Pegging currency to gold and guaranteeing convertibility

Global Business Today 6e

by Charles W.L. Hill

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 10

The International Monetary System

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Introduction

Question: What is the international monetary system?

The international monetary system refers to the institutional arrangements that govern exchange rates

Recall that the foreign exchange market is the primary institution for determining exchange rates

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Introduction

A floating exchange rate system exists in countries where the foreign exchange market determines the relative value of a currency

Examples include the U.S. dollar, the European Union’s euro, the Japanese yen, and the British pound

A pegged exchange rate system exists when the value of a currency is fixed to a reference country and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate

Many developing countries have pegged exchange rates

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Introduction

A dirty float exists when the value of a currency is determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency

China adopted this policy in 2005

With a fixed exchange rate system countries fix their currencies against each other at a mutually agreed upon value

Prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

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Introduction

Question: What role does the international monetary system play in determining exchange rates?

To answer this question, we have to look at the evolution of the international monetary system

The Gold Standard

The Bretton Woods system

The International Monetary Fund

The World Bank

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Classroom Performance System

When the foreign exchange market determines the relative value of a currency, a ________ exchange rate system exists.

Fixed

Floating

Pegged

Market

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Lecture Script 6-*

Classroom Performance System Answer: b

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The Gold Standard

Question: What is the Gold Standard?

The origin of the gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value

To facilitate trade, a system was developed so that payment could be made in paper currency that could then be converted to gold at a fixed rate of exchange

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Mechanics of the Gold Standard

The gold standard refers to the practice of pegging currencies to gold and guaranteeing convertibility

Under the gold standard one U.S. dollar was defined as equivalent to 23.22 grains of "fine (pure) gold

The exchange rate between currencies was based on the gold par value (the amount of a currency needed to purchase one ounce of gold)

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Strength of the Gold Standard

The key strength of the gold standard was its powerful mechanism for simultaneously achieving balance-of-trade equilibrium (when the income a country’s residents earn from its exports is equal to the money its residents pay for imports) by all countries

Many people today believe the world should return to the gold standard

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The Period Between the Wars:

1918 - 1939

The gold standard worked fairly well from the 1870s until the start of World War I

After the war, in an effort to encourage exports and domestic employment, countries started regularly devaluing their currencies

Confidence in the system fell, and people began to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility

The Gold Standard ended in 1939

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The Bretton Woods System

A new international monetary system was designed in 1944 in Bretton Woods, New Hampshire

The goal was to build an enduring economic order that would facilitate postwar economic growth

The Bretton Woods Agreement established two multinational institutions

The International Monetary Fund (IMF) to maintain order in the international monetary system

The World Bank to promote general economic development

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The Bretton Woods System

Under the Bretton Woods Agreement

the US dollar was the only currency to be convertible to gold, and other currencies would set their exchange rates relative to the dollar

devaluations were not to be used for competitive purposes

a country could not devalue its currency by more than 10% without IMF approval

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The Role of the IMF

The IMF was responsible for avoiding a repetition of the chaos that occurred between the wars through a combination of

1. Discipline

a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment

a fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation

Multimedia Lecture Support Package to Accompany Basic Marketing

Lecture Script 6-*

Internet Extra: The IMF has an interactive web page designed especially for students. Go to {http://www.imf.org}. Click on For Students, then click on EconEd Online.

Several interactive activities are available to help students learn more about the IMF and its activities. For example, to see how the IMF evaluates a country, click on The IMF in Action. This interactive exercise allows students to pick an online team to help analyze a member country’s economy.

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The Role of the IMF

2. Flexibility

A rigid policy of fixed exchange rates would be too inflexible

So, the IMF was ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficits

A country could devalue its currency by more than 10 percent with IMF approval

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The Role of the World Bank

The official name of the World Bank is the International Bank for Reconstruction and Development (IBRD)

The World Bank lends money in two ways

under the IBRD scheme, money is raised through bond sales in the international capital market and borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses.

under the International Development Agency scheme, loans go only to the poorest countries

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Classroom Performance System

The gold standard was a ______ exchange rate system.

Fixed

Floating

Pegged

Market

Multimedia Lecture Support Package to Accompany Basic Marketing

Lecture Script 6-*

Classroom Performance System Answer: b

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The Collapse of the

Fixed Exchange Rate System

Question: What caused the collapse of the Bretton Woods system?

The collapse of the Bretton Woods system can be traced to U.S. macroeconomic policy decisions (1965 to 1968)

During this time, the U.S. financed huge increases in welfare programs and the Vietnam War by increasing its money supply which then caused significant inflation

Speculation that the dollar would have to be devalued relative to most other currencies forced other countries to increase the value of their currencies relative to the dollar

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The Collapse of the

Fixed Exchange Rate System

The Bretton Woods system relied on an economically well managed U.S.

So, when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point

The Bretton Woods Agreement collapsed in 1973

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The Floating Exchange Rate Regime

Question: What followed the collapse of the Bretton Woods exchange rate system?

Following the collapse of the Bretton Woods agreement, a floating exchange rate regime was formalized in 1976 in Jamaica

The rules for the international monetary system that were agreed upon at the meeting are still in place today

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The Jamaica Agreement

At the Jamaica meeting, the IMF's Articles of Agreement were revised to reflect the new reality of floating exchange rates

Under the Jamaican agreement

floating rates were declared acceptable

gold was abandoned as a reserve asset

total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion (today, this number is $311 billion)

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Exchange Rates Since 1973

Since 1973, exchange rates have become more volatile and less predictable because of

the oil crisis in 1971

the loss of confidence in the dollar after U.S. inflation jumped between 1977 and 1978

the oil crisis of 1979

the rise in the dollar between 1980 and 1985

the partial collapse of the European Monetary System in 1992

the 1997 Asian currency crisis

the decline in the dollar in the mid to late 2000s

Multimedia Lecture Support Package to Accompany Basic Marketing

Lecture Script 6-*

Country Focus: The U.S. Dollar, Oil Prices, and Recycling Petrodollars

Summary

This feature explores what oil producing nations are likely to do with the dollars they have earned. In 2008, oil prices reached new highs as a result of higher than expected demand, tight supplies, and perceived geopolitical risks. Since oil is priced in dollars, oil producers have seen their dollar reserves increase significantly. Now, speculation abounds as to what will happen to the petrodollars. Some believe that the dollars will go toward public infrastructure projects, others think that it is more likely that investments will be made in dollar denominated assets like U.S. bonds, stocks, and real estate, or in non-dollar denominated assets such as European or Japanese bonds and stocks. Discussion of the feature can revolve around the following questions:

Suggested Discussion Questions

1. With oil prices at record highs, there is significant speculation as to what oil producing states will do with the dollars they are earning. Discuss how a decision to invest in non-dollar denominated assets could affect the value of the U.S. dollar.

Suggested Discussion Points: As a result of higher demand from countries like China and India, tight supplies and perceived geo-political risks, oil prices reached a new high in 2008. For oil producing countries, this has proved to be an unexpected windfall. In 2007, the countries together earned over $1 trillion. Most students will probably recognize that if the countries decide to invest their earnings in non-dollar denominated assets, the value of the dollar could drop sharply.

2. How could a decision by oil producing countries to invest their petrodollars in public infrastructure projects help the value of the dollar?

Suggested Discussion Points: If the oil producing states invest the petrodollars in public infrastructure projects such as roads, telecommunications systems, and education, the U.S. dollar could actually rise in value. The infrastructure investments are likely to generate economic growth in the nations, which could then translate into market opportunities for U.S. firms.

Lecture Note: To extend this discussion, consider {http://www.economist.com/opinion/displaystory.cfm?story_id=11089616} and {http://www.businessweek.com/magazine/content/08_14/b4078084895408.htm?chan=search}.

Video Note: The iGlobes Oil and Gas Prices Rise Due to Pipeline Shutdown and Oil Market Focuses Attention on Middle East Conflict fit in well with this feature.

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Classroom Performance System

Floating exchange rates were deemed acceptable under

The Bretton Woods Agreement

The Gold Standard

The Jamaica Agreement

The Louvre Accord

Multimedia Lecture Support Package to Accompany Basic Marketing

Lecture Script 6-*

Classroom Performance System Answer: c

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Fixed versus Floating

Exchange Rates

Question: Which is better – a fixed exchange rate system or a floating exchange rate system?

Disappointment with floating rates in recent years has led to renewed debate about the merits of a fixed exchange rate system

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The Case for Floating

Exchange Rates

A floating exchange rate system provides two attractive features

monetary policy autonomy

automatic trade balance adjustments

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The Case for Floating

Exchange Rates

1. Monetary Policy Autonomy

The removal of the obligation to maintain exchange rate parity restores monetary control to a government

In contrast, with a fixed system, a country's ability to expand or contract its money supply is limited by the need to maintain exchange rate parity

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The Case for Floating

Exchange Rates

2. Trade Balance Adjustments

The balance of payments adjustment mechanism works more smoothly under a floating exchange rate regime

Under the Bretton Woods system (fixed system), IMF approval was need to correct a permanent deficit in a country’s balance of trade that could not be corrected by domestic policy alone

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The Case for Fixed Exchange Rates

A fixed exchange rate system is attractive because

of the monetary discipline it imposes

it limits speculation

it limits uncertainty

of the lack of connection between the trade balance and exchange rates

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The Case for Fixed Exchange Rates

1. Monetary Discipline

Because a fixed exchange rate system requires maintaining exchange rate parity, it also ensures that governments do not expand their money supplies at inflationary rates

2. Speculation

A fixed exchange rate regime prevents destabilizing speculation

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The Case for Fixed Exchange Rates

3. Uncertainty

The uncertainty associated with floating exchange rates makes business transactions more risky

4. Trade Balance Adjustments

Floating rates help adjust trade imbalances

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Who is Right?

There is no real agreement as to which system is better

History shows that fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work

A different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment

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Exchange Rate Regimes in Practice

Currently, there are several different exchange rate regimes in practice

In 2006

14% of IMF members allow their currencies to float freely

26% of IMF members follow a managed float system

28% of IMF members have no legal tender of their own

the remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs

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Exchange Rate Regimes in Practice

Exchange Rate Policies, IMF Members, 2006

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Classroom Performance System

The most common exchange rate policy among IMF members today is the

Free float

Managed float

Fixed peg

Adjustable peg

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Lecture Script 6-*

Classroom Performance System Answer: b

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Pegged Exchange Rates

Under a pegged exchange rate regime countries peg the value of their currency to that of other major currencies

Pegged exchange rates are popular among the world’s smaller nations

There is some evidence that adopting a pegged exchange rate regime moderates inflationary pressures in a country

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Currency Boards

A country with a currency board commits to converting its domestic currency on demand into another currency at a fixed exchange rate

The currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued

Additional domestic notes and coins can be introduced only if there are foreign exchange reserves to back it

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Crisis Management by the IMF

Question: What has been the role of the IMF in the international monetary systems since the collapse of Bretton Woods?

The IMF has redefined its mission, and now focuses on lending money to countries experiencing financial crises in exchange for enacting certain macroeconomic policies

Membership in the IMF has grown to 185 countries in 2007, 68 of which has some type of IMF program in place

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Financial Crises in

the Post-Bretton Woods Era

Three types of financial crises that have required involvement by the IMF are

1. A currency crisis - occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates

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Financial Crises in

the Post-Bretton Woods Era

2. A banking crisis - refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits

3. A foreign debt crisis - a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt

Two crises that are particularly significant are

the 1995 Mexican currency crisis

the 1997 Asian currency crisis

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The Mexican Currency Crisis of 1995

The Mexican currency crisis of 1995 was a result of high Mexican debts, and a pegged exchange rate that did not allow for a natural adjustment of prices

In order to keep Mexico from defaulting on its debt, a $50 billion aid package was created by the IMF