Lecture 4
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International Finance FINA 5331
Lecture 4: History of Monetary Institutions Read: Chapters 2 Aaron Smallwood Ph.D.
Review • The international gold standard has two advantages: – Prices are very stable since the money supply is directly connected to the amount of gold. – There are not any major distortions associated with the balance of payments. • PRICE SPECIE FLOW MECHANISM
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.
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 $35 per ounce and other currencies were pegged to the U.S. dollar. • Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. • The U.S. was only responsible for maintaining the gold parity. • Under Bretton Woods, the IMF was created. • The Bretton Woods is also known as an adjustable peg system. When facing serious balance of payments problems, countries could re-value their exchange rate. The US and Japan are the only countries to never re-value.
The Fixed-Rate Dollar Standard, 1945-1971 • In practice, the Bretton Woods system evolved into a fixed-rate dollar standard. Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, 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 German mark
British pound r a P lue Va
French franc
Par Value
Pa Va r lue
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)
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 1965
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
Lecture 4: History of Monetary Institutions Read: Chapters 2 Aaron Smallwood Ph.D.
Review • The international gold standard has two advantages: – Prices are very stable since the money supply is directly connected to the amount of gold. – There are not any major distortions associated with the balance of payments. • PRICE SPECIE FLOW MECHANISM
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.
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 $35 per ounce and other currencies were pegged to the U.S. dollar. • Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. • The U.S. was only responsible for maintaining the gold parity. • Under Bretton Woods, the IMF was created. • The Bretton Woods is also known as an adjustable peg system. When facing serious balance of payments problems, countries could re-value their exchange rate. The US and Japan are the only countries to never re-value.
The Fixed-Rate Dollar Standard, 1945-1971 • In practice, the Bretton Woods system evolved into a fixed-rate dollar standard. Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, 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 German mark
British pound r a P lue Va
French franc
Par Value
Pa Va r lue
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)
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 1965
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
