or to
long-term exchange rate stability
• Permit free convertibility of currencies for current
account transactions, while endeavoring to eliminate all
remaining restrictions on capital account transactions
• Use the U.S. dollar as the intervention currency and
keep official reserves primarily in U.S. treasury bonds
• Modify domestic monetary policy to support major
exchange rate interventions, reducing the money
supply when the national currency is weak against the
dollar and expanding the money supply when the
national currency is strong
4.3 Features of this system
• More currencies can be used as
reserve assets
• Governments began to cooperate to
intervene in the foreign exchange
markets and to coordinate their
domestic policies to achieve
“common prosperity”
• Many different kinds of exchange
rates appear
Types of floating exchange
rates
• Whether there is a dirty hand:
1. Free Float/Clean Float
2. Managed Float/Dirty Float
• Whether there is a Connection with other
currencies:
1. Single Float 27 个
2. Pegged Float(1) ： (2) ： SDR; ECU; 。
3. Joint Float
4. Crawling peg
 4.4 Adjustment of imbalances
in balance of payments
• IMF credits
• Change of exchange rates: devaluations
or revaluations
• Coordination between governments: the
Plaza Agreement, the Lourve Accord, etc
• Domestic policies: “Two-gap theory”
C+I+G+X=C+S+T+M

X-M=(S-I)+(T-G)
 5. Should we return to a fixed
rate system?
• What kind of international monetary
system should we adopt?
• What are the advantages and
disadvantages of fixed and floating
exchange rate system respectively?
 5.1 Arguments favoring
floating rates
1. Better adjustment
2. Better confidence
3. Better liquidity
4. Gains from freer trade
5. Avoiding the so-called “Peso
Problem”
6. Increased independence of policy
 5.2 Arguments against
floating exchange rates:
Flexible rates
1. Cause uncertainty and inhibit
international trade and investment
2. Cause destabilizing speculation
3. Will not work for open economies
4. Are inflationary
5. Are unstable because of small trade
elasticities
6. Cause structural unemployment
 Krugman & Obstfeld (1)
1. Discipline. Central banks freed from the
obligation to fix their exchange rates might
embark on inflationary policies.
2. Destabilizing speculation and money
market disturbances. Speculation on
changes in exchange rates could lead to
instability in foreign exchange markets.
3. Injury to international trade and
investment. Floating rates would make
relative international prices more
unpredictable.
 Krugman & Obstfeld (2)
4. Uncoordinated economic policies. The door
would be opened to competitive currency practices
harmful to the would economy.
5. The illusion of greater autonomy. Floating
exchange rates would not really give countries
more policy autonomy. Changes in exchange rates
would have such pervasive macroeconomic effects
that central banks would feel compelled to
intervene heavily in foreign exchange markets even
without a formal commitment to peg.
5.3 Selection of Fixed &
Floating Exchange Rates