Chapter 2 International Monetary System PDF

easier external adjustments ARGUMENTS IN FAVOR OF FLEXIBLE...

easier external adjustments ARGUMENTS IN FAVOR OF FLEXIBLE EXCHANGE RATES national policy autonomy exchange rate uncertainty may hamper international trade & investment ARGUMENTS AGAINST FLEXIBLE EXCHANGE RATES no safeguards to prevent crises...but do they Fixed vs. Flexible Exchange Rate really work in fixed exchange rates? Regimes sufficient liquidity to support the growth of international trade & investment short term, speculative capital inflows are mechanism for adjustment that restores the AN IDEAL INTERNATIONAL MONETARY SYSTEM potentially very destabilizing especially in fixed balance of payments disequilibrium SHOULD PROVIDE exchange rate regimes the best safeguard is "credibility" not the safeguard to prevent crises of confidence in a complex set of agreements, rules & "unofficial promise of a bailout" the system mechanisms regarding exchange rates, international payments and capital flows International Monetary System the institutional framework within which China is a top trading power & the second- international payments are made, movements of largest economy but the renminbi (RMB) lacks capital are accommodated & exchange rates global prominence due to limited capital among currencies are determined market openness the RMB joined the IMF's Special Drawing Rights (SDR) in 2016 a "double standard" in that free coinage was maintained for both gold and silver Rise of Chinese RMB China is reducing barriers to capital flows & promoting RMB use internationally exchange rates among currencies were BIMETALLISM: BEFORE 1875 determined by their gold or silver contents full convertibility since the exchange ratio between the 2 metals open, liquid capital markets to become a global currency, the RMB needs was officially fixed, the abundant metal was GRESHAM'S LAW used as money while the scarce metal was driven out of circulation strong rule of law & property rights gold alone is assured of unrestriced coinage in 1991, Argentina's Convertibility Law pegged there is 2-way convertibility between gold & peso to the US dollar at parity an international gold standard exists when... national currencies at a stable ratio initially, inflation dropped, foreign investment gold can be freely exported or imported surged and the economy boomed SITUATION the exchange rate between any 2 currencies in the late 1990s, a stronger dollar caused the will be determined by the gold contents peso to appreciate, hurting exports & leading to a prolonged downturn London became the center of the international financial system peso-dollar parity was abandoned in 2002, Argentine Peso Crisis triggering severe economic & political turmoil Suppose the pound (£) is pegged to gold at six pounds (£6) per ounce, whereas one ounce of lack of fiscal discipline gold is worth 12 francs (₣) - £6 = 1 oz. gold labor market inflexibility ORIGINS - ₣12 = 1 oz. gold contagion from the financial crises in Brazil & Deducing from the information above, £6 must Russia EXAMPLE equal ₣12. £6 = ₣12; therefore £1 = ₣2. => Exchange rate between the pound and the on 02/07/1997, the Thai baht was devalued, franc should then be two francs per pound triggering capital flight across Asia highly stable exchange rates that are conducive the crisis escalated into a severe global CLASSICAL GOLD STANDARD: 1875 TO 1914 for international trade SITUATION financial crisis money supply cannot get out of control and it cause a prolonged recession in East Asia, cause inflation because gold is naturally scarce previously the fastest-growing region ADVANTAGES larger imports => lower gold reserves, lower weak domestic financial system with poor risk money supply, lower domestic prices levels, management & supervision no country can have a persistent trade deficit higher demand for domestic goods both inland or surplus because countries' balance of and abroad => lower trade deficit free international capital flows that resulted in payments will be regulated automatically via a credit boom & speculations in real estate & the movements of the gold vice versa for largers exports stock markets lack of sufficient monetary reserves due to the fixed (or stable) exchange rates encouraged restricted supply of gold can hamper the unhedged financial transactions & excessive FACTORS RESPONSIBLE CRISIS Asian Currency Crisis growth of world trade investment risk-taking by both borrowers & lenders SHORTCOMINGS no mechanism to compel each major country to booming economy with a monetary police tied abide the rules of the game to the fixed exchange rate also brought about an appreciation of the real exchange rate, which led to a slowdown in export growth currency must be turned into gold, at the official rate Japan's long-lasting recession hurt neighboring countries too gold flows must be free & help adjust trade imbalances THE RULES OF THE GAME financial market liberalization combined with weak domestic systems increases vulnerability the CB must not lower interest rates or increase to crises money supply to counterbalance the deflationary pressure due to lower gold reserve LESSONS the central bank must not "sterilize" the impact a fixed exchange rate Evolution of the International of free gold flows Monetary System the CB must not increase interest rates or the "incompatible trinity" states it is nearly lowering money supply to counterbalance free international capital flows inflation due to higher gold reserves impossible to achieve... independent monetary policy World War I ended the classical gold standard in August 1914 on 20/12/1994, Mexico devalued the peso by attempts were made to restore the gold 14%, triggering rapid sell-offs of pesos, stocks, standard, but they failed and bonds INTERWAR PERIOD: 1915 TO 1944 The Federal Reserve's inaction and tight by 01/1995, the peso had dropped 40%, forcing period marked by the Great Depression & other monetary policy during the Great Depression a free float economic & political instabilities were major contributing factors to the severity Chapter 2: The and duration of the economic collapse the crisis spread to other Latin American & Asian markets Mexican Peso Crisis International no coherent international monetary system during this period, with detrimental impact on the Peso crisis was the first major financial crisis Monetary System international trade & investment driven by cross-border portfolio capital flight to design a postwar international monetary 2 LESSONS PURPOSE system that would provide exchange rate stability without the gold standard dollar-based gold exchange standard whereby formally launched in 1979 US dollar was pegged to gold and other currencies were pegged to the US dollar to establish a "zone of monetary stability" in Europe US dollar was the only currency fully RESULT convertible to gold to coordinate exchange rate policies vis-à-vis GOALS the non-EMS currencies dominance of US dollar as the global currency EUROPEAN MONETARY SYSTEM to pave the way for the eventual European creation of the IMF and the World Bank monetary union economizes on gold European Currency Unit (ECU) -> percursor of BRETTON WOODS SYSTEM: 1945 TO 1972 the euro countries can earn interest on FX holdings MAIN INSTRUMENTS Exchange Rate Mechanism (ERM) -> went ADVANTAGES lower transaction costs without the through a series of realignments and paved the transportation of gold way for the EMU each national currency of the euro-11 countries stable exchange rates was irrevocably fixed to the euro at a conversation rate as of 1/1/1999 Triffin predicted flaws in the global monetary system, leading to its collapse in the 1970s euro notes and coins were introduced to circulation on 1/1/2002, while national bills and EUROPEAN MONETARY UNION reserve currency countries enjoy "exorbinant coins were being gradually withdrawn privilege" (cheap borrowing, unlimited debt, global dominance) THE TRIFFIN PARADOX the first time that sovereign countries voluntarily gave up their monetary to meet global reserve demand, they must run independence to foster economic integration balance of payments deficits monetary police for the euro zone countries these deficits undermine confidence in the currency, especially if gold reserves are Frankfurt insufficient EUROPEAN CENTRAL BANK flexible exchange rates were declared primary objectve is to maintain price stability acceptable to the IMF members; central banks could intervene in exchange markets to iron out independence is legally guaranteed unwarranted volatilities made up of the ECB and central banks of the FLEXIBILE EXCHANGE RATE REGIME: SINCE gold was officially abandoned (demonetized) euro-zone countries 1973 TO PRESENT as an international reserve asset Euro & European Monetary Union define & implement common monetary police EUROSYSTEM non-oil-exporting countries and less-developed of the Union countries were given greater access to IMF funds conduct foreign exchange operations DESIGNED TO hold & manage official foreign reserves of euro member states currency of another country circulates as the sole legal tender NO LEGAL TENDER OF A DOMESTIC reduced transaction costs CURRENCY example: Ecuador, Panama & El Salvador elimination of exchange rate uncertainty extreme form of the fixed exchange rate regime enhanced efficiency & competitiveness of the European economy local currency is fully backed by a foreign KEY BENEFITS CURRENCY BOARD currency at a fixed exchange rate leaving little room for discretionary monetary policy development of continental capital markets with depth & liquidity comparable to those in the US example: Hong Kong -> USD, Bulgaria -> EUR... BENEFITS AND COSTS OF MONETARY UNION country formally pegs its currency at a fixed political cooperation & peace in Europe rate to another currency or basket of currencies CONVENTIONAL PEG loss of national monetary & exchange rate example: Jordan -> USD, Nepal -> INR policy independence, making it hard to deal MAIN COST with asymmetric shocks value of the currency is maintained within certain margins of fluctuation of at least +/- the key criterion for an optimum currency area 1% around a fixed central rate (OCA) or common currency zone is the degree PEGGED EXCHANGE RATE WITH HORIZONTAL of factor mobility within the zone BANDS or the margin between the max. and min. value of the exchange rate exceeds 2% intra–euro-zone trade constitutes approximately 60% of the foreign trade of euro-zone countries the currency is adjusted in small amounts at a PROSPECTS OF THE EURO fixed rate or in respone to changes in selected indicators the impact of asymmetric shocks has CRAWLING PEG diminished in recent years, while the importance of common shocks has increased example: Honduras and Nicaragua entails a spot market exchange rate that the euro is becoming the second global Current Exchange Rate remains within a margin of 2% for 6 months or currency, challenging the dollar's dominance Arrangements more PEG WITH STABILIZED ARRANGEMENT example: Vietnam, Nigeria & Lebanon all -> USD put into circulation by governments FIAT CURRENCIES "managed floating" have no intrinsic values backed by claims on underlying real assets like gold... exchange rate must remain within a narrow margin of 2% relative to a statistically CRAWLING PEG WITH A BAND digital currency designed to function as a identified trend for 6 months or more, and the "medium of exchange" exchange rate cannot be considered floating through a decentralized network of computers example: Singapore -> USD/CNY/JPY/EUR, that keep public records of transaction data CRYPTO "CURRENCY" Romania -> EUR using mostly cryptographic technology residual category used when the exchange rate no involvement of governments or central banks arrangement does not meet the criteria for any of the other categories Cryptocurrencies OTHER MANAGED ARRANGEMENT a digital version of the fiat currency issued by the central bank example: China, Argentina CENTRAL BANK DIGITAL CURRENCY the majority of central banks are actively exhange rate is largely market determined researching the potential for CBDCs, but they without an ascertainable or predictable path have not yet been formally adopted anywhere for the rate FLOATING first & most important => Bitcoin example: Brazil, Turkey, India... unit of accounting intervention occurs only exceptionally and aims to address disorderly market conditions given the extreme volatility of its price => medium of exchange Bitcoin unsuitable to serve the functions of CRYPTO ASSETS money intervention has been limited to at most 3 FREE FLOATING instances in the previous 6 months, each lasting storage of value no more than 3 business days Bitcoin has been used as a highly speculative example: Canada, Australia, Mexico, Japan , US, asset class UK, euro zone