The International Monetary System

Chapter Objective:

Chapter Two

INTERNATIONAL FINANCIAL MANAGEMENT

This chapter serves to introduce the student to the institutional framework within which: International payments are made. The movement of capital is accommodated.RESNICK EUN / Second Edition Exchange rates are determined.

Chapter Two Outline

Evolution of the International Monetary System Current Exchange Rate Arrangements European Monetary System Euro and the European Monetary Union The Mexican Peso Crisis The Asian Currency Crisis Fixed versus Flexible Exchange Rate Regimes
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Evolution of the International Monetary System

Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973Present

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Bimetallism: Before 1875

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. Greshams Law implied that it would be the least valuable metal that would tend to circulate.
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Classical Gold Standard: 1875-1914

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 countrys currencies would be determined by their relative gold contents.
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Classical Gold Standard: 1875-1914

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: $30 = 6
$5 = 1
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Classical Gold Standard: 1875-1914

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.

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Classical Gold Standard: 1875-1914

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.

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Interwar Period: 1915-1944

Exchange rates fluctuated as countries widely used predatory depreciations of their currencies to gain advantage in the world export market. Onset of the Great depression in US 1929 and financial crisis Many banks failed in US and Europe Attempts were made to restore the gold standard, but participants lacked the political will to follow the rules of the game.
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Interwar Period: 1915-1944

Great Britain suspended gold standard in 1931 Canada Sweden Austria Japan (1931) US (1933) France (1936) followed The result for international trade and investment was profoundly detrimental. Paper standards came into being Gradually US $ replaced pound sterling as dominant currency
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Bretton Woods System: 1945-1972

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.
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Bretton Woods System: 1945-1972

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.
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Bretton Woods System: 1945-1972

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US ran BOP deficits to satisfy growing need for reserves Eventually the $ gold standard collapsed 1970s IMF created special drawing rights (IMF) to tide over $ shortage Special Drawing RightsSDR initially basket of 16 currencies In 1981 simplified SDR to basket of 5 currencies US $, German mark, Jap yen, British pound and
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Bretton Woods System: 1945-1972

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Composition changed every 5 years In 2001 euro was introduced and G mark and F franc were removed 1971 Smithsonian agreement by group of ten gold at $ 38 per ounce each of the other countries revalued their currency 10% up against $ - band increased to +2.25% from +1% Lasted little more than 1 year 1973 high inflation plus oil crisis
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The Flexible Exchange Rate Regime: 1973-2001.

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 officially abandoned as an international reserve asset. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.
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The Flexible Exchange Rate Regime: 1973-2001.

Mainly for BOP and Forex crisis conditions apply to macro economic policies Exchange rates substantially more volatile 1980-84 $ appreciated high interest rates After 1985 -88 $ fell due to high trade deficit 1987 G-7 meet managed float system 2001 terrorist attack stock market correction, political uncertainty, trade deficits
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Current Exchange Rate Arrangements

Exchange arrangements with no separate legal tender Eg: Ecuador, El Salvador, Panama US $ France Germany Italy sharing Euro Currency board arrangements explicit legislative commitment to exchange domestic currency into foreign currency fixed rate Other conventional fixed peg arrangement
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Current Exchange Rate Arrangements

Pegged exchange rates within horizontal bands

Eg: Denmark Slovenia Hungary

Crawling pegs Bolivia, Costa rica Tunisia Exchange rates within crawling bands

Belarus Romania

Manged floating with no preannounced path for the exchange rate India, Russia, Singapore Independent floating Australia, Brazil US Canada

Korea Japan Switzerland

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European Monetary System 1979

Snake EEC price band +1.125% from Smithsonian agreement 1971 replaced 1979 EMS Eleven European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives:

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To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis--vis nonEuropean currencies. To pave the way for the European Monetary Union.
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European Monetary System 1979

2 main instruments European currency unit (ECU) Exchange rate mechanism (ERM) 1991 Maastricht Treaty By Jan 1999 common currency Euro European Central Bank Frankfurt Germany
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European Monetary System 1979

Conditions

Budget

deficits below 3% of GDP Gross public debt below 60% Achieve high degree of price stability Maintain its currency within the prescribed exch rate ranges

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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 member states are: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

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EURO CONVERSION RATES

1 Euro is Equal to: 40.3399 BEF 1.95583 DEM 166.386 ESP 6.55957 FRF .787564 IEP 1936.27 ITL 40.3399 LUF 2.20371 NLG 13.7603 ATS 200.482 PTE Belgian franc German mark Spanish peseta French franc Irish punt Italian lira Luxembourg franc Dutch gilder Austrian schilling Portuguese escudo

5.94573 FIM
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Finnish markka
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What is the subdivision of the euro?

During the transitional period up to 31 December 2001, the national currencies of the member states (Lira, Deutsche Mark, Peseta, Franc. . . ) will be "non-decimal" subdivisions of the euro. The euro itself is divided into 100 cents.

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What is the official sign of the euro?

The sign for the new single currency looks like an E with two clearly marked, horizontal parallel lines across it.

It was inspired by the Greek letter epsilon, in reference to the cradle of European civilization and to the first letter of the word 'Europe'.
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What are the different denominations of the euro notes and coins ?

There will be 7 euro notes and 8 euro coins. The notes will be: 500, 200, 100, 50, 20, 10, and 5 euro. The coins will be: 2 euro, 1 euro, 50 euro cent, 20 euro cent, 10, euro cent, 5 euro cent, 2 euro cent, and 1 euro cent.

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How will the euro affect contracts denominated in national currency?

All insurance and other legal contracts will continue in force with the substitution of amounts denominated in national currencies with their equivalents in euro. Euro values will be calculated according to the fixed conversion rates with the national currency unit adopted on 1 January 1999. Generally, the conversion to the euro will take place on 1 January 2002, unless both parties to the contract agree to do so beforehand.
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The Mexican Peso Crisis

On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency traders expectations about the future value of the peso. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent.
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The Mexican Peso Crisis

The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. Two lessons emerge:

It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. An influx of foreign capital can lead to an overvaluation in the first place.
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The Asian Currency Crisis

The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession.
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Currency Crisis Explanations

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In theory, a currencys value mirrors the fundamental strength of its underlying economy, relative to other economies. In the long run. In the short run, currency traders expectations play a much more important role. In todays environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to get to the exits first. Thus, fears of depreciation become self-fulfilling prophecies.
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Fixed versus Flexible Exchange Rate Regimes

Arguments in favor of flexible exchange rates:

Easier external adjustments. National policy autonomy. Exchange rate uncertainty may hamper international trade. No safeguards to prevent crises.

Arguments against flexible exchange rates:

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End Chapter Two

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