3 - International Monetary System

Question 1

International Monetary System (IMS)

Answer 1

Refers to the set of policies, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchange for another

Question 2

What are the four alternative exchange rate systems?

Answer 2

1. Free float
2. Managed float
3. Target-zone arrangement
4. Fixed-rate system

Question 3

Exchange rate systems: Free Float (inc. problems)

Answer 3

• Market forces of supply and demand determine rates
• Forces influenced by: price levels, interest rates, economic growth
• Problems: volatile export industries, price level and uncertain exchange rate acts as a tax on trade and foreign investment (investors lose confidence)

Question 4

Exchange rate systems: Managed Float (Dirty Float)

Answer 4

• Most countries that adopt floating rate attempt to SMOOTH OUT EXCHANGE RATE FLUCTUATIONS through the intervention of the central bank.
• Three categories of central bank interventions:
  1. smoothing out daily fluctuations, 2. leaning against the wind, 3. unofficial pegging

Question 5

Managed float: smoothing out daily fluctuations

Answer 5

• Gov doesn’t resist fundamental market forces
• Gov intervenes occasionally on the buy or sell side to smooth out the fluctuation of exchange rate
• The intervention is consistent with a long term goal (app or depn)
• “Crawling Peg”: local currency depreciates against another currency (or basket) on a regular controlled basis (e.g. Brazil 1990-2000)

Question 6

Managed float: leaning against the wind

Answer 6

• Used to DELAY (not resist) the effects of random events whose effects are expected to be only temporary
• Purpose is to reduce uncertainties surrounding export and import
• Monetary policy of US and other developed countries, seriously effects the currencies of developing currencies

Question 7

Managed float: unofficial pegging

Answer 7

• There is no publicly announced government commitment to a give exchange rate
• But government intervention, often unrelated to market forces, is observed

Question 8

Exchange rate systems: Target-zone arrangement

Answer 8

Rate determination:
-market forces constrained to upper and lower range of rates
-members to the arrangement adjust their national economic policies to maintain target
E.g. Eurpoean monetary system (didn’t work due to conflicting policies)

Question 9

Exchange rate systems: Fixed rate system

Answer 9

• Government maintains target rates
• If rates threatened, central banks buy/sell currency (e.g. China)
• Monetary policies become subordinate of the exchange rate
• Bretton Woods system (1946-71)
• Potential problems: volatile prices

Question 10

The Trilemma of Exchange Rate Regime choice

Answer 10

Policy makers would like to achieve each of the following three goals:
1. Stable exchange rate
2. Independent monetary policy
3. Capital market integration
However, the trilemma is that in pursuing two of these goals, the country must forgo the third

Question 11

Trilemma: example of China

Answer 11

• Buys foreign currency which creates inflation
• Then sterilises through OMOs (to reduce MS)
• So interest rate goes up which attracts foreign capital
• So it must impose capital controls

Question 12

Trilemma: examples of complete cap controls, pure float and credible fixed

Answer 12

• Complete capital controls: Bretton Woods, Argentina, Malaysia
• Pure float: Aus, US, UK
• Credibly fixed: gold standard, Hong Kong