Chapter 8-9 International

Monetary System
You should master:
(1) Features oI a good international monetary system;
(2) Rules oI the games, and the advantages and
disadvantages oI the three international monetary
systems;
(3) The Iundamental and immediate cause Ior the
collapse oI the Bretton Woods system;
(4) Some terms, like gold points,
1.1. What is an international
monetary system?
Narrowly speaking, it reIers to international
exchange rate system.
There are three international exchange rate
systems in history: the gold standard, the
Bretton Woods, and the Iloating exchange
rate system.
1.2. Features oI a good international
monetary system
Adjustment : a good system must be able to adjust
imbalances in balance oI payments quickly and at a
relatively lower cost;
Stability and ConIidence: the system must be able to
keep exchange rates relatively Iixed and people must
have conIidence in the stability oI the system;
Liquidity: the system must be able to provide enough
reserve assets Ior a nation to correct its balance oI
payments deIicits without making the nation run into
deIlation or inIlation.
1.3 ClassiIication oI international
monetary system
gold standard,
gold exchange standard
Iiduciary standard
Floating exchange rate system
Fixed exchange rate system
II. The gold standard system(1880---1914)
Fixed Rate System
The world economy operated under a
system oI fixed dollar exchange rates
between the end oI World War II and 1973,
with central banks routinely trading Ioreign
exchange to hold their exchange rates at
internationally agreed levels.
Two kinds of the fixed
exchange rates
1. ]}]]
2. ]}]]
old Standard:]

,!!!,
2.1 Rules oI the game
Fix an oIIicial gold price or 'mint parity and allow Iree
convertibility between domestic money and gold at that
price.
Impose no restrictions on the import or export oI gold by
private citizens, or on the use oI gold Ior international
transactions.
Issue national currency and coins only with gold backing,
and link the growth in national bank deposits to the
availability oI national gold reserves.
In the event oI a short-run liquidity crisis associated with
gold outIlows, the central bank should lend Ireely to
domestic banks at higher interest rates (Bagehot`s Rule).
II Rule I is ever temporarily suspended, restore
convertibility at the original mint parity as soon as
practical.
2.2 Factors that determine or aIIect
the exchange rates
Factors that determine the exchange rates:
the mint parity
E.g. US$1 British
Factors that inIluence the exchange rates:
gold points and the demand Ior and supply
oI Ioreign exchange
2.3 Adjustment oI balance oI
payments deIicits or surpluses
Price-specie Ilow mechanism:
DeIicit gold Ilow out oI the country
gold reserve decrease money
supply decrease
quantity theory oI money
price level decrease
exchange rate Iixed
export go up, import go down, deIicit
disappear
The adjustment oI surplus is the opposite.
2.4 Remarks and comments
n international gold standard avoids the
asymmetry inherent in a reserve currency
standard - avoiding the ~Ath currenc
pro-lem. Under a gold standard, each
countr fixes the price of its currency in
terms of gold - standing read to trade
domestic currenc for gold whenever
necessar to defend the official price.
The collapse oI the gold standard system
It is virtually a pound standard system :
Britain and British pound`s position in the
system
Outbreak oI World War I.
dvantage of the Gold Standard
Because there are A currenc and A
prices of gold in terms of those currencies,
no single country occupies a privileged
position within the system: each is
responsi-le for pegging its currencs
price in terms of the official international
reserve asset, gold. Gold standard rules
also require each countr to allow
unhindered imports and exports of gold
across its -orders.
Benefits and draw-acks of the
Gold Standard
BeneIits:
1. Smmetr
. Price level and value of national mone
are more sta-le and predicta-le
3. Enhance international transactions
raw-acks:
1. Constraints on the use oI monetary policy to
Iight unemployment.
2. Tying currency values to gold ensures a stable
overall price level only iI the relative price oI
gold is stable.gold discovery in South America
3. An international payments system based on gold
is problematic because central banks cannot
increase their holdings oI international reserves
as their economies grow unless there are
continual new gold discoveries.
4. The gold standard gives gold-producing
countries power to inIluence the world economy
The Gold Exchange Standard
alIway between the gold standard and a pure
reserve currency standard is the gold exchange
standard. Central banks` reserves consist oI gold
and currencies whose prices in terms oI gold are
Iixed, and each central bank Iixes its exchange
rate to a currency with a Iixed gold price.
More flexibility in the growth oI international
reserves.
3. The Bretton Woods System1944-1973
3.1 ow this system came into being
The harms and disasters that the two Wars
brought the world.
3.2 Rules oI the game
Fix an oIIicial par value Ior domestic currency in
terms oI gold or a currency tied to gold as a
numeraire.
In the short run, keep the exchange rate pegged
within 1 oI its par value, but in the long-run
leave open the option to adjust the par value
unilaterally iI the IMF concurs.
Permit Iree convertibility oI currencies Ior current
account transactions, but use capital controls to
limit currency speculation.
ixed Exchange Rates under
currenccirculation sstem
[|;1944
Bretton Woods agreement
';

dollar

135
1
ow to sustain the ixed Rate
1. Use gold reserves''
2. By making use oI discount policies'
'
3. Foreign exchange controls'
]'
4. OIIicial devaluations'last resort'
3.3 Features oI the system
IMF to see that this system runs on
smoothly
More Ilexibility in exchange rates
More channels to correct imbalances in
balance oI payments
3.4 Adjustment oI balance oI
payments imbalances
OIIset short-run balance oI payments
imbalances by use oI oIIicial reserves and
IMF credits, and sterilize the impact oI
exchange market interventions on the
domestic money supply
Adjust Iundamental imbalances by change
the par value permanently, provided agreed
by the IMF
3.4 Adjustment oI balance oI
payments imbalances
Subordinate domestic monetary and Iiscal policies
to maintain Iixed exchange rate (use monetary
policy to keep price level and Iiscal policy---
government expenditures minus tax revenues--- to
oIIset imbalances between private savings and
investment):
DeIicit contractionary monetary or Iiscal
policy price level decrease
exchange rate
Iixed
export go up, import go down, deIicit
disappear
The adjustment oI surplus is the opposite.
3.5 Remarks and comments
Advantages
Disadvantages: exchange rates are not
Ilexible, TriIIin Paradox
TriIIin Paradox
U.S. run deficits U.S. run deficits
U.S. run surplus U.S. run surplus
liquidity
conIidence
3.6 Collapse oI the Bretton Woods
System: Process oI dollar devaluation
D
o
l
l
a
r

v
a
l
u
e


p
e
r

o
u
n
c
e

o
I

g
o
l
d
1944 1971 1973
11
35
38
42.22

Abandoned old Exchange
Standard
The post-World War II reserve currency system
centered on the dollar was, in Iact, originally set up
as a gold exchange standard. While Ioreign central
banks did the job oI pegging exchange rates, the
U.S. Federal Reserve was responsible Ior holding
the dollar price oI gold at $35 an ounce. By the
mid-1960s, the system operated in practice more
like a pure reserve currency system than a gold
standard. President Nixon unilaterally severed the
dollar's link to gold in August 1971, shortly
beIore the system oI Iixed dollar exchange rates
was abandoned.
. The present Floating Exchange Rate
System (1973-present)
4.1 ow this system came into being
sstem of no sstem n order of no order
eatures of this sstem
1. Ao par values, between home currency and foreign
currency or gold
2. Ao upper or lower limits of exchange rate fluctuations
3. The government has no obligation to maintain exchange
rate Iixed, it can choose any kind oI exchange rate
system, Ilexible rates are legal
4. ]
. }
4.2 Rules oI the game
Smooth short-term variability in the dollar exchange rate,
but do not commit to an oIIicial par value or to long-term
exchange rate stability
Permit Iree convertibility oI currencies Ior current account
transactions, while endeavoring to eliminate all remaining
restrictions on capital account transactions
Use the U.S. dollar as the intervention currency and keep
oIIicial reserves primarily in U.S. treasury bonds
ModiIy domestic monetary policy to support major
exchange rate interventions, reducing the money supply
when the national currency is weak against the dollar and
expanding the money supply when the national currency is
strong
4.3 Features oI this system
More currencies can be used as reserve
assets
overnments began to cooperate to
intervene in the Ioreign exchange markets
and to coordinate their domestic policies to
achieve 'common prosperity
Many diIIerent kinds oI exchange rates
appear
Types oI Iloating exchange rates
Whether there is a dirty hand:
1. Free Float/Clean Float
2. Managed Float/Dirty Float
Whether there is a Connection with other
currencies:
1. Single Float ''27
2. Pegged Float(1) '(2)
'SDR; ECU;
3. Joint Float|;
4. Crawling peg
4.4 Adjustment oI imbalances in
balance oI payments
IMF credits
Change oI exchange rates: devaluations or
revaluations
Coordination between governments: the
Plaza Agreement, the Lourve Accord, etc
Domestic policies: 'Two-gap theory
CIXCSTM
X-M(S-I)(T-)
5. Should we return to a Iixed rate
system?
What kind oI international monetary system
should we adopt?
What are the advantages and disadvantages
oI Iixed and Iloating exchange rate system
respectively?
5.1 Arguments Iavoring Iloating rates
1. Better adjustment
2. Better conIidence
3. Better liquidity
4. ains Irom Ireer trade
5. Avoiding the so-called 'Peso Problem
6. Increased independence oI policy
5.2 Arguments against Iloating
exchange rates: Flexible rates
1. Cause uncertainty and inhibit international
trade and investment
2. Cause destabilizing speculation
3. Will not work Ior open economies
4. Are inIlationary
5. Are unstable because oI small trade
elasticities
6. Cause structural unemployment
rugman & ObstIeld (1)
1. Discipline. Central banks Ireed Irom the
obligation to Iix their exchange rates might
embark on inIlationary policies.
2. Destabilizing speculation and money market
disturbances. Speculation on changes in
exchange rates could lead to instability in Ioreign
exchange markets.
3. Injury to international trade and investment.
Floating rates would make relative international
prices more unpredictable.
rugman & ObstIeld (2)
4. &ncoordinated economic policies. The door
would be opened to competitive currency practices
harmIul to the would economy.
5. 1he illusion of greater autonomy. Floating
exchange rates would not really give countries
more policy autonomy. Changes in exchange rates
would have such pervasive macroeconomic eIIects
that central banks would Ieel compelled to
intervene heavily in Ioreign exchange markets
even without a Iormal commitment to peg.
5.3 Selection oI Fixed & Floating
Exchange Rates
}]]|]
'