International Monetary System 2002 by Stefano Mazzotta 1

1 Overview of the Lecture 1. Monetary Authorities 2. Monetary Policy and Exchange Rate

1. Monetary Authorities © 2002 by Stefano Mazzotta

3 A brief history • Classical gold standard: 1821 -1914 – Essentially a managed gold standard: transfers of gold could be substituted by transfers of currencies • Gold exchange standard: 1925 -1931 – U. S. and U. K. could hold only gold reserves, other nations - both gold and dollars and pounds • Bretton Woods system: 1946 -1971 – Countries pegged their currencies to dollar or gold • Post-Bretton Woods system: 1973 -present – Floating exchange rate regime © 2002 by Stefano Mazzotta

Monetary authorities (Central Banks) I 4 • What do they do? – Determine or impact interest rates – Determine or impact the value of the currency – Determine or impact inflation • How do they do it? – – – Print money Buy or sell local currency (bonds) Buy or sell foreign currency Change fiscal and monetary regulations Change interest rates © 2002 by Stefano Mazzotta

Monetary authorities (Central Banks) II 5 • They can try to conduct two types of interventions: • Unsterilized intervention does not disentangle the domestic money supply from the foreign exchange transactions. It may lead to inflation. • Sterilized intervention results in a change in the country’s foreign reserves but no change in the domestic money supply. It does not lead to inflation. © 2002 by Stefano Mazzotta

International monetary - IMF • • • 6 About the IMF The IMF is an international organization of 184 member countries. It was established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment. see Since the IMF was established its purposes have remained unchanged but its operations — which involve surveillance, financial assistance, and technical assistance — have developed to meet the changing needs of its member countries in an evolving world economy. International Monetary Fund (IMF) World Bank – Helps economic development © 2002 by Stefano Mazzotta

7 World Bank • It was founded in 1944, the World Bank Group is one of the world's largest sources of development assistance. • The Bank provided US$19. 5 billion in loans to its client countries in fiscal year 2002, • It is now working in more than 100 developing economies • The World Bank is owned by more than 184 member countries • Member countries are shareholders who carry ultimate decisionmaking power in the World Bank. • The Bank uses its financial resources, its highly trained staff, and its extensive knowledge base to individually help each developing country onto a path of stable, sustainable, and equitable growth. © 2002 by Stefano Mazzotta

8 World Bank cont’ • The main focus is on helping the poorest people and the poorest countries, but for all its clients the Bank emphasizes the need for: – Investing in people, particularly through basic health and education – Focusing on social development, inclusion, governance, and institution-building – Strengthening the ability of the governments to deliver quality services, efficiently and transparently – Protecting the environment Supporting and encouraging private business development – Promoting reforms to create a stable macroeconomic environment, conducive to investment and long-term planning. • Through its loans, policy advice and technical assistance, the World Bank supports a broad range of programs aimed at reducing poverty and improving living standards in the developing world. © 2002 by Stefano Mazzotta

2. Monetary Policy and Exchange Rate Regimes © 2002 by Stefano Mazzotta

Major monetary policy regimes • Exchange-rate targeting – Ex: Argentina – Before the crisis • Monetary targeting – Ex: Switzerland • Inflation targeting – Ex: BCE, UK, US • Economic growth targeting (implicit anchor) – Ex: US © 2002 by Stefano Mazzotta 10

11 Exchange rate regimes • Fixed. There are several possibilities: – fixing the value of the domestic currency to a commodity (e. g. gold), – fixing the value of the domestic currency to that of a large, low-inflation country, – adopting a pegging target in which the home currency is allowed to fluctuate within narrow margins. • Floating. There are two main possibilities: – managed float, – independent float © 2002 by Stefano Mazzotta

12 Exchange rate targeting (I) • Advantages: – Fixes the inflation rate for internationally traded goods keeping inflation under control – Inflation expectations in the home country are tied to those of the target country – Forces to have tight fiscal and monetary policies – Simplicity and clarity of the policy © 2002 by Stefano Mazzotta

13 Exchange rate targeting (II) • Disadvantages: – Leads to the loss of independent monetary policy – Directly transmits shocks from the target country – Leaves a country open to a speculative attack on its currency – Increases the possibility of a financial crises in developing countries © 2002 by Stefano Mazzotta

14 Monetary targeting • Advantages: – Allows the Central Bank to adjust its monetary policy quickly in response to domestic needs – Information on achieving the goal of the monetary policy is known to the public and market almost immediately • Disadvantages: – There must be a clear relation between the monetary aggregate and more visible goal variable (inflation) – The Central bank must efficiently control the targeted monetary aggregate © 2002 by Stefano Mazzotta

15 Inflation targeting • Advantages: – Allows the monetary policy to be focused on domestic needs – Easily understood by the public and policy makers. – Increases accountability of the Central Bank • Disadvantages: – May lead to low and unstable output growth and employment – May put too stringent bounds on policy makers to respond to unforeseen economic circumstances © 2002 by Stefano Mazzotta

16 Implicit targeting • Advantages: – Demonstrated empirical success on the U. S. economy in the 90’s – Forward-looking, “preemptive” monetary policy • Disadvantages: – Lack of transparency – Strong dependence on personal skills and preferences © 2002 by Stefano Mazzotta

Floating vs. fixed exchange rate regimes • Advantages of floating regimes: – Offsets cross-country differences in inflation, so that employment, output, wages need not change – Can stabilize nominal exchange rates if countries pursue coordinated monetary policies • Disadvantages of floating regimes: – Potentially leads to high real exchange rate volatility – Increases uncertainty about future government policies – Increases uncertainty for the private sector © 2002 by Stefano Mazzotta 17

3. Conclusions for the Currency © 2002 by Stefano Mazzotta

19 Currency reputation • They are many determinants of a currency reputation. The Central Bank reputation is one of the main ones. • A country where the Central Bank is able to maintain the relative stability of price levels ends up having a strong (hard) currency, while a country where the Central Banks is unable to maintain the relative stability of price levels ends up having a weak (soft) currency. © 2002 by Stefano Mazzotta

20 The ideal currency 1) Must have fixed value with respect to major currencies 2) Must be convertible, so that there are no restrictions on the flow of capital from one country to another 3) Must support independent monetary policy which will ensure that a country can pursue the best economic policy 4) It is usually not possible to achieved these three attributes at the same time though. © 2002 by Stefano Mazzotta

21 Today’s major currencies AUD Australian Dollar EUR Euro GBP British Pound NZD New Zealand Dollar CAD Canadian Dollar CHF Swiss Franc DKK Danish Krone JPY Japanese Yen SEK Swedish Krona USD United States Dollar © 2002 by Stefano Mazzotta

22 Eurocurrencies • Definition: – A eurocurrency is a domestic currency deposit in a foreign country (not necessarily European!) • Purpose: – A way for holding excess corporate liquidity – A major source of short-term bank loans • Major creators of the market – The United States and … the Soviet Union © 2002 by Stefano Mazzotta

4. A New Currency: the Euro © 2002 by Stefano Mazzotta

24 Europe in numbers © 2002 by Stefano Mazzotta

The European Monetary System (EMS) 25 • Started in 1979 • Members in total: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, U. K. • Currency unit: ECU - a composite currency based on a weighted average of the currencies of 15 states of the European Union. • Exchange rate regime: - narrow target zone arrangement. © 2002 by Stefano Mazzotta

The Maastricht Treaty (1991) 26 • Fixes the single currency as the monetary goal to achieve before the end of the decade • Gives the necessary conditions (convergence criteria): inflation, long-term interest rates, deficit and debt. • Defines the role of the new Central Bank • Confirms the open market economy with free competition as the economic environment (previous step decided in 1986 for 1992) © 2002 by Stefano Mazzotta

27 A very difficult road • Currency crises: 1992, 1993 • Economic crises: impossible convergence criteria • Political crises: Denmark, France, UK • A lot of uncertainty till the end: which countries? Which parities? Which date of beginning? • Conclusion: an incredible success © 2002 by Stefano Mazzotta

The European Monetary Union (EMU) • Started in 1999 • Members: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Greece. • Currency unit: EURO - a currency of the European Monetary Union. • Exchange rate regime: exchange arrangement. © 2002 by Stefano Mazzotta 28

29 Potential benefits of sharing a single currency • Political: – A building block in pan-European nation • Economic: – – – No uncertainty of intra-euro exchange rates More efficient price discovery process Reduction in transaction costs for intra-euro trade Lower costs of maintaining transaction balances Increased flow of capital across EMU members Using it instead of dollar in international transactions © 2002 by Stefano Mazzotta

30 Current situation • Big countries have hard time keeping their budget deficit low: what to do? • Large disparities in the economic situation of the countries: which countries should the Central Bank monitor the most? • In economic slow down: is inflation targeting still relevant? • It is becoming a stable/strong currency: does it mean anything? • The role of Germany: from model to obstacle? © 2002 by Stefano Mazzotta