International Monetary Systems

Question 1

What does the choice of a particular exchange rate regime depend on?

Answer 1

The choice of a particular exchange rate regime depends on the relative importance that a nation places on various policy objectives like low inflation, external stability, credibility of monetary policy, international competitiveness, among others.

Question 2

What is the trilemma and exchange rate regime choice?

Answer 2

The impossible trinity of international finance stems from the fact that in general, economic policy makers would like to achieve each of the following 3 goals:
1) stable exchange rate
2) an independent monetary policy
3) capital market integration
The policy maker’s trilemma is that in pursuing any two of these goals, the country must forgo the third.

Question 3

In the trilemma and exchange rate regime choice, why do policy makers want a stable exchange rate?

Answer 3

A stable exchange rate makes it easier and less risky for businesses and individuals to buy, sell and invest overseas

Question 4

In the trilemma and exchange rate regime choice, why do policy makers want an independent monetary policy?

Answer 4

With a monetary policy independence, a nation can use its control over the money supply and interest rates to help stabilise the economy

Question 5

In the trilemma and exchange rate regime choice, why do policy makers want capital market integration?

Answer 5

Opening the country’s economy to international flows of capital allows for better capital allocation, improved portfolio diversification by investing abroad, and a lower cost of capital.

Question 6

How can a country have monetary independence and capital market integration? Examples

Answer 6

When it has pure float.
US, UK, euro vs the world

Question 7

How can a country have monetary independence and exchange rate stability? Examples

Answer 7

Complete capital controls.
Bretton Woods, Argentina, Malaysia

Question 8

How can a country have capital market integration and exchange rate stability? Examples

Answer 8

Credibly fixed
Gold standard, Hong Kong, within Eurozone

Question 9

What happened when nations ignored the principles of the trilemma and attempted to fully all 3 policy objectives?

Answer 9

They achieved a currency crash.
Examples: Mexico, Russia, Thailand, Brazil, Korea, Indonesia

Question 10

How do some countries ration and control their currencies?

Answer 10

They use capital controls

Question 11

What is the most draconian situation of capital control?

Answer 11

When all foreign exchange earnings must be surrendered to the central bank/government, which, in turn, appropriates these funds.

Question 12

What are typical currency control measures?

Answer 12

• restricting or prohibition of certain remittance categories (e.g. dividends and royalties)
• ceiling on direct foreign investment outflows
• controls on overseas portfolio investments
• import restrictions
• required surrender of hard-currency export receipts to the central bank
• limitations on prepayments for imports

Question 13

More typical currency control measures:

Answer 13

• requirements to deposit in interest-free accounts with the central bank, for a specified time, some percentage of the value of imports and/or remittances
• foreign borrowings restricted to a minimum or maximum maturity
• ceilings on granting credit to foreign firms
• imposition of taxes and limitations on foreign-owned bank deposits
• multiple exchange rates for buying and sellin foreign currencies, depending on category of goods or services each transaction fall into

Question 14

What is a free float mechanism?

Answer 14

In a free float mechanism, as economic conditions change, market participants will adjust their current and expected future currency needs.

Question 15

What does the freely floating nature of the exchange rate in response to market forces allows?

Answer 15

It allows it to act as an automatic stabiliser. A negative shock to the economy usually results in a fall in the exchange rate, which cushions the adjustment to the shock by stimulating exports and contracting imports.

Question 16

What is the downside of the free float mechanism?

Answer 16

The exchange rate volatility of a free float mechanism gives rises to an increase in risk and often substantially affects MNCs profits.

Question 17

What is a managed float mechanism?

Answer 17

In a managed float mechanism, countries with floating currencies try to smooth exchange rate fluctuation, through central bank interventions.

Question 18

Managed float fall into what 4 categories of central bank intervention?

Answer 18

1) smoothing out daily fluctuations
2) crawling peg
3) leaning against the wind
4) unofficial pegging

Question 19

What does smoothing out daily fluctuations mean?

Answer 19

Rather than resisting fundamental market forces, the government occasionally enter the market on the buy or sell side to ease the transaction from one rate to another. The smoother transaction tends to bring about longer-term currency appreciation or depreciation.

Question 20

What does crawling peg mean?

Answer 20

Crawling peg is one variant of smoothing out daily fluctuations, used overtime by countries such as Poland, Russia, Brazil, Costa Rica and China. Under crawling peg, the local currency depreciates against a reference currency or a basket on a regular and controlled basis.

Question 21

What does leaning against the wind mean?

Answer 21

Leaning against the wind is an intermediate policy designed to moderate or prevent abrupt short- and medium-term fluctuations. The rational is to delay, rather than resisting, fundamental exchange rate changes.

Question 22

What is unofficial pegging?

Answer 22

Unofficial pegging involves resisting, for reasons clearly unrelated to exchange market forces, any fundamental upward or downward exchange rate movements.

or a finger in the ass

Question 23

What is a target-zone agreement?

Answer 23

Countries adjust their national economic policies to maintain their exchange rates within a specific margin around the agree upon fixed central exchange rates.

Question 24

True or false: The Target-zone arrangementexisted for the major European currencies participating in the European Monetary System (EMS) and was the precursor to the euro.

Answer 24

True

Question 25

What is a fixed rate system?

Answer 25

Governments are committed to maintaining target exchange rates. Each central bank actively buys or sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than the agreed-on percentage.

Question 26

What is needed for the fixed rate system?

Answer 26

For this system to work each member must accept the group’s joint inflation rate as its own. This implies that monetary policy must become subordinated to exchange rate policy.

Question 27

What is the gold standard?

Answer 27

The gold standard involves a commitment by the participating countries to fix prices of their domestic currencies in terms of a specified amount of gold. Countries maintained these prices by being willing to buy or sell gold to anyone at that price.

Question 28

What is the main advantage of the gold standard?

Answer 28

The main advantage of the gold standard is that it ensures stability, because the price of goods relative to the price of gold does not change over long periods of time.

Question 29

When did the gold standard broke down?

Answer 29

During World War I and was briefly reinstated from 1925 to 1931 as the Gold Exchange Standard. Under this standard, the U.S. and England could hold only gold reserves, but other nations could hold gold, dollar and pounds as reserves.

Question 30

What is the Bretton Woods System?

Answer 30

Under Bretton Woods Agreement, implemented in 1946, each government pledged to maintain a fixed, or pegged, exchange rate for its currency vis-à-vis the dollar or gold. As one ounce of gold was set equal to $35, fixing a currency’s gold price was equivalent to setting its exchange rate relative to the dollar.

Question 31

In the Bretton Woods System, how much was the exchange rate allowed to fluctuate?

Answer 31

1% of its stated par value (usually less in practice)

Question 32

In the Bretton Woods System, how were the fixed exchange rated maintained?

Answer 32

By official intervention in the foreign exchange markets. The intervention took form of purchases and sales of dollars by foreign central banks against their own currency.

Question 33

Why was Bretton Woods a fixed exchange rate system in name only?

Answer 33

In practice, most governments perceived large political cost accompanying any exchange rate changes. Most governments also were unwilling to coordinate their monetary policies, even though it was necessary to maintain the currency values. Of the 21 major industrial countries, only the U.S. and Japan had no change in par value from 1946 to 1971.

Question 34

What were the reasons for the Bretton Woods System?

Answer 34

1) inflation increased in the US, mainly due to the Vietnam war being funded by printing money
2) some countries like Germany, Japan and Switzerland refused to accept the inflation that a fixed exchange rate with the dollar would have imposed on them

Question 35

When and with what purpose did the European Monetary Systems (EMS) began?

Answer 35

March 1979 with the purpose of fostering stability in the European Community (EC)

Question 36

What was the European Currency Unit (ECU)?

Answer 36

The European Currency Unit (ECU) was a composite currency composed of fixed amounts of the 12 European Community members currency. The ECU functioned as a unit of account, a means of settlement, and a reserve asset for the members of the EMS.

Question 37

What happened in 1992?

Answer 37

In 1992, the EC become the European Union (EU), that currently is composed by 27 countries (after the Brexit).

Question 38

What is the Exchange Rate Mechanism (ERM)?

Answer 38

At the start it was an Exchange Rate Mechanist (ERM), which allowed each member of the EMS to determine a mutually agreed-on central exchange rate for its currency. Each rate was denominated in currency units per ECU.

Question 39

What did nations participating in the ERM pledged to do?

Answer 39

to keep their currencies within a 15% margin, with
interventions usually set with changes of ± 2.5%

Question 40

Why did the exchange rate mechanism fail?

Answer 40

This mechanism failed mainly due to different policies adopted by members: Germany put a premium on price stability, while French pursued expansionary policies, in response to high domestic unemployment.

Question 41

What is the European Monetary Union?

Answer 41

Formalised in the Maastricht Treaty, the EU nations established a single central bank with the sole power to issue a single European currency called the euro as of January 1999. In January 1999, conversion rates would be locked in for member currencies.

Question 42

What did the members needed to do to join the European Monetary Union (EMU)?

Answer 42

In order to join the European Monetary Union (EMU) the members needed to agree to meet thRough standards on inflation, currency stability and deficit spending. Government’s deficits could not exceed 3% of GDP and the government debt could not be higher than 60% of GDP.

Question 43

Which is the government agency that may intervene in the foreign exchange markets to control a currency’s value?

Answer 43

Central Bank