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Chapter 5

The International Monetary System and


Exchange Rate Arrangements

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

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Definition
The IMS is the framework of rules, regulations and
conventions that govern the financial relations
among countries

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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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Criterias of Classification
Two criteria's
Nature of International reserves held by central bank
Degree of Flexibility of exchange rate

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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, movement of 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
1944
The creation of the system was accompanied by the
creation of international institutions (the IMF
and IBRD or the World Bank)

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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 dollars 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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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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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, preannounced 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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Realignments
The first realignment involving all currencies took
place in March 1983
The period January 1987-September 1992 was
tranquil

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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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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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The AUD exchange rate arrangements


Until December 1971, the AUD was pegged to the
pound
Until September 1974, the AUD was pegged to the
US dollar

(cont.)
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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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The AUD exchange rate arrangements (cont.)


Until December 1983, the AUD was pegged to a
basket
In December 1983, the AUD was floated

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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

Copyright 2010 McGraw-Hill Australia Pty Ltd


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

(cont.)
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New international financial architecture (cont.)


Making the private sector partly responsible for the
consequences of sovereign bond issues
Discouraging fixed but adjustable exchange rates in
favour of either managed floating or currency boards

(cont.)
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New international financial architecture (cont.)


Directing the IMF to lend less freely and to
distinguish between country crises and systemic
crises
Removing overlap from the responsibilities of the
IMF and the World Bank

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A global currency?
Convenience
Loss of exchange rate policy
A small open economy has more to gain from the
convenience

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The Tobin tax


Proposed by James Tobin in 1972, it is a uniform
international tax payable on all spot FX transactions
Although the idea sounds appealing, there are
serious implementation problems

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