International Monetary
System
FINA6222 Selected Topics in Finance: International Finance
CUHK Business School
Week 2
Lesson Outline
• History of international monetary system: gold standard, Bretton Woods, floating
regime
• Types of exchange rate regimes
• Currency crises
• Fixed vs. floating exchange rate system
• Optimum currency area: The Euro
1
Evolution of the International Monetary
System
2
Gold Standard (1875—1914)
• First full-fledged gold standard, a monetary system in which currencies are
defined in terms of their gold content, was established in 1821 in Great Britain
• Majority of countries moved away from gold in 1914 when World War I
began.
• Under the gold standard, the exchange rate between any two currencies will be
determined by the gold contents
3
Example of Gold Standard
• Suppose the pound (£) is pegged to gold at six pounds (£6) per ounce, whereas
one ounce of gold is worth
12 francs (₣)
• £6 = 1 oz. gold.
• ₣12 = 1 oz. gold.
• Deducing from the information given above, £6 must equal ₣12
• 6/12 reduces to 1/2; therefore £1 = ₣2.
• Exchange rate between the pound and the franc should then be two francs per
pound
4
Gold Standard Adjustment Mechanism
• But suppose the exchange rate is now £1 for ₣1.9, what would happen?
• Since £ is undervalued, investors will buy more £. 1/6
• Investors can buy £ with ₣1.9 → then use £1 to buy 1 oz. gold in Britain, ship the
gold to France and sell for ₣2, a net gain of ₣0.1 can be obtained.
Arbitrage Profit
• However, the inflow of gold to France will lead to a rise in the supply of ₣
leading to a lower value of ₣ and causing the exchange rate to return to £1 = ₣2.
5
Gold Standard Adjustment Mechanism
• Price-specie-flow mechanism was an automatic correction of payment
imbalanced between countries operating under the gold standard
• Based on the fact that domestic money stock rises or falls as the country
experiences inflows or outflows of gold.
• Key shortcomings of the gold standard:
• Supply of newly minted gold is so restricted that the growth of world trade and
investment can be seriously hampered for lack of sufficient monetary reserves.
• No mechanism to compel each major country to abide by the rules of the
game.
• Expansionary monetary policy of the government was limited to the supply of
gold (i.e. money supply can increase only when there is a corresponding rise in
the supply of gold).
6
Inter-War Years and WWII (1915—1944)
• World War I ended the classical gold standard in August 1914.
• Major countries followed sterilization of gold policy
• Countries widely used “predatory” depreciations of their currencies as a means of
gaining advantages in the world export market
• Period characterized by economic nationalism, halfhearted attempts and failure
to restore the gold standard, economic and political instabilities, bank failures,
and panicky flights of capital across borders.
• During this period of time, currencies were allowed to fluctuate over a fairly wide
range in terms of gold and each other’s currency.
• During WWII and its chaotic aftermath the U.S. dollar was the only major trading
currency that continued to be convertible to gold.
7
Bretton Woods System (1945—1972)
• Named for a July 1944 meeting of 44 nations at Bretton Woods, New Hampshire
• Purpose of meeting was to discuss and design the postwar international
monetary system (that is, Bretton Woods system).
• The Bretton Woods Agreement established:
• a U.S. dollar based international monetary system
• US$ is maintained at a rate of US$35 = 1 oz. gold and other countries fixed
their currencies in terms of US$. As a result, participating countries
established an exchange rate against the US dollar.
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Gold Standard: Fixed Exchange Rate System
Fixed FX Rate
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Triffin Paradox
• Triffin paradox explains the collapse of this system in the early 1970s
• Reserve-currency country should run a balance of payments deficit, but this can decrease
confidence in the reserve currency and lead to the downfall of the system.
• As only US$ is convertible to gold under the system, US$ then became the main
reserve currency held by central banks of other countries.
• That resulted in a consistent and growing balance of payments deficit in the US,
which required a heavy capital outflow of dollars to finance these deficits and
meet the growing demand for dollars from investors and businesses.
• Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of
confidence in the ability of the US government to meet its commitment to convert
dollars to gold.
10
Collapse of Bretton Woods
• The lack of confidence forced US President Richard Nixon to suspend official
purchases or sales of gold by the U.S. Treasury on August 15, 1971.
• This resulted in subsequent devaluations of the dollar.
• Most currencies were allowed to float to levels determined by market forces as of
March 1973.
11
Floating Exchange Rate Regime (1973—
present)
• Flexible exchange rate regime was ratified in January 1976 when the IMF
members met in Jamaica and agreed to a new set of rules, referred to as the
Jamaica Agreement:
1. Flexible exchange rates were declared acceptable to the IMF members; central banks could
intervene in exchange markets to iron out unwarranted volatilities.
2. Gold was officially abandoned (that is, demonetized) as an international reserve asset.
3. Non-oil-exporting countries and less-developed countries were given greater access to IMF
funds.
12
Trade-Weighted Value of the US Dollar
13
Exchange Rate Classifications: Hard Pegs
1. No separate legal tender:
• Currency of another country circulates as the sole legal tender (for example, Ecuador, El
Salvador, and Panama).
2. Currency board:
• An extreme form of the fixed exchange rate regime under which local currency is fully backed
by the U.S. dollar or another chosen standard currency (for example, Hong Kong, Bulgaria,
and Brunei).
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Exchange Rate Classifications: Soft Pegs Fixed
3. Conventional peg:
• Country formally pegs its currency at a fixed rate to another currency or basket of currencies
(for example, Jordan, Saudi Arabia, and Morocco).
4. Stabilized arrangement:
• Entails a spot market exchange rate that remains within a margin of 2% for 6 months or more
(for example, Indonesia, Singapore, and Lebanon).
5. Crawling peg:
• Involves the confirmation of the country authorities’ de jure exchange rate arrangement (for
example, Honduras and Nicaragua).
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Exchange Rate Classifications: Soft Pegs
6. Crawl-like arrangement: moving average
• Exchange rate must remain within a narrow margin of 2% relative to a statistically identified
trend for 6 months or more (for example, Iran, China, and Serbia).
7. Pegged exchange rate with horizontal bands:
• Value of currency is maintained within certain margins of fluctuation of at least +/− 1% around
a fixed central rate, or the margin between the maximum and minimum value of the exchange
rate exceeds 2% (for example, Tonga).
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Exchange Rate Classifications: Floating
8. Floating:
• Largely market determined, without an ascertainable or predictable path for the rate (for
example, Brazil, Korea, Turkey, India, South Africa, and Thailand).
9. Free floating:
• Intervention occurs only exceptionally and aims to address disorderly market conditions;
authorities confirm intervention has been limited to at most 3 instances in the previous 6
months, each lasting no more than 3 business days (for example, Australia, Canada, Mexico,
Japan, UK, US, and euro zone).
10. Other managed arrangement:
• Residual category used when the exchange rate arrangement does not meet the criteria for any
of the other categories (for example, Algeria, Cambodia, and Sudan).
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Currency Crises
• Three major currency crises revealed the fragility of the international monetary
system (IMS)
• Mexican peso crisis (1994 to 1995).
• Asian currency crisis (1997 to 1998).
• Argentine peso crisis (2002).
18
Mexican Peso Crisis
• On December 20, 1994, the Mexican government announced a plan to devalue the
peso against the dollar by 14 percent
• This decision caused pesos, as well as Mexican stocks and bonds, to be sold
rapidly
• By early January 19 95, the peso had fallen against the US dollar by as much as 40 percent,
forcing the Mexican government to float the peso.
• Peso crisis rapidly spilled over to other Latin American and Asian financial
markets
19
US Dollar and Peso Exchange Rate
20
Mexican Peso Crisis
• 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.
• Mexico excessively depended on foreign portfolio capital to finance economic development
when a higher priority should have been placed on saving domestically.
21
Asian Currency Crisis
• 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.
• Led to an unprecedentedly deep, widespread, and long-lasting recession in East
Asia, a region that has enjoyed the most rapidly growing economy in the world
over the last few decades.
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Asian Currency Crisis
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Origins of the Asian Currency Crisis
• As capital markets were opened, large inflows of private capital resulted in a
hot money
credit boom in the Asian countries.
• Fixed or stable exchange rates also encouraged unhedged financial transactions
and excessive risk-taking by both borrowers and lenders.
• The real exchange rate rose, which led to a slowdown in export growth.
• Also, Japan’s long-lasting recession (and yen depreciation) hurt neighboring
countries.
24
Origins of the Asian Currency Crisis
• If the Asian currencies had been allowed to depreciate in real terms (which was
not possible due to the fixed exchange rates), the sudden and catastrophic changes
in exchange rates observed in 19 97 might have been avoided
• Eventually, something had to give—it was the Thai baht
• Sudden collapse of the baht touched off a panicky flight of capital from other
Asian countries.
25
Origins of the Asian Currency Crisis
• A fixed, but adjustable, exchange rate is problematic in the face of integrated
international financial markets
• Invites speculative attack at the time of financial vulnerability.
• Incompatible (or impossible) trinity suggests it is very difficult, if not impossible, to have all
three conditions:
1. A fixed exchange rate.
2. Free international flows of capital.
3. Independent monetary policy.
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Incompatible Trinity
capital restriction
floating
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Argentine Peso Crisis
• In February 1991, the Argentine government passed the Convertibility Law,
linking the peso to the US dollar at parity.
• The initial economic effects were positive:
• Argentina’s chronic inflation was curtailed dramatically, and foreign investment began to pour
in, leading to an economic boom.
• Peso appreciated against most currencies as the U.S. dollar became increasingly
stronger in the second half of the 1990s.
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Argentine Peso Crisis
• A strong peso hurt exports from Argentina and caused a protracted economic
downturn that led to the abandonment of peso–dollar parity in January 2002.
• This change caused severe economic and political distress in the country:
• Unemployment rate rose above 20 percent.
• Inflation rate reached a monthly rate of 20 percent.
29
Collapse of Argentine Peso Currency Board
30
Argentine Peso Crisis
• There are at least three factors that are related to the collapse of the currency board
arrangement and the ensuing economic crisis:
• Lack of fiscal discipline.
• Labor market inflexibility.
• Contagion from the financial crises in Brazil and Russia.
31
Rise of Chinese RMB
• China has recently become one of the top trading powers in the world
• GDP is second only to the US among individual countries, but its currency, the renminbi
(RMB), has not achieved similar international prominence.
• China’s currency has the potential to become a global currency, but China will
need to meet a few critical conditions:
• Full convertibility of its currency.
• Open capital markets with depth and liquidity.
• Rule of law and protection of property rights.
32
Fixed vs. Floating Exchange Rate Systems
• Arguments in favor of floating exchange rates:
• Easier external adjustments.
• National policy autonomy.
• Arguments against floating exchange rates:
• Exchange rate uncertainty may hamper international trade and investment.
• No safeguards to prevent crises.
33
Fixed vs. Floating Exchange Rate Systems
• A nation’s choice as to which currency regime to adopt reflects national priorities
about all aspects of the economy, including:
• Inflation / deflation,
• unemployment,
• interest rate levels,
• trade balances (deficit), and
• economic growth.
• Therefore, the choice between fixed and flexible rates may change over time as
priorities change.
34
Fixed vs. Floating Exchange Rate Systems
• Countries would prefer a fixed rate regime for the following reasons:
• Stability in international prices, hence less risks.
• Inherent anti-inflationary nature of fixed prices.
• However, a fixed rate regime has the following problems:
• Central banks need to maintain large quantities of hard currencies and gold to defend the fixed
Foreign Reserves
rate.
• Fixed rates can be maintained at rates that are inconsistent with economic fundamentals.
Indirect intervention is to impact the demand of the other currency Direct Intervention
35
Attributes of an “Ideal” Currency
• A “good” (or ideal) international monetary system should provide the following:
• Liquidity.
• Adjustment.
• Confidence.
36
Optimum Currency Area
• Instead of choosing between fixed and floating exchange rate systems, several
countries may choose to use a common currency.
• The theory of optimum currency area states that it is not necessary for each
country in an area to have their own currency.
37
European Monetary System
• The chief goals of the European Monetary System (EMS) are the following:
• To establish a “zone of monetary stability” in Europe.
• To coordinate exchange rate policies vis-à-vis the non-EMS currencies.
• To pave the way for the eventual European monetary union.
• Two main instruments of the EMS:
• European Currency Unit (ECU).
• Exchange Rate Mechanism (ERM).
38
Creation of the Euro
• 11 of 15 EU countries adopted a common currency, the euro, on January 1, 19 99
• European Monetary Union (EMU) created.
• Each national currency of the euro-11 countries was irrevocably fixed to the euro
at a conversation rate as of January 1, 19 99.
• Euro notes and coins were introduced to circulation on January 1, 2002, while
national bills and coins were being gradually withdrawn.
• Changeover completed by July 1, 2002.
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US Dollar and Euro Exchange Rate
40
Brief History of the Euro
• Monetary policy for euro zone countries is now conducted by the European
Central Bank (ECB)
• Primary objective is to maintain price stability.
• Independence is legally guaranteed.
• Eurosystem is made up of ECB and central banks of euro-zone countries; tasks
include:
1. Defining and implementing common monetary policy of the Union.
2. Conducting foreign exchange operations.
3. Holding and managing official foreign reserves of euro member states.
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Benefits and Costs of Monetary Union
• Key benefits
• Reduced transaction costs.
• Elimination of exchange rate uncertainty.
• Enhanced efficiency and competitiveness of the European economy.
• Conditions conducive to the development of continental capital markets with depth and
liquidity comparable to those of the US.
• Political cooperation and peace in Europe.
• Main cost
• Loss of national monetary and exchange rate policy independence.
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