Mishu Agarwal LecturerLecturer- AKGIM

Alternative exchange rate systems A brief history of the international monetary system The European monetary system Costs and benefits of a single currency

Evolution of the IMF 
    Pre 1875 Bimetallism 1875-1914: Classical Gold Standard 1915-1944: Interwar Period 1945-1972: Bretton Woods System 1973-Present: Flexible (Hybrid) System

Pre 1875 Bimetallism
A double standard in the sense that both gold and silver were used as money Some countries were on the Gold Standard some on the silver standard, some on both Both silver and gold were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents Gresham¶s Law implied that it would be the least valuable metal that would tend to circulate

The Classical Gold Standard (1875(18751914)
The Classical Gold Standard had two essential features 
Nations fixed the value of the currency in terms of Gold and  Gold is freely transferable between countries

Essentially a fixed rate system (Suppose the US announces a willingness to buy gold for $200/oz and Great Britain announces a willingness to buy gold for £100. Then £1=$2)

Interwar Period: 1915-1944 1915Periods of serious chaos such as German hyperinflation and the use of exchange rates as a way to gain trade advantage. Britain and US adopt a kind of gold standard (but tried to prevent the species adjustment mechanism from working).

Bretton Woods System:1945-1972 System:1945British pound German mark
Par Value

French franc

U.S. dollar
Pegged at $35/oz.


Bretton Woods System:1945-1972 System:1945U.S.$ was key currency valued at $1 = 1/35 oz. of gold All currencies linked to that price in a fixed rate system. In effect, rather than hold gold as a reserve asset, other countries hold US dollars (which are backed by gold)

Collapse of Bretton Woods (1971)
U.S. high inflation rate U.S.$ depreciated sharply Smithsonian Agreement (1971) US$ devalued to 1/38 oz. of gold 1973 The US dollar is under heavy pressure, European and Japanese currencies are allowed to float 1976 Jamaica Agreement 
Flexible exchange rates declared acceptable  Gold abandoned as an international reserve

Under a floating rate system, exchange rates are set by demand and supply The model of demand and supply is extremely useful in explaining exchange rates under a floating system (just make sure you keep track of what currency is purchased and what is sold). Any number of factors might influence exchange rates, including 
price levels  interest rates  economic growth

Alternate exchange rate systems: Managed Float ( Dirty Float )
Market forces set rates unless excess volatility occurs, then, central bank determines rate by buying or selling currency. Managed float isn¶t really a single system, but describes a continuum of systems 
Smoothing daily fluctuations  ³Leaning against the wind´ slowing the change to a different rate

Alternate exchange rate systems: Managed Float ( Dirty Float ) 
Unofficial pegging: actually fixing the rate without saying so.  Target-Zone Arrangement: countries agree to maintain exchange rates within a certain bound What makes target zone arrangements special is the understanding that countries will adjust real economic policies to maintain the zone.

Alternate exchange rate systems: Fixed Rate System
One way to do this is to dictate an exchange rate and shoot people who try to trade currency at anything other than the official exchange rate. Price controls are hard to enforce (and even if they could be enforced lead to a misallocation of resources)

An alternative is to simply instruct the monetary authority to buy stand willing to buy or sell currency at the desired rate

A fixed rate system is the ultimate good news bad news joke. The good is very good and the bad is very bad. 
Advantage: stability and predictability  Disadvantage: the country loses control of monetary policy (note that monetary policy can always be used to control an exchange rate).

Current Exchange Rate Arrangements (IMF Classification)
No national currency (e.g., dollars in Panama and Euros in Italy) Currency Board: Explicit commitment to fix exchange rates to some foreign currency (Hong Kong fixed to dollar) Other fixed rate systems fixing the countries currency to a single currency or some basket of currencies (allowing some narrow fluctuations of less than 1%)

Current Exchange Rate Arrangements (IMF Classification)
Crawling pegs: exchange rate adjusted at a prepre-announced rate, usually in response to some objective qualitative indicator (e.g., Costa Rica). Floating within crawling bands Managed float: authorities manipulate the exchange rate but do not announce their intentions Independent float

The Mexican Peso Crisis
On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency trader s expectations about the future value of the peso. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent

The Mexican Peso Crisis
The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border crossflight of portfolio capital. Two lessons emerge: 
It is essential to have a multinational safety net in place to safeguard the world financial system from such crises.  An influx of foreign capital can lead to an overvaluation in the first place.

The Asian Currency Crisis (1997)
In 1996 several Asian countries experienced an inflow of nearly $100 billion in foreign capital. This explosion of credit led to a kind of speculative bubble in some sectors (e.g., real estate). In mid-1997 the Thai bhat came under much midpressure. The Thai Central Bank tried to defend the bhat by drawing down foreign exchange reserves. In the end, however, they had to devalue and the bhat lost about 40% of its value

The Asian Currency Crisis (1997)
The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession.

The Argentinean Peso Crisis
In 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar at parity. The initial economic effects were positive: 
Argentina¶s chronic inflation was curtailed  Foreign investment poured in

As the U.S. dollar appreciated on the world market the Argentine peso became stronger as well

The Argentinean Peso Crisis
The strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of peso±dollar parity in peso± January 2002. 
The unemployment rate rose above 20 percent  The inflation rate reached a monthly rate of 20 percent

The Argentinean Peso Crisis
There are at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis: 
Lack of fiscal discipline  Labor market inflexibility  Contagion from the financial crises in Brazil and Russia

Benefits of Single Currency
Reduces exchange rate risk Allows for larger capital markets which may provide greater liquidity May promote a sense of political unity among nations sharing the currency

Costs of a Single Currency
Lack of national monetary flexibility. Leaving countries vulnerable to ³asymmetric shocks´ (problems in one country not common to all)

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