Today’s Agenda
 Note on TF office hours: W, 1:30-2:30pm, KMEC 7






181,TF: Ms. Desi Peteva, MBA2
Why study int’l monetary systems?
Terminology of exchange rates & currency regimes.
Differences b/n devaluation & depreciation?
Ideal currency?
Explain currency regime choices.
Describe Euro creation.
Case-in-point: the stubborn forex regime in China.
1
Why study int’l monetary system?
 Fact: the volatility of exchange rates has increased.
 Volatile exchange rates increase risk, create profit
opportunities.
 The international monetary system is the structure
within which foreign exchange rates are determined.
2
Currency Terminology
• Foreign currency exchange rate: price of one
country’s currency in units of another currency or
commodity
– The system, or regime, classified as:
– fixed,
– floating, or
– managed exchange rate regime.
• Par value: the rate @ which currency is fixed, pegged.
• Floating or flexible currency: government does not
interfere in valuation of currency
3
Currency Terminology
 Spot exchange rate: quoted price for foreign
exchange to deliver @ once, or @ T+2 for interbank
transactions
• ¥114/$ (114 yen to buy one US $), immediate delivery
 Devaluation: drop in foreign exchange value pegged
to gold or another currency. Opposite to revaluation.
 Weakening, depreciation: refers to drop in foreign
exchange of a floating currency. Opposite to
appreciation.
4
Currency Terminology
 Soft or weak currency: currency expected to devalue/


depreciate relative to major currencies;
Hard or strong: the opposite.
Eurocurrencies: type of money although in reality
they are domestic currencies of a country deposited in
another country.
• E.g.: Eurodollar - US$ denominated deposit in bank
outside of US
5
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: 1973-Present
6
Bimetallism: Before 1875
 A “double standard”: both gold and silver were


used as money, accepted as means of payment.
Some countries were on the gold standard, some
on the silver standard, some on both.
Exchange rates among currencies were determined
by either their gold or silver contents.
7
The Gold Standard, 1876-1913
•
•
•
•
Countries set par value for currency in terms of gold
Acceptance in Europe in 1870s
US adopted it 1879
“Rules of the game”:
– Rule 1: Set a rate @ which can buy/sell gold for
currency.
– Rule 2: Credibly maintain adequate reserves of gold.
– E.g. US$ gold rate $20.67/oz, Brits pegged at
£4.2474/oz
– US$/£ rate calculation
$20.67/£4.2472 = $4.8665/£
8
The Gold Standard, 1876-1913
 Since the rate of exchange for gold was fixed, the



exchange rates b/n currencies was fixed too.
Gold standard worked until WW1
WW1 interrupted trade flows & free movement of
gold forcing nations suspend gold standard.
J.M. Keynes called it “the barberian relique”.
9
Inter-War years & WWII, 1914-1944
• During WWI: currencies fluctuate over wide ranges to gold
– Due to S & D for imports/exports
– Due to speculative pressure,
– SHORT SELLING week currencies.
– BUYING strong currencies.
SHORT SELLING: investor expects price to fall soon, borrows
currency & sells it.
• 1934: US devalued currency to $35/oz from $20.67/oz.
• 1924 - end WWII: exchange rates determined by currency
value in gold.
• During WWII & after, main currencies lost convertibility.
US$ remained only convertible currency.
10
Bretton Woods & IMF
• Bretton Woods, NH: US coalition created post-war
international monetary system.
– establishes US$ based monetary system
– IMF (International Monetary Fund) & World Bank
– IMF renders temp assistance to member-countries to defend
currency & overcome econ problems
• All member-countries fix currencies in gold, not
required to exchange it.
• Only US$ convertible to gold (@ $35/oz, Central
banks only)
– The advent of central banking worldwide.
11
Bretton Woods
• Countries establish exchange rate vis-à-vis US$
• Agree to maintain currency values +/- 1% par by
trading US$ & gold.
• No use of devaluation as a competitive trade policy
• Up to 10% devaluation w/o formal approval by IMF.
12
Bretton Woods
• Special Drawing Right (SDR): international reserve
assets
– A unit of account for IMF & base some countries peg
exchange rates.
– Is weighted average 5 IMF members currencies, w/
largest exports/ imports
• Members deposits US$ & Gold in IMF, get SDR.
13
Fixed exchange rates, 1945-1973
• Worked well for post-WW2
• Fiscal & monetary policies & external shocks caused
collapse
– US$ main reserve currency.
– Heavy overhang of US$ abroad.
– Lack of confidence.
– Heavy outflows of US gold.
• Nixon (08/15/71): suspend trading gold. Allow
exchange rates to float freely.
• Nixon (08/15/71): yet another run on US$.
• Devalue US$ to $42/oz gold.
14
Fixed exchange rates, 1945-1973
Triffin paradox
 To maintain the gold-exchange system, the US had
to run Balance of Payment deficits continuously.
 But: large, persistent deficits would diminish
confidence and lead to a run on the US$.
 This would destroy the system – indeed, it
happened in the 50s & 60s.
15
World Currency Events
OPEC embargo
1973-74
Jamaica
Agreement
1/1976
EMS created
3/1979
OPEC raises
prices
1979
Latin American
Debt Crisis
8/1982
Plaza
Agreement
9/1985
Louvre Accord
2/1987
Maastricht
Treaty
9/1991
EMS crisis
2/1992
Peso Collapse
12/1994
Asian Crisis
6/1997
Russian Crisis
8/1998
Euro Launched
1/1999
Brazilian real
crisis
1/1999
Turkey
2001
Argentine peso
crisis
1/2002
16
Why do Currency Crises Happen?
 Long run: In theory, a currency’s value mirrors the

fundamental strength of its underlying economy,
relative to other economies.
Short run: currency traders’ expectations play a
much more important role.
17
How do Currency Crises Happen?
 Mass exodus causes sharp drop in currency


valuation  currency crisis.
Fears of depreciation become self-fulfilling
prophecies.
Policy for recovery unclear – appears to be
contextual. Therefore we can examine Mexican &
Asian crises to gain perspective.
18
Mexican Peso Crisis (1994-95)
 The Mexican government announced a plan to


devalue the peso against the dollar by 14%.
Investors’ response: dump Mexican currency, stocks
and bonds  40% drop in peso.
Led to flotation of peso. Crisis spilled over to Latin
America/Asia. “Tequila Crisis”.
19
Importance of Mexican Crisis
 This was the 1st serious int’l financial crisis sparked
by cross-border flight of portfolio capital.
• In prior crises, currency had been abandoned; here also
the stocks & bonds.
 Underscored degree of interdependency of financial

systems world-wide.
Highlighted the inherent riskiness of relying on
foreign capital to finance domestic investments.
• Influx of foreign capital can cause overvaluation of
currency.
20
Asian Crisis (1997-98)




Thai baht devalued on July 2, 1997. Sparked crisis regionwide; overflowed to Russia and Latin America.
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,
which is still ongoing, despite IMF bail-out packages.
• Moral hazard?
21
Why Asia?
 Weak domestic financial systems.
 Free international capital flows.
 Market sentiment – sparked contagion.
 Inconsistent economic policies and incomplete

disclosure thereof.
Hardest hit countries (Indonesia, Korea, Thailand)
had especially high ratios of
• (1) short-term foreign debt/FX reserves and
• (2) broad money (representing banking system
liabilities)/FX reserves.
22
Lessons?
 Financial market liberalization must be paired with


development of strong domestic financial system.
Note: Mexico and Korea joined the OECD a few
years prior to crises – OECD membership had
required significant market liberalization.
Governments should
• strengthen financial market regulation & supervision
• discourage short-term cross-border investments
• encourage FDI and long-term equity & bond
investments.
23
IMF on Currency Regimes
IMF Regime Classification
 No separate legal tender (39): Ecuador
 Currency Board (8): commit exchanging domestic currency
at a fixed rate to foreign currency.
 Conventional Fixed Peg (44): Country pegs its currency
(formally) at a fixed rate to major currency ± 1% variation
 Pegged Exchange w/in Horizontal Bands (6): maintain
within margins wider than ± 1% around de facto fixed peg.
 Crawling Peg (4): Currency adjusted periodically in small
amounts at pre-announced rate
24
Contemporary Currency Regimes
 Exchange Rates w/in Crawling Peg (5): Currency


maintained within certain fluctuation margins around
a central rate that is adjusted periodically
Managed Floating w/ No Preannounced Path for
Exchange Rate (33): Monetary authority active
intervention in foreign exchange markets
Independent Floating (47): Exchange rate is market
determined.
25
Fixed vs. Flexible Exchange Rates
 Why countries prefer fixed exchange rates?
• Stability in international prices for the conduct of trade
• Anti-inflationary, requires country to follow restrictive
monetary & fiscal policies
• Credibility, if central banks maintain large
international reserves to defend fixed rate
• Fixed rates may be maintained @ rates inconsistent
with economic fundamentals. For example, Asia these
days…
26
The curious case of Asia
 Recently Asian countries have shown reluctance to

allow their currencies to rise against the dollar
Why?
• Prefer fixed exchange rates (ergo stability)
 Consequences:
• Rise of the euro – good or bad? What do you think?
 Solutions:
• Float of exchange rates of Asian economies.
• Financial sector liberalization in China.
27
28
Ideal Currency Or Impossible Trinity?

Exchange rate stability –value of currency would be fixed to
other currencies

Full financial integration – complete freedom of monetary
flows allowed, traders & investors could move funds in
response to economic opportunities

Monetary independence – domestic monetary policies by
each individual country to pursue national economic policies,
e.g. limiting inflation, foster prosperity & full employment.
29
The Impossible Trinity
Full Capital Controls
Monetary
Independence
Exchange Rate
Stability
Increased Capital
Mobility
Pure Float
Full Financial
Integration
Monetary Union
Can have only 2-sides/ system.E.g., if Monetary Independence
& Financial Integration,
cannot attain Exchange Rate Stability.
30
Emerging Markets & Regime Choices
 Currency Boards: country’s central bank commits to
back monetary base, with foreign reserves @ all
times
• means a unit of domestic currency cannot be
introduced w/o an additional forex reserves
– Argentina (1991), fixed Peso to US$
– Bulgaria (1997), fixed Leva to Euro.
31
Emerging Markets & Regime Choices

Dollarization: use of US$ as official currency
– Panama, 1907 & Ecuador, 2000.

Why dollarization?
• Removes possibility of currency volatility;
• Eliminate possibility of currency crises;
• Economic integration with US & other dollar based markets

Why not dollarization?
• Loss of sovereignty over monetary policy
• Loss of power of seignorage, the ability to profit from printing
•
own money.
Central bank no longer lender of last resort.
32
Living on the edge…
Emerging Market
Country
Free-Floating Regime
•Currency free to float
•Independent monetary
policy & free
movement of capital
allowed, but @ loss of
stability
High capital mobility
Currency Board or
Dollarization
•No monetary
independence
•No political influence
on monetary policy
•Seignorage rights lost
•Increased volatility
33
The Euro
 European Monetary System (EMS):15 Member

nations
Maastricht Treaty’ 92 – timeline of economic &
monetary union.
• Convergence criteria called
– Nominal inflation < 1.5% above average for EU lowest
3 inflation rates year before.
– LT interest rate < 2% above average for EU lowest 3
interest rates.
– Fiscal deficit < 3% of GDP.
– Government debt < 60% of GDP.
• European Central Bank (ECB) established.
34
The Euro & Monetary Unification
 The euro, €, was launched on Jan. 4, 1999 with 11

member states
Benefits of the euro?
• Lower transaction costs in EU.
• Currency risks reduced.
• All consumers and businesses, both inside and outside
of the euro zone enjoy price transparency and
increased price-based competition
35
The Euro & Monetary Unification
 Successful unification ?
• ECB has to coordinate monetary policy
– Focus on price stability.
• Fixing the euro
– 12/1998, national exchange rates were fixed to the Euro.
– 1/1999 euro trading on world currency markets.
36
Euro’s Way-up
37
Tradeoffs b/n Exchange Rate Regimes
Policy Rules
Non-cooperation
Between Countries
Cooperation
Between Countries
Discretionary Policy
38
What Lies Ahead?

Tradeoff b/n rules & discretion, cooperation & independence.
•Gold
Standard
•Bretton
Woods
Rules
•European
Monetary
System Cooperation b/n
No cooperation b/n
Countries
Countries
?
•US Dollar,
1981-1985
Discretion
39
Summary

Terminology
•
•
•
•




Foreign currency exchange rate
Spot exchange rate
Devaluation (revaluation)
Depreciation (appreciation)
The impossible trinity of goals for forex: fixed value,
convertibility, independent monetary policy.
Currency board or dollarization?
Fixed vs. Floating Exchange Rates.
Euro advent.
40