BFW3331 Suggested Solutions for Tutorial 2 Week 3

Monash University Malaysia, BFW3331 S1, 2014 1

Tutorial 2: International Monetary System: Past, Present and Future
1. Explain the following terms:
i) beggar- thy- neighbor devaluation: a devaluation that is designed to cheapen a nations
currency and thereby increase its exports at others expense and reduce imports. Such
devaluation often leads to trade wars.
ii) Seigniorage: simply means the profit from the issue of its own currency. Under the Bretton
Woods system, there was a need for other countries to hold US$ reserves. The issue of US$ by
US government was at zero yield, therefore, the profit derives from printing money is the
difference between the printing cost involved and the goods and services that the US Govt was
able to acquire. However, the profits would decrease if the funds were used to purchase
government securities. That is the US Govt needed to pay interest for the Govt securities
iii) Triffin Pradox: Triffin Paradox simply means that to avoid a liquidity shortage, the US must run
a deficit BOP, this would undermine the US$. To avoid speculation against US$, the deficit must
shrink, which would create a liquidity shortage

2. What are the main differences between Classical Gold Standard and the Bretton
Woods Agreement?

Classic Gold Standard ---- each country sets the rate at which its currency unit could be
converted to a weight of gold (usually at 1 oz) e.g. US$ 20/Ounce of gold. Each country
government is ready to buy or sell gold on demand at its own fixed parity rate. Individual
country could expand its monetary supply by acquiring more gold.

Bretton Woods Agreement ------ All countries fixed the value of their currencies in term of gold
but not required to exchange their currencies for gold. Only US$ remained convertible to gold.
Countries agreed to maintain the value of their currencies within 1% change of par by buying
or selling gold/ foreign currencies.


3. Explain what is meant by concept of the impossible trinity in regard to
exchange rate regimes.
Answer:
Countries with floating rate regimes can maintain monetary independence and financial
integration but must sacrifice exchange rate stability.
Countries with tight control over capital inflows and outflows can retain their monetary
independence and stable exchange rate, but surrender being integrated with the worlds
capital markets.
Countries that maintain exchange rate stability by having fixed rates give up the ability to
have an independent monetary policy.




BFW3331 Suggested Solutions for Tutorial 2 Week 3

Monash University Malaysia, BFW3331 S1, 2014 2

4. Bekaert & Hodrick. Chapter 5 page 171 Questions: 10, 16, 17, 18, 19, and 20

10. What was the Bretton Woods currency system?

Answer: In the Bretton Woods System, in place between 1944 and 1973, the participating
countries agreed to an exchange rate regime that linked their exchange rates to the dollar.
They could fluctuate in a 1% band around a fixed parity. The dollar itself had a fixed gold
parity ($35 per ounce). When a country ran into a temporary balance of payments problem
(a current account deficit) that threatened the currency peg, it could draw on the lending
facilities of the IMF, also established at Bretton Woods in 1944, to help it defend the
currency. Countries were also allowed to change their parities when their balances of
payments were considered to be in fundamental disequilibrium.

16. What was the EMS?

Answer: EMS stands for European Monetary System, a target zone system that operated in
Europe between 1979 and 1999. Exchange rates were, for most of the time, maintained
between bands of 2.25% around central rates. The countries participating in the EMS were a
gradually increasing number of European Union countries.


17. What is a basket currency?

Answer: A basket of currencies is a composite currency consisting of various units of other
currencies. Examples include the ECU (European Currency Unit) in the EMS and the SDR
(Special Drawing Right) of the IMF.

19. What is an optimum currency area?

Answer: An optimum currency area is an area that balances the microeconomic benefits of
perfect exchange rate certainty against the costs of macroeconomic adjustment problems.
The area is therefore suitable for the introduction of a single currency and monetary union.
Sharing a currency across a border enhances price transparency (that is, makes prices
easier to understand and compare across countries), lowers transactions costs, removes
exchange rate uncertainty for investors and firms, and enhances competition. The potential
cost of a single currency is the loss of independent monetary policies for the participating
countries. If countries experience adverse shocks, such as a sudden fall in demand for a
countrys main export product or a sudden increase in the price of one of the main inputs for
a countrys manufacturing sector, it can no longer stave off a recession or unemployment
through monetary policy actions when it has a common currency.








BFW3331 Suggested Solutions for Tutorial 2 Week 3

Monash University Malaysia, BFW3331 S1, 2014 3

20. Do you believe its monetary union will be beneficial for Europe?

Answer: The gains are already being realized throughout Europefor example, car prices
have decreased and converged across Europe. The European Commission has estimated
the microeconomic gains of monetary union to amount to 0.5% of GDP of the entire EUa
substantial sum. Other studies suggest that initial concerns regarding the effects of EMU on
member countries have been dispelled. For example, trade and financial integration have
been enhanced, and business cycle synchronization remains high. These developments
lower the incidence of asymmetric shocks, which may require country-specific monetary
policy action. Finally, recent research suggests that the cost of capital within the European
Union has decreased as a result of the introduction of the euro.