34 The International Monetary System: Order or Disorder? Cecily, you will read your Political...

34

The International Monetary System: Order or

Disorder?Cecily, you will read your Political Economy in my

absence. The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational.

MISS PRISM IN OSCAR WILDE’S THE

IMPORTANCE OF BEING EARNEST

● What Are Exchange Rates?

● Exchange Rate Determination in a Free Market

● Fixed Exchange Rates and the Balance of Payments

● A Bit of History: The Gold Standard and the Bretton Woods System

● What Are Exchange Rates?

● Exchange Rate Determination in a Free Market

● Fixed Exchange Rates and the Balance of Payments

● A Bit of History: The Gold Standard and the Bretton Woods System

ContentsContents

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

● Adjustment Mechanism Under Fixed Exchange Rates

● Why Try to Fix Exchange Rates?

● The Current “Nonsystem”

● Adjustment Mechanism Under Fixed Exchange Rates

● Why Try to Fix Exchange Rates?

● The Current “Nonsystem”

Contents (continued)Contents (continued)


Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

● Exchange rate = price, in terms of one currency, at which another currency can be bought

● A currency appreciates when it becomes more expensive in terms of another; the other currency depreciates.

● Exchange rate = price, in terms of one currency, at which another currency can be bought

● A currency appreciates when it becomes more expensive in terms of another; the other currency depreciates.

What are Exchange Rates?What are Exchange Rates?

TABLE 34-1 Exchange Rates with the U.S. Dollar

TABLE 34-1 Exchange Rates with the U.S. Dollar



What are Exchange Rates?What are Exchange Rates?

● Appreciation and depreciation refer to exchange rate changes in free markets.

● In a system of fixed exchange rates, the corresponding movements are called revaluation and devaluation.

● Appreciation and depreciation refer to exchange rate changes in free markets.

● In a system of fixed exchange rates, the corresponding movements are called revaluation and devaluation.


● The exchange rate of a currency is determined by its supply and demand.

● The exchange rate of a currency is determined by its supply and demand.

Exchange Rate Determination in Free MarketExchange Rate Determination in Free Market

FIGURE 34-1 Determination of Exchange Rates in a Free Market

FIGURE 34-1 Determination of Exchange Rates in a Free Market


Number of Euros

D

D

S

S

$0.90

Pri

ce o

f a

Eu

ro

E


● Sources of demand: ♦ A country’s exports

♦ Foreign demand for its financial instruments like stocks and bonds

♦ Capital inflow to acquire physical assets like factories and machines

● Sources of demand: ♦ A country’s exports

♦ Foreign demand for its financial instruments like stocks and bonds

♦ Capital inflow to acquire physical assets like factories and machines



● Sources of supply:♦ A country’s imports

♦ Capital outflows for both financial and physical assets

● Sources of supply:♦ A country’s imports

♦ Capital outflows for both financial and physical assets


FIGURE 34-2 Stock Market Boom on the Exchange Rate

FIGURE 34-2 Stock Market Boom on the Exchange Rate


Number of Euros

D

D

S1

S1

0.80

Pri

ce

of

a E

uro

(i

n d

olla

rs)

$0.90 E

S2

S2

A



● Interest Rates and Exchange Rates: The Short Run♦ Massive amounts of liquid capital cross

national boundaries in search of interest rate differentials.

♦ Thus, a country that increases its interest rates will experience a capital inflow demand for its bonds ■Appreciation of its currency

● Interest Rates and Exchange Rates: The Short Run♦ Massive amounts of liquid capital cross

national boundaries in search of interest rate differentials.

♦ Thus, a country that increases its interest rates will experience a capital inflow demand for its bonds ■Appreciation of its currency



● The Medium-Run: Economic Activity and Exchange Rates♦ A country’s imports will rise quickly when its

economy booms, but rise only slowly when its economy stagnates.

● The Medium-Run: Economic Activity and Exchange Rates♦ A country’s imports will rise quickly when its

economy booms, but rise only slowly when its economy stagnates.



● The Medium-Run: Economic Activity and Exchange Rates♦ Thus, a country with a relatively high growth

rate will experience: imports demand for foreign currency■Depreciation of its own currency

● The Medium-Run: Economic Activity and Exchange Rates♦ Thus, a country with a relatively high growth

rate will experience: imports demand for foreign currency■Depreciation of its own currency



● The Purchasing-Power Parity Theory: The Long Run♦ Purchasing-power parity = exchange rates

adjust so that the same good costs the same, whatever currency it is measured in■Only applies over the long run■Thus, the exchange rate should reflect differences

in price levels

● The Purchasing-Power Parity Theory: The Long Run♦ Purchasing-power parity = exchange rates

adjust so that the same good costs the same, whatever currency it is measured in■Only applies over the long run■Thus, the exchange rate should reflect differences

in price levels

Deviations from Big Mac PPP, December 2001

Deviations from Big Mac PPP, December 2001


FIGURE 34-3 The Effect of a Rise in U.S. Interest Rates

FIGURE 34-3 The Effect of a Rise in U.S. Interest Rates


Number of Pounds

D1

D1

S1

S1

1.40

Pri

ce

of

a P

ou

nd

D2

D2

S2

S2

$1.60 E1

E2



● Market Determination of Exchange Rates: Summary♦ Exchange rates will appreciate in countries

whose:■Inflation rates are lower than other countries’■Economic growth rates are slower■Interest rates are higher

● Market Determination of Exchange Rates: Summary♦ Exchange rates will appreciate in countries

whose:■Inflation rates are lower than other countries’■Economic growth rates are slower■Interest rates are higher


● Countries can maintain fixed exchange rates by buying or selling reserves.♦ Compensates for shifts in the demand or

supply of their currencies

● Countries can maintain fixed exchange rates by buying or selling reserves.♦ Compensates for shifts in the demand or

supply of their currencies

Fixed Exchange Rates and the Balance of PaymentsFixed Exchange Rates and the Balance of Payments



● With a fixed exchange rate, the balance of payments will likely be in either surplus or deficit.

● A deficit cannot be maintained forever since the country will run out of reserves.

● With a fixed exchange rate, the balance of payments will likely be in either surplus or deficit.

● A deficit cannot be maintained forever since the country will run out of reserves.

FIGURE 34-5 A Balance of Payments Deficit

FIGURE 34-5 A Balance of Payments Deficit


Balance of payments deficit

8 4

Billions of Pesos per Year

D

D

S

S

0.50 Pri

ce o

f a

Pes

o

1.00

E

A B

FIGURE 34-6 A Speculative Run on the Peso

FIGURE 34-6 A Speculative Run on the Peso


12 8 4

Billions of Pesos per Year

D

D

S1

S1

Pri

ce o

f a

Pes

o

$1.00 B

S2

S2

C

A

FIGURE 34-7 A Balance of Payments Surplus

FIGURE 34-7 A Balance of Payments Surplus


Balance of payments surplus

E

A B 0.33

D S

S

50 40

Billions of Marks per Year

D

Pri

ce

of

a M

ark $0.50


Fixed Exchange Rates and the Balance of Payments Fixed Exchange Rates and the Balance of Payments

● Defining the Balance of Payments in Practice♦ The current account totes up exports and

imports of goods and services.■The United States has been running large current

account deficits for years.

● Defining the Balance of Payments in Practice♦ The current account totes up exports and

imports of goods and services.■The United States has been running large current

account deficits for years.



● Defining the Balance of Payments in Practice♦ The capital account includes purchases and

sales of financial assets to and from citizens and companies of other countries.■In recent years, this part of our balance of

payments accounts has registered persistently large surpluses, as foreigners have acquired U.S. assets.

● Defining the Balance of Payments in Practice♦ The capital account includes purchases and

sales of financial assets to and from citizens and companies of other countries.■In recent years, this part of our balance of

payments accounts has registered persistently large surpluses, as foreigners have acquired U.S. assets.



● Defining the Balance of Payments in Practice♦ In a system of floating exchange rates, the

exchange rates adjust in order to balance the balance of payments.

♦ In a system of fixed exchange rates, the balance of payments need not balance.

● Defining the Balance of Payments in Practice♦ In a system of floating exchange rates, the

exchange rates adjust in order to balance the balance of payments.

♦ In a system of fixed exchange rates, the balance of payments need not balance.


The Gold Standard and the Bretton Woods SystemThe Gold Standard and the Bretton Woods System

● The Bretton Woods System♦ Readjustments in exchange rates were

permitted only in cases of “fundamental disequilibrium.”

♦ Deficit nations were expected to follow restrictive monetary and fiscal policies voluntarily just as they would have done automatically under the gold standard.

● The Bretton Woods System♦ Readjustments in exchange rates were

permitted only in cases of “fundamental disequilibrium.”

♦ Deficit nations were expected to follow restrictive monetary and fiscal policies voluntarily just as they would have done automatically under the gold standard.


The Gold Standard and the Bretton Woods SystemThe Gold Standard and the Bretton Woods System

● The Bretton Woods System♦ However, just as under the gold standard, this

medicine was often unpalatable.

♦ The Bretton Woods system collapsed in 1971 in the face of the U.S. chronic balance of payments deficit.

● The Bretton Woods System♦ However, just as under the gold standard, this

medicine was often unpalatable.

♦ The Bretton Woods system collapsed in 1971 in the face of the U.S. chronic balance of payments deficit.


● Under a system of fixed exchange rates, a country’s government loses some control over its domestic economy.

● Under a system of fixed exchange rates, a country’s government loses some control over its domestic economy.

Adjustment Mechanisms Under Fixed Exchange RatesAdjustment Mechanisms Under Fixed Exchange Rates


● There may be times when balance of payments considerations force it to contract its economy even though domestic needs call for expansion AD demand for imports demand for foreign currency

● There may be times when balance of payments considerations force it to contract its economy even though domestic needs call for expansion AD demand for imports demand for foreign currency




● Conversely, there may be times when the domestic economy needs to be reined in, but balance of payments considerations suggest expansion.

● Conversely, there may be times when the domestic economy needs to be reined in, but balance of payments considerations suggest expansion.

FIGURE 34-8 Adjusting to Balance of Payments Deficits

FIGURE 34-8 Adjusting to Balance of Payments Deficits


(b)

D

D

1.00

Number of Pesos

0.50

S1

S1

(a)

D1

D1

1.00

Number of Pesos

0.50

S

S

Pri

ce

of

a P

es

o i

n D

oll

ars

Pri

ce

of

a P

es

o i

n D

oll

ars

D2

D2

A B C

S2

S2

B C A


Why Try to Fix Exchange Rates?Why Try to Fix Exchange Rates?

● Those in favor of fixed rates think that floating rates are so unpredictable that they reduce the amount of international trade.

● However, the experience with so-called “fixed rates” was that they were unpredictable and unstable.

● Those in favor of fixed rates think that floating rates are so unpredictable that they reduce the amount of international trade.

● However, the experience with so-called “fixed rates” was that they were unpredictable and unstable.


Why Try to Fix Exchange Rates?Why Try to Fix Exchange Rates?

● Speculation in foreign exchange markets smoothes out the highs and lows.

● Speculators can destabilize prices only if they are systematically willing to lose money.

● Consequently, floating rates are usually less variable than feared.

● Speculation in foreign exchange markets smoothes out the highs and lows.

● Speculators can destabilize prices only if they are systematically willing to lose money.

● Consequently, floating rates are usually less variable than feared.


The Current “Nonsystem”The Current “Nonsystem”

● Currently, some exchange rates are fixed and some are floating.

● Few people think that rates can or should be fixed for a long time.

● Even in the case of floating rates, central banks often intervene.

● Currently, some exchange rates are fixed and some are floating.

● Few people think that rates can or should be fixed for a long time.

● Even in the case of floating rates, central banks often intervene.



● Today, gold is a purely private commodity.♦ Has virtually no role in international finance

● Today, gold is a purely private commodity.♦ Has virtually no role in international finance



● The Role of the IMF♦ The role of the International Monetary Fund

(IMF) in the current non-system is quite different from what it was under the old Bretton Woods system.■No longer the policeman of fixed exchange rates■IMF has evolved into a general-purpose

international fire-and-rescue squad

● The Role of the IMF♦ The role of the International Monetary Fund

(IMF) in the current non-system is quite different from what it was under the old Bretton Woods system.■No longer the policeman of fixed exchange rates■IMF has evolved into a general-purpose

international fire-and-rescue squad



● The Volatile Dollar♦ The U.S. dollar depreciated in 1977 and 1978

♦ Appreciated sharply from 1980 through 1985

♦ Depreciated even more sharply from 1985 to 1988

♦ Fluctuated without much trend since then

● The Volatile Dollar♦ The U.S. dollar depreciated in 1977 and 1978

♦ Appreciated sharply from 1980 through 1985

♦ Depreciated even more sharply from 1985 to 1988

♦ Fluctuated without much trend since then

FIGURE 34-9 The Ups and Downs of the Dollar

FIGURE 34-9 The Ups and Downs of the Dollar


2001 1998 1994 1990 1986 1982 1978 1974

Years

Exc

han

ge

Rat

e

180

160

140

120

100

80

60

0



● The Birth of the Euro♦ As part of the long-range goal of the European

Union (EU) to create a unified market like that of the U.S., the EU perceived a need to establish a single currency for all member countries--a monetary union.

● The Birth of the Euro♦ As part of the long-range goal of the European

Union (EU) to create a unified market like that of the U.S., the EU perceived a need to establish a single currency for all member countries--a monetary union.



● The Birth of the Euro♦ Since January 1999, electronic and checking

transactions in eleven of the fifteen EU nations have been denominated in euro rather than in national currencies.

● The Birth of the Euro♦ Since January 1999, electronic and checking

transactions in eleven of the fifteen EU nations have been denominated in euro rather than in national currencies.



● The Birth of the Euro♦ Three member nations (the United Kingdom,

Sweden, and Denmark) have decided to opt out of the common currency project for now.

♦ One country (Greece) has so far been unable to qualify because its inflation rate and budget deficit are too high.

● The Birth of the Euro♦ Three member nations (the United Kingdom,

Sweden, and Denmark) have decided to opt out of the common currency project for now.

♦ One country (Greece) has so far been unable to qualify because its inflation rate and budget deficit are too high.



● The Birth of the Euro♦ In the year 2002, euro coins and paper money

are scheduled to be introduced.

♦ Then French francs, German marks, Italian lira, and at least eight other national currencies will be withdrawn from circulation--and will become relics of the past.

● The Birth of the Euro♦ In the year 2002, euro coins and paper money

are scheduled to be introduced.

♦ Then French francs, German marks, Italian lira, and at least eight other national currencies will be withdrawn from circulation--and will become relics of the past.



● The Birth of the Euro♦ The establishment of the euro marks a giant

step beyond fixed exchange rates.■Abolishes exchange rates among the participating

nations■Just as there has long been no exchange rate

between New York and New Jersey, there is now no exchange rate between Germany and France.

● The Birth of the Euro♦ The establishment of the euro marks a giant

step beyond fixed exchange rates.■Abolishes exchange rates among the participating

nations■Just as there has long been no exchange rate

between New York and New Jersey, there is now no exchange rate between Germany and France.

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