Lecture 8

 International Monetary System

o Global Capital Markets

o Eurocurrencies
 If I am Canadian and have CAD in Europe, or I’m Australian and have
Australian dollars in Canada, both are eurocurrencies
 Domestic currencies of one country on deposit in a second country
 Any convertible currency can exist in “Euro-” form
 Don’t confuse this with the European Euro
 Eurocurrency markets serve two valuable purposes:
 Money market device for excess corporate liquidity
 Source of short-term bank loans
o Eurocurrency Interest Rates: LIBOR
 Reference rate of interest, The London Interbank Offered Rate
 Used in standardized quotations, loan agreements, or financial
derivatives valuations
 US LIBOR= man of 16 multinational banks interbank offered rates as
sampled at 11am London time.
o The Potential Limits of Financial Globalization
 Frictions in the system: agency problems
 People who run a business may not choose the best thing to do
 Alignment of incentives are not perfectly aligned.
 Make a system in place to make things as flexible as possible.
o The Evolution of Capital Mobility

o The Gold Standard, 1876-1913

 Countries set par value for their currency in terms of gold
 Exchange rates were in effect “fixed”
 Gold reserves were needed to back a currency’s value
 Worked until WW1, which interrupted trade flows and free
movement of gold
 If you wanted to print more money, you had to have more gold in
your country
 The problem was to have more money, the only way was to have
more gold
o The Interwar Years and WW1, 1914-1944
 This system doesn’t work (gold standard) so let us float, markets
determine the currency
 Currencies were allowed to fluctuate in terms of gold and each other
 Aftermath of WW1: US dollar was the only major trading currency
that continued to be convertible
 Asymmetrical, everyone didn’t have access to the same information
 Some individuals have more advantage over others
 Short selling: you are anticipating something going down in value,
you sell it today, when it goes down you buy it. You make money off
of it.
o Bretton Woods and the IMF, 1944
 Allied powers met in Bretton Woods, NH and created a post-war
international monetary system
 Facilitate international trade!
 US dollar based monetary system that created the IMF and World
Bank
 Countries fixed their currencies in terms of gold but were not
required to exchange their currencies
  Need US dollars to print more money, every country still had gold
you were allowed to use them too.
 Devaluation was allowed up to 10% without formal approval from
the IMF.
o The IMF
 Primary goal: country having trouble with economy, they help with
loans and etc.
 Like a bank account, countries put money in their currencies
 The key institution in the new international monetary system and
was created to:
 Help countries defend their currencies against cyclical,
seasonal, or random occurrences.
 Assist countries having structural trade problems if they
promise to take adequate steps to correct these problems
 Special Drawing Right (SDR) serves as a unit of account for
the IMF and other international and regional organizations
o Fixed exchange rates, 1945-1973
 People starting to question the US economy, concerns
 Diverging fiscal and monetary policies and external shocks caused the
system’s demise.
 Heavy capital outflows of dollars became required to meet investor’s
and deficit needs and eventually created a lack of confidence in the
US’s ability to convert dollars to gold.
 Maybe US dollar is not the one that we should be using.
 We are going to allow it float.
o Floating Era, 1973-1977
 Exchange rates became much more volatile and less predictable than
they were during the fixed period
 Several emerging market currency crises
 EMS restructuring (1992), and the introduction of Euro (1999)
o Emerging Era, 1997-Present
 Growth in emerging market economies and currencies.
o The Impossible Trinity
 The ideal currency possesses three attributes:
 Exchange rate stability
 Full financial integration
 Advantage: incentivize people to invest in your
country, system with more flexibility
 Monetary independence
 allowed to print you own money or not
 European countries gave up monetary independence
to have exchange rate stability: All use Euro now
o Taxonomy of Exchange Rate
o Hard peg
o Soft peg
 you allow some movement around the exchange rate,
fluctuate around that fixed rate
o Free floating rate
 whatever happens happens,
o Managed flows
 whatever happens happens, but once in a while country
can intervene
o Crawling peg
 I wanted a rate I wanted to go to, manage it to get to the
new rate
o Fixed vs. Flexible exchange rates:
o France wants Maple syrup, CAD value goes up, but CAD has
a fixed value, when demand goes up you have to increase
your supply to keep the equilibriums
o A nation’s choice as to which currency regime to follow
reflects national priorities about all facets of the economy,
including:
o Inflation
o Unemployment
o Interest rate levels
o Trade balances
o Economic growth
o The choice between fixed and flexible rates may change
over time as priorities change.

o Emerging Markets and Regime Choices

o No one knows what’s going to happen in the future.
o Next class: We are going to talk about The Balance of Payments