Chapter 11 The International Monetary System LERARNING OBJECTIVES

Chapter 11 The International Monetary System

LERARNING OBJECTIVES • Historical development of the modern global monetary system. Role of world bank and the IMF in the international monetary system. • Know differences between a fixed and floating exchange rate system. • Know what exchange rate regimes are used in the world today and why countries adopt different exchange rate regimes. • Understand the debate surrounding the role of the IMF in the management of financial crises.

What Is The International Monetary System? ØThe international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates ØA floating exchange rate system exists when a country allows the foreign exchange market to determine the relative value of a currency Øthe U. S. dollar, the EU euro, the Japanese yen, and the British pound all float freely against each other Øtheir values are determined by market forces and fluctuate day to day

Exchange Rate Regimes in the International Financial System Fixed exchange rate regime ◦ Value of a currency is pegged relative to the value of one other currency (anchor currency) Pegged exchange rate system exists when a country fixes the value of its currency relative to a reference currency ◦ many Gulf states peg their currencies to the U. S. dollar Floating exchange rate regime ◦ Value of a currency is allowed to fluctuate against all other currencies Managed float regime (dirty float) ◦ Attempt to influence exchange rates by buying and selling currencies ◦ A dirty float exists when a country tries to hold the value of its currency within some range of a reference currency such as the U. S. dollar (e. g. China pegs the yuan to a basket of other currencies)

Exchange Rate Regimes in the International Financial System Gold standard ◦ Fixed exchange rates ◦ No control over monetary policy ◦ Influenced heavily by production of gold and gold discoveries Bretton Woods System ◦ Fixed exchange rates using U. S. dollar as reserve currency ◦ The fixed exchange rates were maintained by intervention of central banks ◦ International Monetary Fund (IMF)

Exchange Rate Regimes in the International Financial System Bretton Woods System (cont’d) ◦ World Bank ◦ General Agreement on Tariffs and Trade (GATT) ◦ World Trade Organization European Monetary System ◦ Exchange rate mechanism

How the Bretton Woods System Worked Exchange rates adjusted only when experiencing a “fundamental disequilibrium” (large persistent deficits in balance of payments) Loans from IMF to cover loss in international reserves IMF encouraged contractionary monetary policies Devaluation only if IMF loans were not sufficient No tools for surplus countries U. S. could not devalue currency

How a Fixed Exchange Rate Regime Works When the domestic currency is overvalued, the central bank must: ◦ Purchase domestic currency to keep the exchange rate fixed (it loses international reserves), or ◦ Conduct a devaluation When the domestic currency is undervalued, the central bank must: ◦ Sell domestic currency to keep the exchange rate fixed (it gains international reserves), or ◦ Conduct a revaluation

Figure 2 Intervention in the Foreign Exchange Market Under a Fixed Exchange Rate Regime

Application: How Did China Accumulate $4 Trillion of International Reserves? By 2014, China had accumulated $4 trillion in international reserves. The Chinese central bank engaged in massive purchases of U. S. dollar assets to maintain the fixed relationship between RMB and the U. S. dollar. The undervaluation of RMB has caused Chinese goods abroad so cheap that many countries (like the U. S. ) have threatened to erect trade barriers.

Managed Float ØHybrid of fixed and flexible ØSmall daily changes in response to market ØInterventions to prevent large fluctuations ØRates fluctuate in response to market forces but are not solely determined by them ØAppreciation hurts exporters and employment ØDepreciation hurts imports and stimulates inflation ØSpecial drawing rights as substitute for gold

Are Capital Controls A Good Ideas? Disadvantages of Capital Controls on capital outflows: ◦ ◦ Seldom effective and may increase capital flight Weaken confidence in government Lead to corruption Lose opportunity to reform the financial system Controls on capital inflows: ◦ Lead to a lending boom and excessive risk taking by financial intermediaries

Capital Controls on inflows (cont’d): ◦ Controls may block funds for productions uses ◦ Produce substantial distortion and misallocation (Households and businesses need to find a way to get around these barriers) ◦ Lead to corruption Strong case for improving bank regulation and supervision

The Role of the IMF ØFixed exchange rates stopped competitive devaluations and brought stability to the world trade environment ØFixed exchange rates imposed monetary discipline on countries, limiting price inflation ØIn cases of fundamental disequilibrium, devaluations were permitted ØIMF lent foreign currencies to members during short periods of balance -of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment

International Considerations and Monetary Policy Balance of payment considerations: ◦ Current account deficits in the U. S. suggest that American businesses may be losing ability to compete because the dollar is too strong. ◦ U. S. deficits mean surpluses in other countries large increases in their international reserve holdings world inflation.

International Considerations and Monetary Policy Exchange rate considerations: A contractionary monetary policy will raise the domestic interest rate and strengthen the currency. An expansionary monetary policy will lower interest rates and weaken currency.

Exchange Rate Since 1973 Ø Since 1973, exchange rates is less predictable because Ø 1971 and 1979 oil crises Ø The loss of confidence in the dollar after U. S. inflation in 1977 -78 Ø the rise in the dollar between 1980 and 1985 The partial collapse of the European Monetary System (EMS) in 1992 Ø The 1997 Asian currency crisis Ø The decline in the dollar from 2001 to 2009

Which one is better- Fixed or Floating exchange rates provide ØMonetary policy autonomy Øremoving the obligation to maintain exchange rate parity restores monetary control to a government Automatic trade balance adjustments Ø under Bretton Woods, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would have to agree to a currency devaluation. BUT ØFixed exchange rate system Provides monetary discipline � Øensures that governments do not expand their money supplies at inflationary rates Ø Minimizes speculation and s uncertainty and promotes growth of international trade and investment

Pegged Exchange System ØPegged exchange rate system pegs the value of its currency to that of another major currency Øpopular among the world’s smaller nations Øimposes monetary discipline and leads to low inflation Øadopting a pegged exchange rate regime can moderate inflationary pressures in a country

Currency Boards A monetary authority that makes decisions about the valuation of a nation's currency A strong commitment to the fixed exchange rate and a solution to lack of transparency and commitment to target Domestic currency is backed 100% by a foreign currency Note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate

Currency Boards Money supply can expand only when foreign currency is exchanged for domestic currency. Stronger commitment by central bank Loss of independent monetary policy and increased exposure to shock from anchor country Loss of ability to create money and act as lender of last resort

Role of IMF A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates A banking crisis refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt �Greece and Ireland 2010