International Finance FINA 5331 Lecture 5: A History of Monetary Arrangements

International Finance
FINA 5331
Lecture 5:
A History of Monetary Arrangements
Read: Chapters 2
Aaron Smallwood Ph.D.
International Monetary Arrangements
•  International Monetary Arrangements
in Theory and Practice
–  The International Gold Standard, 1879-1913
–  Bretton Woods Agreement, 1945-1971
–  Smithsonian Agreement 1971-1973
–  The Floating-Rate Dollar Standard,
•  Jamaica Agreement 1976
–  The Plaza-Louvre Intervention Accords (1985
and 1987) and the Floating-Rate Dollar
Standard, 1985-1999
•  What exchange rate systems exist today?
–  The choice between a fixed system and a flexible
•  How does another country’s exchange rate
system affect you? How does China’s changing
exchange rate system affect you?
•  What are currency crises and how can they
impact your business?
•  What is the euro? Will the euro-zone expand?
How does expansion of the euro-zone affect
The International Gold Standard, 1879-1913
Fix an official gold price or “mint parity”
and allow free convertibility between
domestic money and gold at that price.
•  Countries unilaterally elected to follow the rules of
the gold standard system, which lasted until the
outbreak of World War I in 1914, when European
governments ceased to allow their currencies to be
convertible either into gold or other currencies.
The International Gold Standard, 1879-1913
For example, during the gold standard,
the dollar is pegged to gold at :
U.S.$20.67 = 1 ounce of gold
The British pound is pegged at :
£4.2474 = 1 ounce of gold.
The exchange rate is determined by the
relative gold contents: $20.67 = £4.2474
$4.866 = £1
The International Gold Standard, 1879-1913
•  Highly stable exchange rates under the
classical gold standard provided an
environment that was conducive to
international trade and investment.
•  Misalignment of exchange rates and
international imbalances of payment were
automatically corrected by the pricespecie-flow mechanism.
Price-Specie-Flow Mechanism
•  Suppose Great Britain experienced a balance
of payments imbalance associated with an
official settlements surplus.
•  This cannot persist under a gold standard.
–  Net export of goods from Great Britain to France will be
accompanied by a net flow of gold from France to Great
–  This flow of gold will lead to a lower price level in France and,
at the same time, a higher price level in Britain.
•  The resultant change in relative price levels
will slow exports from Great Britain and
encourage exports from France.
The International Gold Standard, 1879-1913
•  With stable exchange rates and a
common monetary policy, prices of
tradable commodities were much
equalized across countries.
•  Real rates of interest also tended toward
equality across a broad range of
•  On the other hand, the workings of the
internal economy were subservient to
balance in the external economy.
The International Gold Standard, 1879-1913
•  There are shortcomings:
–  The supply of newly minted gold is so restricted that the
growth of world trade and investment can be hampered for
the lack of sufficient monetary reserves.
–  Even if the world returned to a gold standard, any national
government could abandon the standard.
–  Countries with large gold holdings may be able to exert an
inordinate influence on the global economy.
–  Prices are stable only to the extent that the relative price of
gold to goods and services is stable.
The Relationship Between Money and Growth
•  Money is needed to facilitate economic transactions.
•  MV=PY →The equation of exchange.
•  Assuming velocity (V) is relatively stable, the quantity
of money (M) determines the level of spending (PY)
in the economy.
•  If sufficient money is not available, say because gold
supplies are fixed, it may restrain the level of
economic transactions.
•  If income (Y) grows but money (M) is constant, either
velocity (V) must increase or prices (P) must fall. If
the latter occurs it creates a deflationary trap.
•  Deflationary episodes were common in the U.S.
during the Gold Standard.
Interwar Period: 1918-1941
•  Exchange rates fluctuated as countries
widely used “predatory” depreciations of their
currencies as a means of gaining advantage
in the world export market.
•  Attempts were made to restore the gold
standard, but participants lacked the political
will to “follow the rules of the game”.
•  The result for international trade and
investment was profoundly detrimental.
•  Smoot-Hawley tariffs
•  Great Depression
Economic Performance and Degree of Exchange Rate
Depreciation During the Great Depression
Bretton Woods System: 1945-1971
•  Named for a 1944 meeting of 44
nations at Bretton Woods, New
•  The purpose was to design a postwar
international monetary system.
•  The goal was exchange rate stability
without the gold standard.
•  The result was the creation of the IMF
and the World Bank.
Bretton Woods System: 1945-1971
•  Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.
•  Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par value
by buying or selling foreign reserves as necessary.
•  The U.S. was only responsible for maintaining the
gold parity.
•  Under Bretton Woods, the IMF and World Bank were
•  The Bretton Woods is also known as an adjustable
peg system. When facing serious balance of
payments problems, countries could re-value their
exchange rate. The US and Japan are the only
countries to never re-value.
The Fixed-Rate Dollar Standard, 1945-1971
•  In practice, the Bretton Woods system
evolved into a fixed-rate dollar standard.
Industrial countries other than the United States :
Fix an official par value for domestic currency in terms
of the US$, and keep the exchange rate within 1% of
this par value indefinitely.
United States : Remain passive in the foreign change
market; practice free trade without a balance of
payments or exchange rate target.
Bretton Woods System: 1945-1971
U.S. dollar
Pegged at $35/oz.
Purpose of the IMF
The IMF was created to facilitate the
orderly adjustment of Balance of
Payments among member countries by:
•  encouraging stability of exchange rates,
•  avoidance of competitive devaluations,
•  providing short-term liquidity through loan
facilities to member countries
Composition of SDR
(Special Drawing Right)
Today: The SDR
•  $/SDR: 1.54576
–  Number of dollars: 0.66
•  $ equivalent: 0.66 (42.7%)
–  Number of euros: 0.423
•  $ equivalent: 0.555568 (35.9%)
–  Number of pounds: 0.111
•  $ equivalent: 0.179620 (11.6%)
–  Number of yen: 12.1
•  $ equivalent: 0.150572 (9.74%)
Collapse of Bretton Woods
•  Triffin paradox – world demand for $ requires U.S. to
run persistent balance-of-payments deficits that
ultimately leads to loss of confidence in the $.
•  SDR was created to relieve the $ shortage.
•  Throughout the 1960s countries with large $ reserves
began buying gold from the U.S. in increasing
quantities threatening the gold reserves of the U.S.
•  Large U.S. budget deficits and high money growth
created exchange rate imbalances that could not be
sustained, i.e. the $ was overvalued and the DM and
£ were undervalued.
•  Several attempts were made at re-alignment but
eventually the run on U.S. gold supplies prompted
the suspension of convertibility in September 1971.
•  Smithsonian Agreement – December 1971
The Floating-Rate Dollar Standard, 1973-1984
•  Without an agreement on who would set
the common monetary policy and how it
would be set, a floating exchange rate
system provided the only alternative to
the Bretton Woods system.
The Floating-Rate Dollar Standard, 1973-1984
Industrial countries other than the United States :
Smooth short-term variability in the dollar exchange rate,
but do not commit to an official par value or to long-term
exchange rate stability.
United States : Remain passive in the foreign exchange
market; practice free trade without a balance of
payments or exchange rate target. No need for sizable
official foreign exchange reserves.
The Plaza-Louvre Intervention Accords and
the Floating-Rate Dollar Standard, 1985-1999
•  Plaza Accord (1985):
–  Allow the dollar to depreciate following
massive appreciation…announced that
intervention may be used.
•  Louvre Accord (1987) and “Managed
–  G-7 countries will cooperate to achieve
exchange rate stability.
–  G-7 countries agree to meet and closely
monitor macroeconomic policies.
Value of $ since 1973
IMF Classification of Exchange Rate
Independent floating
Managed floating
Exchange rate systems with crawling bands
Crawling peg systems
Pegged exchange rate systems within horizontal
•  Conventional pegs
•  Currency board
•  Exchange rate systems with no separate legal tender