Chapter 34 The international monetary system David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith Key issues Exchange rate regimes and their implications for the world economy Possibilities of policy co-ordination Policy co-ordination in Europe 34.2 Exchange rate regimes Exchange rate Fixed Forex intervention Floating Free float Gold standard currency board Adjustable peg None Automatic Managed float Some discretion 34.3 The gold standard Characteristics of the gold standard: – – – The government of each country fixes the price of gold in terms of its domestic currency The government maintains convertibility of domestic currency into gold Domestic money creation is tied to the government's holding of gold Adjustment to full employment is via domestic wages and prices – creating vulnerability to long and deep recessions 34.4 The adjustable peg and the dollar standard In an adjustable peg regime, exchange rates are normally fixed, but countries are occasionally allowed to alter their exchange rate Under the Bretton Woods system, each country announced a par value for their currency in terms of US dollars – the dollar standard 34.5 The dollar standard Faced with a balance of payments deficit under the dollar standard countries could try to avoid monetary contraction by running down foreign exchange reserves but devaluation could not be postponed for ever, given finite reserves expansion of US money supply began to spread inflation world-wide 34.6 Floating exchange rates Under pure/clean floating, forex markets are in continuous equilibrium the exchange rate adjusts to maintain competitiveness but in the short run, the level of floating exchange rates is determined by speculation – given that capital flows respond to interest rate differentials 34.7 Fixed versus floating exchange rates Robustness – – Bretton Woods system was abandoned because it could not cope with real and nominal strains a flexible rate system is probably more robust Volatility – – – fixed rate system offers fundamental stability flexible rate system is potentially volatile but instability must be accommodated in other ways under a fixed rate system Financial discipline – fixed rate system imposes discipline and policy harmonization 34.8 International policy co-ordination Can a concerted attempt by a group of countries to co-ordinate their policy bring benefits to the group? Externality argument: – non-co-operative policy can impose costs that can be avoided by agreement between governments Reputation argument – co-ordination may allow individual governments to pre-commit to policies that would otherwise not be credible 34.9 The European Monetary System Established by members of the European Community (including the UK) in 1979 A system of monetary and exchange rate co-operation Included the Exchange Rate Mechanism (ERM) – – which the UK did not join until 1990 and it left again in 1992 The system had some success in reducing exchange rate volatility – – – through co-ordination of monetary policy plus exchange rate controls even if it did not work for the UK 34.10