The International Monetary System

Question 1

What are floating or flexible rates?

Answer 1

They fluctuate according to market forces. They depreciate (decrease in value of one currency against another) and appreciate (rise in the value of one currency against another)

Question 2

What are fixed exchange rates?

Answer 2

They do not fluctuate and are constant over time. They can have a devaluation (official reduction in the par value of a currency by the government of that currency) and a revaluation (official increase in the par value of a currency by the government of that currency)

Question 3

What is the gold standard?

Answer 3

• from 1876-1913
• Gold has been medium of exchange since 300BC
• each country would set a rate at which its currency could be converted to a weight of gold
• exchange rates were fixed
• Expansionary monetary policy was limited to government supply of gold
• In effect until WW1

Question 4

What is Bretton Woods and the International Monetary Fund?

Answer 4

-1945 to 1973
- Established in 1944 as a fixed exchange rate system by the international monetary fund (IMF)
- Dollar pegged to gold and all other currencies were set at fixed rates against the dollar
- Dollar only currency convertible to gold and main international reserve currency
- Foreign banks buy/sell dollars to keep parity. This caused involuntary decrease and increase in foreign money supplies
- US has monetary independence
- BOP imbalances to be offset by a buffer stock of international reserves and IMF credits

Question 5

What is IMF

Answer 5

key institution in the new international monetary system. Created to:
- Help countries defend their currencies against cyclical, seasonal or random occurences
- Assist countries having structural trade problems if they promise to take adequate steps to correct these
- Special drawing rights is the IMF reserve assets. Weighted average of five currencies including the Chinese Renminbi

Question 6

What caused the demise of fixed exchange rates?

Answer 6

• US dollar became main reserve currency which resulted in a consistent and growing BOP deficit which required heavy capital outflow of dollars.
• Heavy overhang of dollars held by foreigners resulted in a lack of confidence in the US to meet its commitment to convert dollars to gold
• Lack of confidence forced President Nixon to suspend purchase/sale of gold by US treasury on august 15, 1971.
• Caused devaluation of the dollar and currencies were allowed to float to levels determined by market forces

Question 7

What is the floating era?

Answer 7

• 1973-1997
• Exchange rates are much more volatile and less predictable than they were during the fixed period

Question 8

What is the emergin era?

Answer 8

• Emerging market economics and their currencies are multiplying in number and growing in complexity

Question 9

What are the four categories of IMF classification of currency regimes?

Answer 9

Category 1: Hard Pegs (13.0%)
– Countries that have given up their own sovereignty over monetary policy
– E.g., dollarization or currency boards

*Category 2: Soft Pegs (39.6%)
– AKA fixed exchange rates, with five subcategories of classification

*Category 3: Floating Arrangements (37%)
– Mostly market-driven, these may be free floating or floating with occasional government intervention

Category 4: Residual (10.4%)
– The remains of currency arrangements that don’t well fit the previous categorizations

Question 10

What are fixed exchange rates?

Answer 10

It is pegged to something

Hard peg: Extreme currency regime peg forms such as currency boards and dollarization

Soft Peg: Fixed exchange rates where authorities maintain a set band about some other currency

Question 11

What are floating exchange rates?

Answer 11

They are market driven.

Managed float: market forces of supply/demand set exchange rate with occasional government intervention

free Float: market forces of supply/demand set exchange rate with NO government intervention

Question 12

How is the choice between fixed vs flexible exchange rates determined?

Answer 12

Decision reflects national priorities about all facets of the economy such as inflation, unemployment, interest rates, trade balances, economic growth.

Choice between fixed/flexible could change over time

Question 13

Why would a country prefer a fixed rate regime and what could be the problems with a fixed rate regime?

Answer 13

Prefer: stable international prices and anti-inflationary nature

Problems: Need for central bank to maintain large quantity of hard currencies and gold to defend rate and the maintained rates can be inconsistent with economic fundamentals.

Question 14

Why would a country prefer a floating rate regime and what could be the problems with a floating rate regime?

Answer 14

Prefer: Monetary policy autonomy, easier excahnge rate adjustments, avoid currency crises.

Problem: Detrimental for global trade!

Question 15

Review global outloon of IMF

Answer 15

OKAY its on slides 20/21

Question 16

What are the three “prices” of money/

Answer 16

– Price relative to time → interest rate
– Price relative to foreign → currency exchange rate
– Price relative to all goods and services → aggregate
price level (price deflator)

Question 17

What is GDP

Answer 17

Market value of all final goods and services produced by a country in a give year. (Remember real vs nominal GDP)

Question 18

How is domestic money created? (Central and commercial banks)

Answer 18

Central: Buys assets and pays for these assets by creating liabilities (Currency, member bank deposits, treasury deposits)

Commercial: Take deposits and lending out most of the funds received contributes to money supply or M1. (the currency is in circulation and demand deposits) Money is also created by writing loans against reserves (money multiplier depends on legal reserve requirement and how much public is willing to hold)

Question 19

What is monetary policy?

Answer 19

The central bank’s way of controlling the moeny supply and credit.

Tools: Discount rate, reserve requirement, open market operations.

Objective: stimulate GDP, lower unemployment and inflation, target a level of exchgange rate.Wh

Question 20

What are the trade offs with monetary policy?

Answer 20

When GDP increases, likely that inflation increases.

Question 21

What are open market operations?

Answer 21

OMOs, they are tools for changing short-term interest rates.

They affect the monetary base which is the portion of commercial banks’ reserves that are maintained in accounts with teh central bank plus the total currency in circulation.

Question 22

What are open market purchases vs open market sales?

Answer 22

Purchases:
1. Inject liquidity
2. Increase monetary base
3. Money supply increases

Sales:
1. Withdrawal of liquidity
2. Monetary base decreases
3. Money supply decreases

Question 23

What is fiscal policy?

Answer 23

Done by government through taxes and spending.

Objectives: Manage aggregate demand and stimulate GDP/reduce unemployment

Used to manage surpluses and deficits (debt = accumulation of deficits)

Important metrics: Deficit to GDP, Debt to GDP and Debt service

Question 24

What are the attributes of the ideal currency system?

Answer 24

The impossible trinity: 1) Exchange rate stability; 2) Full financial integration; 3) Monetary independence

Forces of economics do not allow all three to be achieved simultaneously (look at graph slide 29)

Question 25

What is a currency board?

Answer 25

When a country’s central bank commits to back its monetary base/money supply entirely with foreign reserves.

Means that no new domestic currency can be introduced without additional units of foreign exchange reserves

Question 26

What is dollarization?

Answer 26

Its the use of U.S dollars as the official currency. The advantage is that sound monetary and exchange-rate policies no longer depend on the intelligence and discipline of domestic policymakers

(Panama and Ecuador)

Question 27

What are the currency regime choices for emerging markets and why is it dificult

Answer 27

Experts think that its best to be on either extreme (hard peg or free-floating)

Difficulties:
1. Weak fiscial, financial and monetary institutions
2. Tendencies for commerce to allow currency substitution and the denomination of liabilities in dollars
3. Emerging market vulnerabilities to sudden stoppage of outside capital flows

Question 28

Why would (or not) and emerging market choose Free-floating regime?

Answer 28

• Independent monetary policy
• Free movement of capital allowed but at the loss of stability and with the possibility of sudden massive capital outflows
• Increased volatility may be more than what a small economy can handle

Question 29

Why would (or not) an emerging market choose fixed rate/currency boards?

Answer 29

-Requires all exchange at the government set rate of exchange
- Currency board fixes the value of local currency to another currency or basket
- Independent monetary policy is lost
- Political influence on monetary policy is eliminated
- Seignorage which is the benefit to a government of printing its own money is lost

Question 30

What is triffin dilemma

Answer 30

Conflict in objectives between domestic monetary and currency policy objectives and external or international objectives when a country’s currency is used as a reserve

Question 31

Review structure of chinese renminbi market

Answer 31

This includes currency internationalization