chapter 11 - international monetary system Flashcards
International monetary system
Refers to the institutional arrangements that govern exchange rates
floating exchange rate regime
when the foreign exchange market determines the relative value of currency
Exchange rates are determined by market forces and fluctuate against each other
pegged exchange rate
the value of the currency is fixed relative to a reference currency such as the US dollar (moves in accordance to the US dollar instead of the market)
Managed/dirty float system
The value of the currency is determined by market forces, but managed by the government (demand and supply)
fixed exchange rate
The values of a set of currencies are fixed against each other at some mutually agreed-on exchange rate
i.e. the EU monetary system (regardless of which countries are in the EU)
Gold standard
Pegging currencies to gold and guaranteeing convertibility
Mechanics of the gold standard
1880: the value of any currency in units of any other currency (the exchange rate) was easy to determine
Gold par value: The amount of currency needed to purchase one ounce of gold
Strengths of gold standard
balance of trade equilibrium:
the income its residents earn from exports is equal to the money its residents pay to other countries for imports
abandoned in 1914, then tried again until 1939 truly dead
The Bretton-Woods system
around WWII, 44 countries met to decide on new international monetary system. two institutions were born;
- IMF
- World bank
World bank
-initial mission was to help finance the building of Europe’s economy by providing low-interest loans
The bank returned its focus to development and began lending money to third world countries
IMF
tasked with maintaining order in the international monetary system through discipline
rights to lend but also to impose conditions + adjustable parities
world bank has two lending schemes
- IBRD
2. IDA (International development Association)
IBRD
Lends money by raising money through bond sales in the international capital market
- Borrowers pay a market rate of interest- the bank’s cost of funds plus a margin for expenses
- The bank offers low interest loans to risky customers whose credit rating is often poor, such as the governments of underdeveloped nations
IDA
Resources to fund IDA loans are raised through subscriptions of wealthy members such as the U.S, Japan and Germany.
IDA loans go to the poorest countries
Borrowers have 50 years to repay at an interest rate of less than 1% a year
collapse of bretton woods system in 1973
- ->Managed-float system now in place
- ->Traced break-up of fixed exchange rate system to US macroeconomic policy package of 1965-1968
- ->dollar devalued
Floating exchange rate regime
The jamaica agreement: floating exchange rates were acceptable, gold was a reserve asset and total annual IMF quota were increased
Exchange rates since 1973
- > more volatile
- > less predictable
- > fluctuations in dollar value
favourable factors to overcome unfavourable effect of trade deficit
Strong economic growth in US: heavy inflow of capital and high real interest rates
political turmoil in rest of the world:
the case for floating exchange rate
Monetary political autonomy
automatic trade balance adjustment
Economic recovery following severe economic crisis
Monetary political autonomy
expand or contract money supply
inflation puts pressure on a fixed system
contraction puts upward pressure on fixed system
The removal of the obligation to maintain exchange rate parity would restore monetary control to a government.
Automatic trade balance adjustment
works more smoothly under floating exchange rate, does not require the IMF to agree to currency devaluation if there is a deficit
Economic recovery
exchange rate adjustments can help a country deal with economic crisis because Reason for this is that investors respond to the crisis by taking their money out of the country, selling the local currency, and driving down its value, then it becomes so cheap it stimulates exports
The case for fixed exchange rates
- monetary discipline
- speculation
- uncertainty
- trade balance adjustments and economic recovery
Monetary discipline
ensures that governments do not expand their money supplies at inflationary rates
governments should not be able to influence inflation because they often take it too far
Speculation
with floating exchange rates, speculation can cause fluctuations in the currency value
–>damage a country’s economy by distorting export and import prices
Uncertainty
floating exchange rate has uncertainty surrounding future currency movements which adds risk to exporting, importing, and foreign investment activities (Not present with fixed) therefore it promotes the growth of international trade and investment
pegged exchange rates in practice
- Country will peg value of its currency to that of a major currency
- Popular among smaller nations
- Imposes monetary disciplines on country and leads to low inflation
Currency boards (governing bodies)
- converting its domestic currency on demand into another currency at fixed exchange rate
- Holds reserve of foreign currency equal at fixed exchange rate to at least 100 percent of domestic currency issued
- Can issue additional domestic notes and coins only when there are foreign exchange reserves to back it
Financial crisis post Bretton Woods
Currency crisis
banking crisis
foreign debts crisis
Currency crisis
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 to defend the previous exchange rate
banking crisis
Refers to a loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits
foreign debt crisis
a country cannot service its foreign debt obligations, whether private-sector or government debt
Causes of these crises
High relative price inflation rates Widening current account deficit Excessive expansion of domestic borrowing High government deficits Asset price inflation
IMF’s policy prescription
counterproductive or only had limited success
Also notable accomplishments
Currency management
Combination of government intervention and speculative activity can drive the foreign exchange market
Must adjust accordingly
Business strategy
increase strategic flexibility in the face of unpredictable exchange rate movements
Corporate-government relations
Business can influence government policy toward the international monetary system (lobbyist)
try to minimizes volatile exchange rate movements, particularly when those movements are unrelated to long run economic fundamentals
