International Finance FINA 5331 Lecture 5: A History of Monetary Arrangements Read: Chapters 2 Aaron Smallwood Ph.D. International Monetary Arrangements •  International Monetary Arrangements in Theory and Practice –  The International Gold Standard, 1879-1913 –  Bretton Woods Agreement, 1945-1971 –  Smithsonian Agreement 1971-1973 –  The Floating-Rate Dollar Standard, 1973-1984 •  Jamaica Agreement 1976 –  The Plaza-Louvre Intervention Accords (1985 and 1987) and the Floating-Rate Dollar Standard, 1985-1999 Additionally •  What exchange rate systems exist today? –  The choice between a fixed system and a flexible system. •  How does another country’s exchange rate system affect you? How does China’s changing exchange rate system affect you? •  What are currency crises and how can they impact your business? •  What is the euro? Will the euro-zone expand? How does expansion of the euro-zone affect you? The International Gold Standard, 1879-1913 Fix an official gold price or “mint parity” and allow free convertibility between domestic money and gold at that price. •  Countries unilaterally elected to follow the rules of the gold standard system, which lasted until the outbreak of World War I in 1914, when European governments ceased to allow their currencies to be convertible either into gold or other currencies. The International Gold Standard, 1879-1913 For example, during the gold standard, the dollar is pegged to gold at : U.S.$20.67 = 1 ounce of gold The British pound is pegged at : £4.2474 = 1 ounce of gold. The exchange rate is determined by the relative gold contents: $20.67 = £4.2474 $4.866 = £1 The International Gold Standard, 1879-1913 •  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 pricespecie-flow mechanism. Price-Specie-Flow Mechanism •  Suppose Great Britain experienced a balance of payments imbalance associated with an official settlements surplus. •  This cannot persist under a gold standard. –  Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. –  This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. •  The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France. The International Gold Standard, 1879-1913 •  With stable exchange rates and a common monetary policy, prices of tradable commodities were much equalized across countries. •  Real rates of interest also tended toward equality across a broad range of countries. •  On the other hand, the workings of the internal economy were subservient to balance in the external economy. The International Gold Standard, 1879-1913 •  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. –  Countries with large gold holdings may be able to exert an inordinate influence on the global economy. –  Prices are stable only to the extent that the relative price of gold to goods and services is stable. The Relationship Between Money and Growth •  Money is needed to facilitate economic transactions. •  MV=PY →The equation of exchange. •  Assuming velocity (V) is relatively stable, the quantity of money (M) determines the level of spending (PY) in the economy. •  If sufficient money is not available, say because gold supplies are fixed, it may restrain the level of economic transactions. •  If income (Y) grows but money (M) is constant, either velocity (V) must increase or prices (P) must fall. If the latter occurs it creates a deflationary trap. •  Deflationary episodes were common in the U.S. during the Gold Standard. Interwar Period: 1918-1941 •  Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. •  Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”. •  The result for international trade and investment was profoundly detrimental. •  Smoot-Hawley tariffs •  Great Depression Economic Performance and Degree of Exchange Rate Depreciation During the Great Depression Bretton Woods System: 1945-1971 •  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. Bretton Woods System: 1945-1971 •  Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. •  Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. •  The U.S. was only responsible for maintaining the gold parity. •  Under Bretton Woods, the IMF and World Bank were created. •  The Bretton Woods is also known as an adjustable peg system. When facing serious balance of payments problems, countries could re-value their exchange rate. The US and Japan are the only countries to never re-value. The Fixed-Rate Dollar Standard, 1945-1971 •  In practice, the Bretton Woods system evolved into a fixed-rate dollar standard. Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, and keep the exchange rate within 1% of this par value indefinitely. United States : Remain passive in the foreign change market; practice free trade without a balance of payments or exchange rate target. Bretton Woods System: 1945-1971 British pound German mark French franc Par Value U.S. dollar Pegged at $35/oz. Gold Purpose of the IMF The IMF was created to facilitate the orderly adjustment of Balance of Payments among member countries by: •  encouraging stability of exchange rates, •  avoidance of competitive devaluations, and •  providing short-term liquidity through loan facilities to member countries Composition of SDR (Special Drawing Right) Today: The SDR •  $/SDR: 1.54576 –  Number of dollars: 0.66 •  $ equivalent: 0.66 (42.7%) –  Number of euros: 0.423 •  $ equivalent: 0.555568 (35.9%) –  Number of pounds: 0.111 •  $ equivalent: 0.179620 (11.6%) –  Number of yen: 12.1 •  $ equivalent: 0.150572 (9.74%) Collapse of Bretton Woods •  Triffin paradox – world demand for $ requires U.S. to run persistent balance-of-payments deficits that ultimately leads to loss of confidence in the $. •  SDR was created to relieve the $ shortage. •  Throughout the 1960s countries with large $ reserves began buying gold from the U.S. in increasing quantities threatening the gold reserves of the U.S. •  Large U.S. budget deficits and high money growth created exchange rate imbalances that could not be sustained, i.e. the $ was overvalued and the DM and £ were undervalued. •  Several attempts were made at re-alignment but eventually the run on U.S. gold supplies prompted the suspension of convertibility in September 1971. •  Smithsonian Agreement – December 1971 The Floating-Rate Dollar Standard, 1973-1984 •  Without an agreement on who would set the common monetary policy and how it would be set, a floating exchange rate system provided the only alternative to the Bretton Woods system. The Floating-Rate Dollar Standard, 1973-1984 Industrial countries other than the United States : 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. United States : Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target. No need for sizable official foreign exchange reserves. The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999 •  Plaza Accord (1985): –  Allow the dollar to depreciate following massive appreciation…announced that intervention may be used. •  Louvre Accord (1987) and “Managed Floating” –  G-7 countries will cooperate to achieve exchange rate stability. –  G-7 countries agree to meet and closely monitor macroeconomic policies. Value of $ since 1973 IMF Classification of Exchange Rate Regimes •  •  •  •  •  Independent floating Managed floating Exchange rate systems with crawling bands Crawling peg systems Pegged exchange rate systems within horizontal bands •  Conventional pegs •  Currency board •  Exchange rate systems with no separate legal tender