Lecture International finance: An analytical approach (3/e): Chapter 5 - Imad A. Moosa

Chapter 5 - The international monetary system and exchange rate arrangements. In this chapter, the learning objectives are: To classify international monetary systems, to outline the history of exchange rate arrangements, to outline the pros and cons of fixed and flexible exchange rates, to examine the Australian exchange rate arrangements.

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Chapter 5

The International Monetary System and Exchange Rate Arrangements

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Objectives

• To classify international monetary systems

• To outline the history of exchange rate arrangements

• To outline the pros and cons of fixed and flexible

exchange rates

• To examine the Australian exchange rate

arrangements

5-2

PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa

Slides prepared by Afaf Moosa

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Components of the IMS

• A public component consisting of a series of

agreements

• A private component represented by the banking and finance industry

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Classification according to reserve assets

• Pure commodity standards (e.g the gold standard)

• Pure fiat standards

• Mixed standards (e.g the Bretton Woods system)

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Classification according to

flexibility of exchange rates

• Several systems may arise by restricting, or

otherwise, the exchange rate

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Fixed exchange rates

• The exchange rate is fixed by the central bank and is not allowed to move

• The FX market is likely to be out of equilibrium

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Perfectly flexible exchange rates

• The exchange rate moves continuously, propelled by market forces, to maintain equilibrium in the FX

market

• Under this system, currencies appreciate and

depreciate

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Fixed but adjustable exchange

rates

• Countries alter the fixed values of their exchange

rates

• Devaluation and revaluation are implemented to

‘correct’ some economic fundamentals such as the BOP

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Fixed exchange rates and flexible within a band

• Exchange rates are flexible within upper and lower limits defined by a band around the par value

• Central bank intervention is required to keep the

exchange rate within the band

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Crawling peg

• The par value of the exchange rate is revised

periodically according to its recent behaviour or

economic indicators such as inflation

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Dual exchange rates

• A commercial (fixed) rate is used for imports and

exports

• A financial (flexible) rate is used for trading in

financial assets

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Managed floating

• The exchange rate is flexible, but the central bank

intervenes to limit the frequency and amplitude of

exchange rate fluctuations

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Target zones

• Major countries establish a set of mutually consistent targets for real effective exchange rates

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The classical gold standard

• This system operated between approximately 1870 and 1914

• It is remembered with nostalgia because the world

economy prospered during that period

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Pillars of the gold standard

• The monetary authorities fix the price of gold in

terms of their currencies, which produces a fixed

exchange rate

• The market exchange rate can move above or below the fixed rate by certain limits: the gold points

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The collapse of the gold standard

• The gold standard collapsed in 1914 as the warring countries suspended the convertibility of their

currencies and prohibited the export of gold

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The inter-war period

• Between the end of World War I and 1926 a system

of flexible exchange rates was adopted

• In 1925, Britain re-established the convertibility of the pound into gold, signalling the creation of the gold

exchange standard

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The collapse of the gold exchange standard

• In 1931 Britain abolished the convertibility of the

pound, bringing to an end the era of the gold

exchange standard

• This was followed by the decade of the Great

Depression (1931-1939)

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Failure of the inter-war experiment: reasons

• The golden age was a myth

• The world economy experienced significant changes

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The Bretton Woods system

• Forty-four countries signed the BW agreement in

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The BW exchange rate system

• Fixed but adjustable exchange rates

• The US dollar was pegged to gold, whereas other

currencies were pegged to the dollar

• Exchange rates could move within a 1% band

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Problems of the BW system

• The adjustment mechanism lacked flexibility and

stability

• Speculation could be destabilising

• There were defects in the liquidity creation

mechanism (Triffin Paradox)

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The collapse of the BW system

• In 1971, the United States suspended the

convertibility of the dollar into gold As a result, the

system collapsed

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The present system

• In 1971, the Smithsonian Agreement was signed, but

it failed to salvage the BW system

• In 1973, floating became widespread

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The US dollar’s effective exchange rate under the present system

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Current exchange rate

arrangements

• The Jamaica Accord gave countries the freedom of choosing the arrangements they deemed appropriate for their economies

• Not all countries opted for floating

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Arrangements with no separate

legal tender

• Under this arrangement, the currency of another

country circulates as the sole legal tender

• Alternatively, the country belongs to a monetary or

currency union in which the same legal tender is

shared by members of the union

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Currency boards

• A currency board is an arrangement that is based on

an explicit legislative commitment to exchange the

domestic currency for a specified foreign currency at

a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its

legal obligation

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Other fixed peg arrangements

• Pegging to a single currency

• Pegging to a basket of currencies

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Pegged exchange rates with

horizontal bands

• Under this arrangement the exchange rate is

allowed to fluctuate within a band that is wider than

±1 per cent

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Crawling peg

• Under a crawling peg, the exchange rate is adjusted periodically at a fixed, pre-announced small rate or in response to changes in some quantitative indicators (for example, inflation)

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Crawling bands

• This arrangement requires the exchange rate to be maintained within a certain band around a central

rate that is adjusted periodically at a fixed,

pre-announced rate or in response to changes in some indicators

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Managed floating without a

preannounced path

• Under this arrangement, the exchange rate is

determined by market forces but the monetary

authority intervenes actively in the foreign exchange market without specifying a path for the exchange

rate

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Independent floating

• Under independent floating the exchange rate is

determined by market forces Any intervention in the foreign exchange market aims at curbing exchange rate volatility

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The EMS

• The system started functioning in March 1979 when the Snake ceased to exist

• It is a system of fixed but adjustable exchange rates

as governed by the exchange rate mechanism

(ERM)

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Speculative attacks

• In September 1992, speculative attacks forced the

pound and the lira out of the ERM

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The EMU and the euro

• The EMU was established by the 1991 Maastricht

Treaty

• In January 1999, the euro was introduced

• In January 2002, the euro replaced national

currencies

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The EUR/USD exchange rate

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Arguments for the euro

• Currency stability reduces inflation

• Reduction in transaction and hedging costs

• Efficiency gains

• Transparency gains

• Benefits to trade and capital markets

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Arguments against the euro

• For the system to work well, countries should be

similar

• Individual countries have to give up national interest and exchange rate policies

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The AUD exchange rate

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The AUD exchange rate

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The USD/AUD exchange rate

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Arguments for flexible exchange

rates

• The BOP adjustment mechanism is smoother and

less painful

• Large and persistent BOP deficits do not arise

• Liquidity problems do not arise or are less acute

(cont.)

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Arguments for flexible exchange

rates (cont.)

• Flexible rates are conducive to free trade

• Flexible rates are conducive to policy independence

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Arguments against flexible

exchange rates

• They cause uncertainty and inhibit international trade and investment

• They cause destabilising speculation

• They are not suitable for small countries

• They are unstable

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New international financial

architecture

• Linking IMF loans to crisis prevention efforts

• Imposition of holding-period taxes on short-term

capital flows in countries characterised by financial

fragility

(cont.)

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