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CHAPTER 3
The InternationalMonetary System
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PART I. ALTERNATIVE EXCHANGERATE SYSTEMS
I. FIVE MARKET MECHANISMS A. Freely Floating (Clean Float)1. Market forces of supply
and demand determine
rates.2. Forces influenced bya. price levelsb. interest rates
c. economic growth3. Rates fluctuate over time
randomly.
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ALTERNATIVE EXCHANGE RATE
SYSTEMS
B. Managed Float (Dirty Float)
1. Market forces set rates unless
excess volatility occurs.
2. Then, central bank determinesrate.
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ALTERNATIVE EXCHANGE RATE
SYSTEMS
C. Target-Zone Arrangement1. Rate Determination
a. Market forces constrainedto upper and lower range of
rates.
b. Members to the arrangementadjust their national economicpolicies to maintain target.
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ALTERNATIVE EXCHANGE RATE
SYSTEMS
D.Fixed Rate System1. Rate determination
a. Government maintainstarget rates.
b. If rates threatened, centralbanks buy/sell currency.
c. Monetary policies coordinated.
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ALTERNATIVE EXCHANGE RATE
SYSTEMS
D. Fixed Rate System (con’t)2. Some Government Controls:
a. On global portfolio
investments.b. Ceilings on direct foreign
direct insurance.
c. Import restrictions.
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ALTERNATIVE EXCHANGE RATE
SYSTEMS
E. Current System
1. A hybrid system
a. Major currencies:usefreely-floating method
b. Others move in and outof various fixed-rate systems.
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PART II. A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
I. THE USE OF GOLD A. Desirable properties
B. In short run: High production costs limitshort-run changes.
C. In long run: Commodity money insuresstability.
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A BRIEF HISTORY OF THEINTERNATIONAL MONETARY SYSTEM
II.The Classical Gold Standard(1821-1914) A. Major currencies on gold standard.
1. Involved commitment bynations to fix the price of domestic currency in terms of aspecific amount of gold.
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A BRIEF HISTORY OF THEINTERNATIONAL MONETARY SYSTEM
2. Maintenance involved the buying
and selling of gold at that price.3. Disturbances in Price Levels:
Would be offset by the price-
specie*-flow mechanism.
* specie refers to gold coins
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A BRIEF HISTORY OF THEINTERNATIONAL MONETARY SYSTEM
a. Price-specie-flow mechanism
had automatic adjustments:1.) When a balance of payments surplus
led to a gold inflow;
2.) Gold inflow led to higher prices whichreduced surplus;
3.) Gold outflow led to lower prices and
increased surplus.
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
III. The Gold Exchange Standard
(1925-1931) A. Only U.S. and Britain allowed to
hold gold reserves.
B. Others could hold both gold, dollarsor pound reserves.
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
C. Currencies devalued in 1931
- led to trade wars.
D. Bretton Woods Conference
- called in order to avoid futureprotectionist and destructiveeconomic policies
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
IV. The Bretton Woods System(1946-71)
A. The Bretton Woods Agreement
1. U.S.$ was key currency;
valued at $1 = 1/35 oz. of gold.2. All currencies linked to that price in
a fixed rate system.
3. Exchange rates allowed to fluctuateby 1% above or below initially setrates.
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
B. Collapse, 1971
1. Causes:a. U.S. high inflation rate
b. U.S.$ depreciated sharply.
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
V. Post-Bretton Woods System
(1971-Present) A. Smithsonian Agreement, 1971
US$ devalued to 1/38 oz. of gold.By 1973: World on a freelyfloating exchange rate system.
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
B. OPEC and the Oil Crisis (1973-1974)
1. OPEC raised oil prices four fold;2. Exchange rate turmoil resulted;3. Caused OPEC nations to earn
large surplus B-O-P.4. Surpluses recycled to debtor nations
which set up debt crisis of 1980’s.
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
C. Dollar Crisis (1977-78)
1. U.S. B-O-P difficulties
2. Result of inconsistent monetary
policy in U.S.3. Dollar value falls as confidence
shrinks.
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
D. The Rising Dollar (1980-85)1. U.S. inflation subsides as the Fed
raises interest rates
2. Rising rates attracts global capital toU.S.
3. Result: Dollar value rises.
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
E. The Sinking Dollar:(1985-87)
1. Dollar revaluated slowly downward;
2. Plaza Agreement (1985)
G-5 agree to depress US$ further.3. The Louvre Agreement (1987)
G-7agree to support the falling US$.
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A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
F. Recent History (1988-Present)1. 1988 US$ stabilized2. Post-1991 Confidence resulted in
stronger dollar
3. 1993-1995 Dollar value falls
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PART III.
THE EUROPEAN MONETARYSYSTEM
I. INTRODUCTION
A. The European Monetary System(EMS)
1. A target-zone method (1979)2. Close macroeconomic policy
coordination required.
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THE EUROPEAN MONETARY
SYSTEM
B. EMS Objective:
to provide exchange rate stability to all
members by holding exchange rateswithin specified limits.
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THE EUROPEAN MONETARY
SYSTEM
C.European Currency Unit(ECU)
a “cocktail” of European currencies with
specified weights as the unit of account.1. Exchange rate mechanism (ERM)
each member determines mutually agreed
upon central cross-rate for its currency.
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THE EUROPEAN MONETARY
SYSTEM
2. Member Pledge:
to keep within 15% margin above or belowthe central rate.
D. EMS ups and downs1. Foreign exchange interventions failed due
to lack of support by coordinated monetarypolicies.
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THE EUROPEAN MONETARY
SYSTEM
2. Currency Crisis of Sept. 1992
a. System breaks down
b. Britain and Italy forced to withdraw fromEMS.
G. Failure of the EMS
members allowed political priorities
to dominate exchange rate policies.
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THE EUROPEAN MONETARY
SYSTEM
H. Maastricht Treaty
1. Called for Monetary Union by 1999(moved to 2002)
2. Established a single currency: the
euro3. Calls for creation of a single central EU
bank
4. Adopts tough fiscal standards
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THE EUROPEAN MONETARY
SYSTEM
I. Costs / Benefits of A Single
Currency A. Benefits
1. Reduces cost of doing business2. Reduces exchange rate risk
B. Costs
1. Lack of national monetary flexibility.
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