1

The International Monetary System (IMS)

• Official Part of the International Financial System

• Presents a Structure within which Exchange rates are determined Trade and capital flows are accommodated Balance of payments adjustments are made

• Includes instruments, institutions, and agreement which link together the world’s financial and commodity markets

• Exchange Rate Systems Exchange rate systems can be classified

according to the degree by which exchange rates are controlled by the government.

• Fixed• Freely Floating• Managed Float• Pegged

2

World Trade and the International Monetary System

• Integration of the world’s marketsfor goods and services Creation of the World Trade Organization (WTO)

Emergence of China as a major trading partner

Global trend toward free-market economies

Industrialization of the Far East and Pacific Rim

Emergence of central and eastern Europe

Reunification of East and West Germany

Hong Kong’s 1997 return to China

Introduction of the euro

• Integration of financial markets An increase in cross-border financing

Increasingly interdependent national financial markets

An increasing number of cross-border mergers, acquisitions, and joint ventures

An increasing number of cooperative linkages among securities exchanges

3

History of the international monetary system

• 1971 - Exchange rate turmoil Dollar falls off the gold standard Most currencies float on world markets

• 1971 - Smithsonian Agreement (G-10) dollar devalued to $38/oz of gold other currencies revalued against the dollar 4.5% band adopted

• 1972 - European Joint Float Agreement “The snake” adopted by EEC

• 1976 - Jamaica Agreement Floating rates are declared “acceptable”

• 1979 - European Monetary System (EMS) European Exchange Rate Mechanism (ERM) established to maintain EEC

currencies within a 2.25% band around central rates European currency unit (ECU) created

• 1985 - Plaza Accord (G-10) The Group of Ten agree to cooperate in controlling exchange rate volatility

and bringing down the value of the dollar

• 1987 - Louvre Accord (G-5) The Group of Five agree to maintain current exchange rate levels

• 1991 - Treaty of Maastricht EC members agree to a broad agenda of economic, financial and monetary

reforms A single European currency is proposed as the ultimate goal of monetary

union

• 1999 - Introduction of the euro Emu-zone currencies pegged to the euro European bonds convert to the euro

• 2002 - Euro begins public circulation

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Gold Standard (1821-1914)

• Gold is the dominant international money• Currencies are valued in terms of a gold

equivalent• All players had to adhere to the rules of the game• Government intervention• International reserves• Limited growth of the money supply• Automatic balance of payment adjustments• Gold Exchange Standard

(1925-1931) Each currency is freely convertible into gold at a

fixed rate but also into other currencies at relatively stable prices.

Greater convenience for international traders and investors.

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Bretton Woods System (1944-1971) Fixed Rates with Narrow Bands

• A dollar based system• Maintain a fixed, or pegged, exchange rate in terms of gold or the U.S.

dollar• Dollar per gold value of $35.00• Allow currencies to fluctuate within a narrow band of ±1%.• Government intervention• International reserves

• World Bank which now includes International Bank for Reconstruction and Development International Development Association International Finance Corporation Multilateral Investment Guarantee Agency International Centre for Settlement of Investment Disputes

• International Monetary Fund (IMF) Responsible for ensuring the stability of the international financial system Compiles balance-of-payments statistics

• Exchange rate systems• Pegged or fixed exchange rate systems

Forges a direct link between inflation differentials and employment levels Can result in large adjustments

• Floating exchange rate systems Allows exchange rates to adjust for inflation differences Allows employment levels and wages to equalize through the exchange rate

mechanism

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Smithsonian Agreement (1971-1973) Fixed Rates with Wider Bands

• Dollar per gold value was changed to $38.02• Allow currencies to fluctuate within a wider band

of ±2.25%.• Eclectic Currency Arrangement

Free or Clean Float (March 1973) Managed or Dirty Float (January 1976) Joint Float - European Monetary System (March

1979)• Freely Floating Exchange Rate System

Market forces determine the exchange rate No government intervention No need for international reserves Independent monetary and fiscal policies No capital flow restrictions Price instability

• Contemporary Currency Regimes IMS (national currencies, artificial currencies,

composite currency) Exchange Rate Regimes (8)

• Rigidly fixed system (euro area)• Independently floating (developed and emerging

market countries)

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Recent exchange rate arrangements

FX regime

Africa Asia/Pacific

Europe/Mid East

Americas

No separate

legal tender

WAEMU

CAEMC

Marshall Is, Micronesia

Euro Area

Ecuador, Panama

Currency board or fixed peg

Libya, Sudan, Zimbabwe

China, HK, Malaysia Taiwan,

Iran, Kuwait, Saudi Arabia, Syria

Argentina Bahamas,

Suriname

Crawling peg or horiz band

Egypt Denmark Israel

Bolivia, Venezuela

Source: International Financial Statistics, April 2003 (as of Dec 2001)

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Recent exchange rate arrangements

FX regime

Africa Asia/Pacific

Europe/Mid East

Americas

Managed float

Algeria, Ethiopia

Kenya, Nigeria

India, Indonesia Singapore, Thailand

Croatia, Iraq, Russian Fed., Yugoslavia

Dom. Rep, Guatemala, Jamaica, Trinidad

Independent float

Mozambique, S. Africa, Uganda

Afghanistan, Australia, Japan, S. Korea

Czech Rep, Norway Poland, SwedenTurkey, Switzerland, UK

Brazil, Canada, Chile, ColombiaMexico, Peru, United States

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Major exchange rate agreements

1946 Bretton Woods Conference

1971 Smithsonian Agreement

1972 European Joint Float Agreement

1976 Jamaica Agreement

1979 European Monetary System (EMS) created

1985 Plaza Accord

1987 Louvre Accord

1991 Treaty of Maastricht

1999 Introduction of the euro

2002 Euro begins public circulation

• History of the international monetary system• 1946 Bretton Woods Conference

The U.S. dollar is convertible into gold at $35/ounce Other currencies are pegged to the dollar Created the IMF and the World Bank

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Fixed versus Flexible Exchange Rates

• Preference for Fixed Exchange Rates Price stability Anti-inflationary Large international reserves Inconsistency with economic fundamentals

• Attributes of the Ideal Currency Fixed value Convertibility Independent monetary policy

• Emerging Markets and Regime Choices A currency board is a system for maintaining the value of

the local currency with respect to some other specified currency.

Dollarization refers to the replacement of a local currency with U.S. dollars

• Currency Board System• Argentina (1991)• Fixed Rate System• 100% Reserve System• Monetary Policy and Money Supply• Dollar-Denominated Accounts (interest differential)• End of Argentine Currency Board (2002)

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Currency Board System

• Characteristics No Central Bank No Discretionary Monetary Policy

• Advantages Promotes price stability Responsible fiscal policy

• Disadvantages Sharp contraction in money supply High interest rates

• Dollarization Use of U.S. dollar as the official currency

• Panama, Ecuador, Liberia Requires change in structure and responsibilities of

monetary policy authorities Arguments for:

• Removes currency volatility against dollar• Expectations of greater economic integration

Argument against:• Loss of sovereignty over monetary policy• Loss of power of seignorage• Loss of role of lender of last resort

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The Birth of a European Currency: The Euro

• European Monetary System Target Zone Arrangement Pegged Exchange Rate System Joint Float Agreement

• European Monetary Union Why Monetary Unification Launch of the Euro How to Achieve Monetary Unification

• Target Zone Arrangement Member countries maintain fixed exchange rates

within a flexible range, called target zone, among themselves.

Each member’s currency is pegged to all the other members’ currencies.

The group as a whole floats jointly against the rest of the world.

• The EMS:A Joint Float Agreement EMS members peg their currencies to each other. Exchange outside the EMS is subject to a managed

float. Objective: Exchange rate stability

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Maastricht Treaty (December 1991)

• Common European Currency - Euro Fixed rate system Replaces individual national currencies

• European Central Bank (ECB) Issues common currency Conducts monetary policy

• The Maastricht Treaty Criteria Inflation not to exceed that in three EU states with the lowest rate

by more than 1.5%. Long-term interest rates not to exceed that in three EU states with

the lowest inflation rates by more than 2%. The annual fiscal deficit not to exceed 3% of GDP. Cumulative public debt not to exceed 60% of GDP. A country must have maintained its membership in the EMS for

two years without having initiated a devaluation.• Monetary Unification

Why Monetary Unification?• A single currency area called euro zone• Competing globally

How to Achieve Monetary Unification• Fiscal policy• Monetary policy• Fixing the value of the euro

Performance of The Euro

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Currency crises

• Recent currency crises Mexican peso crisis of 1995 Asian contagion of 1997 Russian ruble crisis in 1998 Argentinian peso crisis of 1998

• Contributing factors in each crisis A fixed or pegged exchange rate system that

overvalued the local currency A large amount of foreign currency debt

• Transmission Mechanisms Trade Links Financial System

• Emerging Market Currency Crises Origins

• Moral Hazard• Fundamental Policy Conflict

Policy Proposals• Currency Controls• Free Float• Fixed Exchange Rates

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The debate over IMF lending

• Proponents of IMF lending policies believe Short term loans help countries overcome

temporary crises

• Critics of IMF lending believe Belt-tightening is counterproductive Capital market liberalizations increase risks Loans are often spent supporting unsustainable

exchange rates IMF loans last for decades IMF remedies benefit developed countries

• IMF lending and moral hazard• Moral hazard

The existence of a contract can change the behaviors of parties to the contract

• The IMF’s challenge develop policies that promote economic stability and ensure that the consequences of poor

investment decisions are borne by investors and not taxpayers