International Finance

FINA 5331

Lecture 4:
History of Monetary Institutions
Read: Chapters 2
Aaron Smallwood Ph.D.
 Review
• The international gold standard has two
advantages:
– Prices are very stable since the money supply
is directly connected to the amount of gold.
– There are not any major distortions
associated with the balance of payments.
• PRICE SPECIE FLOW MECHANISM
The International Gold Standard, 1879-1913

• There are shortcomings:

– The supply of newly minted gold is so
restricted that the growth of world trade
and investment can be hampered for the
lack of sufficient monetary reserves.
– Even if the world returned to a gold
standard, any national government could
abandon the standard.
 The Relationship Between Money and Growth

• Money is needed to facilitate economic transactions.

• MV=PY →The equation of exchange.
• Assuming velocity (V) is relatively stable, the
quantity of money (M) determines the level of
spending (PY) in the economy.
• If sufficient money is not available, say because gold
supplies are fixed, it may restrain the level of
economic transactions.
• If income (Y) grows but money (M) is constant, either
velocity (V) must increase or prices (P) must fall. If
the latter occurs it creates a deflationary trap.
• Deflationary episodes were common in the U.S.
during the Gold Standard.
 Interwar Period: 1918-1941

• Exchange rates fluctuated as countries

widely used “predatory” depreciations of their
currencies as a means of gaining advantage
in the world export market.
• Attempts were made to restore the gold
standard, but participants lacked the political
will to “follow the rules of the game”.
• The result for international trade and
investment was profoundly detrimental.
• Smoot-Hawley tariffs
• Great Depression
Economic Performance and Degree of Exchange Rate
Depreciation During the Great Depression
Bretton Woods System: 1945-1971
• Named for a 1944 meeting of 44
nations at Bretton Woods, New
Hampshire.
• The purpose was to design a postwar
international monetary system.
• The goal was exchange rate stability
without the gold standard.
• The result was the creation of the IMF
and the World Bank.
Bretton Woods System: 1945-1971
• Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.
• Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par value
by buying or selling foreign reserves as necessary.
• The U.S. was only responsible for maintaining the
gold parity.
• Under Bretton Woods, the IMF was created.
• The Bretton Woods is also known as an adjustable
peg system. When facing serious balance of
payments problems, countries could re-value their
exchange rate. The US and Japan are the only
countries to never re-value.
The Fixed-Rate Dollar Standard, 1945-1971

• In practice, the Bretton Woods system

evolved into a fixed-rate dollar standard.
Industrial countries other than the United States :
Fix an official par value for domestic currency in terms
of the US$, and keep the exchange rate within 1% of
this par value indefinitely.

United States : Remain passive in the foreign change

market; practice free trade without a balance of
payments or exchange rate target.
Bretton Woods System: 1945-1971

German
British mark French
pound franc
Par Pa
a r Va r
P lue Value lue
Va
U.S. dollar

Pegged at $35/oz.

Gold
 Purpose of the IMF
The IMF was created to facilitate the
orderly adjustment of Balance of
Payments among member countries by:
• encouraging stability of exchange rates,
• avoidance of competitive devaluations,
and
• providing short-term liquidity through loan
facilities to member countries
 Composition of SDR
(Special Drawing Right)
 Collapse of Bretton Woods
• Triffin paradox – world demand for $ requires U.S. to
run persistent balance-of-payments deficits that
ultimately leads to loss of confidence in the $.
• SDR was created to relieve the $ shortage.
• Throughout the 1960s countries with large $ reserves
began buying gold from the U.S. in increasing
quantities threatening the gold reserves of the U.S.
• Large U.S. budget deficits and high money growth
created exchange rate imbalances that could not be
sustained, i.e. the $ was overvalued and the DM and
£ were undervalued.
• Several attempts were made at re-alignment but
eventually the run on U.S. gold supplies prompted
the suspension of convertibility in September 1971.
• Smithsonian Agreement – December 1971
 The Floating-Rate Dollar Standard, 1973-1984

• Without an agreement on who would set

the common monetary policy and how it
would be set, a floating exchange rate
system provided the only alternative to
the Bretton Woods system.
The Floating-Rate Dollar Standard, 1973-1984

Industrial countries other than the United States :

Smooth short-term variability in the dollar exchange rate,
but do not commit to an official par value or to long-term
exchange rate stability.

United States : Remain passive in the foreign exchange

market; practice free trade without a balance of
payments or exchange rate target. No need for sizable
official foreign exchange reserves.
 The Plaza-Louvre Intervention Accords and
the Floating-Rate Dollar Standard, 1985-1999

• Plaza Accord (1985):

– Allow the dollar to depreciate following
massive appreciation…announced that
intervention may be used.
• Louvre Accord (1987) and “Managed
Floating”
– G-7 countries will cooperate to achieve
exchange rate stability.
– G-7 countries agree to meet and closely
monitor macroeconomic policies.
Value of $ since 1965
 IMF Classification of Exchange Rate
Regimes
• Independent floating
• Managed floating
• Exchange rate systems with crawling bands
• Crawling peg systems
• Pegged exchange rate systems within horizontal
bands
• Conventional pegs
• Currency board
• Exchange rate systems with no separate legal tender