International Monetary System

International Monetary System From The Exchange Rate Regime to International Monetary System International Economic Policy Finance and Development (LM-81), a.a. 2016-2017 Prof. Emanuele Ragusi Presentation taken from Reinert, K.A. (2012) An Introduction to International Economics, Instructor Materials

Exchange Rate System

Modern economy is everything but closed; Everyday goods and services are exchanged on international markets using foreign currencies

How are the prices of goods and services settled in foreign markets? The exchange rate is the price of a foreign currency expressed in home currency There are other ways to define the exchange rate.

Relative price of two currencies Often expressed as number of units of local or home currency required to buy a unit of foreign currency We will usually view Euro Area (euro) as our home country and United States (dollar) as our foreign country Nominal or currency exchange rate (e) is defined as euro e dollar Or Kenneth A. Reinert, Cambridge University Press 2012 e hom e currency foreign currency

Country or region Currency Nominal Exchange Rate Nominal Exchange Rate 1 Year Earlier Argentina Peso 14.9 8.68 Brazil Real 3.98 2.83 China Yuan 6.53 6.26 Euro Zone Euro 0.90 0.88 Japan Yen 114 119 Mexico Peso 18.4 14.9 Pakistan Rupee 105 102 South Africa Rand 15.5 11.7 Thailand Baht 35.6 32.6 Turkey Lira 2.95 2.45 Source: www.economist.com Kenneth A. Reinert, Cambridge University Press 2012

If e increases the value of the euro (home currency) falls If e decreases the value of the euro (home currency) rises Since e and the value of the euro are inversely related, e is often graphed as its inverse which is equal to the value of the euro(figure 14.1) It is important when looking at exchange rate data to be aware of which country is the home country Kenneth A. Reinert, Cambridge University Press 2012

1 e High value of the euro Low value of the euro Kenneth A. Reinert, Cambridge University Press 2012

Date Quotation Change Convenction $/ Quotation Change Convenction /$ 03/03/2014 $1.377 Units of $ per one unit of 0,7263 Units of per one $ 04/03/2014 $1.377 Units of $ per one unit of 0,7263 Units of per one $ 05/03/2014 $1.373 Units of $ per one unit of 0,7282 Units of per one $ 06/03/2014 $1.375 Units of $ per one unit of 0,7275 Units of per one $ 07/03/2014 $1.389 Units of $ per one unit of 0,7197 Units of per one $ 10/03/2014 $1.388 Units of $ per one unit of 0,7204 Units of per one $ 11/03/2014 $1.385 Units of $ per one unit of 0,7204 Units of per one $ 12/03/2014 $1.389 Units of $ per one unit of 0,7220 Units of per one $ 13/03/2014 $1.394 Units of $ per one unit of 0,7201 Units of per one $ 14/03/2014 $1.388 Units of $ per one unit of 0,7173 Units of per one $ 17/03/2014 $1.391 Units of $ per one unit of 0,7203 Units of per one $ 18/03/2014 $1.390 Units of $ per one unit of 0,7191 Units of per one $ 19/03/2014 $1.391 Units of $ per one unit of 0,7193 Units of per one $ 20/03/2014 $1.376 Units of $ per one unit of 0,7188 Units of per one $ 21/03/2014 $1.378 Units of $ per one unit of 0,7266 Units of per one $ 24/03/2014 $1.377 Units of $ per one unit of 0,7257 Units of per one $ 25/03/2014 $1.379 Units of $ per one unit of 0,7260 Units of per one $ 26/03/2014 $1.379 Units of $ per one unit of 0,7251 Units of per one $ 27/03/2014 $1.376 Units of $ per one unit of 0,7269 Units of per one $

Time Series Exchange Rate $/ Time Series Exchange Rate /$

Measures the rate at which two countries goods trade against each other Makes use of the price levels in the two countries under consideration P EU overall price level in Euro Zone (the home country) P US overall price level in the United States (the foreign country) re e P P US EU re e P P foreign home Kenneth A. Reinert, Cambridge University Press 2012

Change Intuition Effect in re equation P US increases P EU increases e increases US goods increase in price. Therefore, it takes more European goods to buy a unit of US goods. The real value of the euro has fallen. European goods increase in price. Therefore, it takes fewer European goods to buy a unit of US goods. The real value of the euro has risen. It takes more Euros to buy US dollars. The real value of the euro has fallen. Because it is in the numerator, the increase in P US increases the value of re. Because it is in the denominator, the increase in P EU decreases the value of re. The increase in increases the value of re. Kenneth A. Reinert, Cambridge University Press 2012

1 st : how many units of home currency can be exchanged for one unit of foreign currency; 2 nd : how many units of foreign currency can be exchange for one unit of domestic currency

In order to explain the exchange rate role in an open economy, it s extremely important to define which is the home country and which is the foreign one. Why? A practical example: the Simpson family decides to have a journey in Europe. Homer likes donuts, and now he has a big trouble: he usually buys them at 5$ per pound in Springfield. How much will he have to spend in Paris?

In Paris the donuts price is 5 /lb. Does Homer buy the donuts? We suppose that the Homer s family was in Paris on March, 13 th 2014, and so it needs 1,394 $ per one unit of. In Paris the donuts cost is 6,97$, more or less 2$ plus than in US. Is Homer sure to buy the donuts? In the Homer s case, as we know, the price s matter doesn t represent a trouble

In the chart we have seen how the dollars and euros price changes day by day! We usually say that the dollar price is weaker against euro; The formal terms used to define the fluctuations of exchange rate of domestic currency respect to a foreign one are appreciation and depreciation. Appreciation : when a currency buys more of another currency Depreciation: when a currency buys less of another currency

Focus on US perspective: When the US exchange rate (E $/ ) rises, more dollars are needed to buy one euro. The price of one euro goes up in dollar terms, and the US dollar experiences a depreciation. When the E $/ falls, less dollars are needed to buy one euro. The price of one euro goes down in dollar terms, and the US dollar experiences an appreciation. Focus on Eurozone perspective: When the Eurozone exchange rate (E /$ ) rises, more euros are needed to buy one dollar. The price of one dollar goes up in euro terms, and the euro experiences a depreciation. When the E /$ falls, less euros are needed to buy one dollar. The price of one dollar goes down in euro terms, and the euro experiences an appreciation. When the dollar price of a euro falls, it means that the dollar exchange rate has experienced an appreciation against the euro.

Case e Value of Domestic Currency Term Flexible e Depreciation Flexible e Appreciation

Changes in e have an impact on trade flows Consider the case of EU s imports and exports World prices (P W ) are typically in US dollar terms European prices (P EU ) are in euro terms Relationship between the euro and world prices of EU s import (Z) goods can be expressed as P EU Z e P W Z Kenneth A. Reinert, Cambridge University Press 2012

Suppose e were to increase (the value of the euro falls) Movement down the scale increases the euro price of the imported good in EU Import demand consequently decreases Suppose e were to decrease (the value of the euro rises) Movement up the scale decreases the euro price of the imported good in EU Import demand consequently increases Kenneth A. Reinert, Cambridge University Press 2012

Relationship between the euro and dollar prices of EU s exported (E) goods can be expressed as P EU E e P W E Suppose e were to increase (the value of the peso falls) Movement down the scale increases the euro price of the export good in European Union Export supply in EU consequently increases Kenneth A. Reinert, Cambridge University Press 2012

Suppose e were to decrease (the value of the peso rises) Movement up the inverse scale decreases the euro price of exports in EU Export supply consequently decreases The relationship between exchange rates and trade flows is important in its own right as a link between the international trade and international finance windows of the world economy Kenneth A. Reinert, Cambridge University Press 2012

Prices expressed in domestic currency Prices expressed in foreign currency CURRENT ACCOUNT BALANCE x = 1$ 1 = x$ Export UE Import UE Export US Import US Appreciation 1$ 1 $ X < 0 IM > 0 X > 0 IM < 0 Depreciation 1$ 1 $ X > 0 IM < 0 X < 0 IM > 0

Begins with the hypothesis that the nominal exchange rate will adjust so that the purchasing power of a currency will be the same in every country The purchasing power of a currency in a given country is inversely related to price level in that country Therefore, the PPP hypothesis can be stated as 1 P EU 1 e 1 P US Kenneth A. Reinert, Cambridge University Press 2012

The PPP equation can be rearranged as e P P EU US e P P It can also be arranged as home foreign e P P US EU 1 Here we see that the PPP model is a special case of the real exchange rate being fixed at unity In reality, though, real exchange rates do change Kenneth A. Reinert, Cambridge University Press 2012

If a Big Mac costs 1.71 in UK and only 3 $ in US, the PPP ratio is 1.71/3=0.57. Suppose that the e is 0.5, it means that we need to 1.5 to buy 3 $, it implies that the Big Mac is more expensive in UK than in USA. American tourists can t buy the same quantity of Big Mac in UK than in USA. The PPP is useful to evaluate the purchasing power of aggregates.

The PPP assumes that all goods entering into country price levels are traded In reality, many goods are non-traded Currency trading is also dominated by financial asset considerations rather than trade considerations The PPP is useful to get a sense of the longterm tendency towards which nominal exchange rates move absent other changes Kenneth A. Reinert, Cambridge University Press 2012

How are the exchange rates determined? It depends upon the exchange rate regime. Each regime reflect the policy choices made by governments.

Fixed or pegged (Currency board, Monetary Union, Dollarization) Floating or flexible (free fluctuation) Pegged floating or Managed (Target zone, Basket Peg, Crawling Peg)

Fixed Exchange Rate Regimes are those in which a country s exchange rate fluctuates in narrow range against some base currency over a sustained period, usually a year or longer. To hold exchange rate constant a Central Bank must always be willing to currencies at fixed exchange rate with private actors in foreign exchange market. The CB can succeed in holding the exchange rate fixed only if its financial transactions ensure that asset markets remain in equilibrium

i i1 i2 ie. E E. 1 IS. E 2 LM IS 1 LM 1 FE IS 0 Ye Y1 Y2 Y 0 Y 1 i i 1 i e. E Ye. E 1 LM LM 1 FE Y Expansionary Fiscal Policy: IS curve moves to the right; New equilibrium point in E (surplus b.p.); Increasing of foreign currency in domestic monetary base, LM moves in right, E new equilibrium Expansionary Monetary Policy: LM cure moves to the right; E is the new equilibrium point. In E the b.p. registers a strong deficit due to the capital flight in other countries and the implementation of Imports. It needs a sterilization policy (sell foreign currency to buy domestic units).

Currency Board: it has special legal and procedural rules design to make the peg harder Dollarization: it consists in abolishing its own national currency and unilaterally adopting the currency of another country (as US dollar) Monetary Union: A group of countries decide to submit its monetary sovereignty to an institution that represents the monetary authority (as Eurozone)

Floating exchange rate regimes are all the other cases in which a country s exchange rate fluctuates in wider range, and the government makes no attempt to fix it against any other base currency The price level of exchange rate is settled into market of exchange rates; it refers to demand and supply law.

i i 1 i 2 i e 0 E. 1 E.. 2 E IS LM IS 1 IS 2 Y e Y 1 Y Y 2 FE 1 FE Expansive Fiscal Policy: IS curve moves to rightward, in E the b.p. Country registers a surplus due to the foreign capital inflow, appreciation of exchange rate against foreign currency, Export reduction and consequently reduction of Income (Y ) i i1 ie 0 LM. E. IS FE E 1 LM 1 IS 1 Ye Y1 Y FE 1 Expansive Monetary Policy: LM curve moves to rightward, the interest rate goes down and the income rises due to augmentation of the demand for liquidity. In E the b.p. registers a strong deficit and it needs the depreciation of exchange rate to increase the export level and, as consequence, the demand of goods and services goes up and the IS move t right

Free Floating Exchange Rate Regime: the movements between peaks and through may take many months and years to occur, the exchange rate shows also a great deal of short run volatility, with lots of up-and-down movement from day to day

This is a special hybrid or dirty exchange rate regime, it s between fixed rate and free float In this kind of exchange rate regime, the National Monetary Authority has more degrees of freedom than other two. Until the first half of 90s the 64% of countries in the world have adopted a dirty exchange regime; due to the exchange rate crisis (two corner solutions) the percentage of managed floating exchange rates reduced to 34%

Target zone: the monetary authorities establish a fluctuation. Basket peg: it provides for the fixing of the exchange rate to a reference value, calculated on the basis of a basket of currencies Crawling peg: this kind of regime follows a predetermined target trend. The authorities kept the domestic currency steadily depreciating at an almost constant rate from, for example, 1996 to 2001. this is type of arrangement is called crawl.

International Monetary Fund

the International Monetary System is a set of internationally agreed rules, convention and supporting institutions that facilitate the international transactions (trade, Foreign Direct Investments, reallocation of capitals) Fiscal Policy Monetary Policy Exchange Rate Regime

Modern economic systems are all open; The International Monetary System influenced the macroeconomic policy; The macroeconomic policy has two main goals: Internal Balance External Balance

This goal requires: Full employment of human and physical resources; The stability of the price level. Full employment Price level stable

It s more difficult to define the external macroeconomic goal of each country, because the equilibrium depends on several factors: Economic particular circumstances; Conditions of outside world; Institutional arrangements governing economic relations with foreign countries.

Since the 19 th century the world economy has evolved through a various international monetary system; Social, economic and political factors influenced countries to adopt one system rather than another. The trilemma focus on three goals whose each country want achieve: Exchange rate stability; Monetary policy orientated toward domestic goals; Freedom of international capital movements.

Since the 19 th century we assist a succession of different international monetary system: Gold Standard (1871-1939); Gold Exchange Standard (1944-1971); Floating Exchange Rate System (1973 to present)

Each country fixes the price of its currency in terms of gold by standing ready to trade domestic currency for gold whenever necessary to defend the official price. Each country pegs its currency s price in terms of the official international reserve asset: gold

International Reserve A practical example: The Dollar currency s price was fixed at $35 per ounce by FED; The Pound currency s price was fixed a 14,58 per ounce by Central Bank of England. Which was the exchange rate $/? ($35 per ounce) ( 14,58 per ounce)= $2,40 per pound; And the exchange rate /$? ( 14,58 per ounce) ($35 per ounce)= 0,4166 per dollar.

Benefits: Symmetric Monetary Adjustment; The Central Banks of the world had the duty to fix their currency s price in terms of gold; The Gold Standard permitted to maintain stable the domestic price level. Drawbacks: It implies an undesirable constraints on the use of monetary policy to fight the unemployment; The domestic stability price level was ensured only if the gold and goods level price was stable; The Central Banks were not encouraged to hold foreign currencies as reserve; The Countries with large gold production had more ability to influence the gold price.

This monetary system is halfway between the gold standard and a reserve currency standard. The Central Bank reserves consist in gold and currencies with a fixed gold price. The Bretton Woods Agreement settled the dollar currency as official international reserve together the gold.

On July 22 nd, 1944 the Bretton Woods Agreement was drafted and signed by 44 countries; The Bretton Woods Agreement aimed to avoid the repetitions of the turbulent interwar experience. The main problem of this International Monetary System was the strict relation of dollar as official international reserve and international medium of payment. In fact to increase the Monetary World Demand occurred that the US Payments Account was always in deficit. This situation had consequence on dollar currency. On August 15 th, 1971 the President Nixon declared the end of Convertibility of Dollar and the end of Bretton Woods

In March 1973 the International Monetary System adopted a Floating Exchange Rate Regime with the aim to overcome the International and National Instabilities

Monetary policy autonomy CB not obliged to intervene in currency markets to fix exchange rate; Governments would be able to use monetary policy to reach internal and external balance; Symmetry USA would no longer to be able to set the world monetary conditions; USA had the same opportunities as other countries to influence the exchange rate markets Exchange Rate As automatic stabilizers: the swift adjustment of exchange rates would help countries to maintain the internal and external balance. And External Balance: as to prevent the emergence of big current account deficits or supluses

On July 22 nd 1944 The governmental representatives of 44 Countries drafted and signed the Bretton Woods Agreement that found the International Monetary Fund The IMF s main goal is to promote world economic stability and growth 188 Member States

To Promote international monetary cooperation through an institution To Facilitate the expansion of international trade, to contribute to maintain an high level of employment and to develop of productive resource To promote exchange stability to avoid competitive exchange depreciations To assist the establishment of multilateral system of payments To give confidence to members by making the general resources of the IMF To lessen the disequilibrium in international balances of payments

The Board of Governors: It s the highest decision-making body of the IMF. It consists of one governor and one alternate governor for each member country. The governor is appointed by the member country and is usually the minister of finance or the head of the central bank; it retains the right to approve quota increases, special drawing right (SDR) allocations, the admittance of new members, compulsory withdrawal of members, and amendments to the Articles of Agreement and By-Laws; The Board of Governors also elects or appoints executive directors and is the ultimate arbiter on issues related to the interpretation of the IMF's Articles of Agreement.

Ministerial Committee: The IMF Board of Governors is advised by two ministerial committees, the International Monetary and Financial Committee (IMFC) and the Development Committee; The IMFC has 24 members, drawn from the pool of 187 governors. Its structure mirrors that of the Executive Board and its 24 constituencies. As such, the IMFC represents all the member countries of the Fund.

The Executive Board: The IMF's 24-member Executive Board takes care of the daily business of the IMF. Together, these 24 board members represent all 188 countries. Large economies, such as the United States and China, have their own seat at the table but most countries are grouped in constituencies representing 4 or more countries. The largest constituency includes 24 countries; The Board discusses everything from the IMF staff's annual health checks of member countries' economies to economic policy issues relevant to the global economy. The board normally makes decisions based on consensus but sometimes formal votes are taken. At the end of most formal discussions, the Board issues what is known as a summing up, which summarizes its views. Informal discussions may be held to discuss complex policy issues still at a preliminary stage.

Surveillance over Members Economic Policy Increasing the Global Supply of International Reserves Financing Temporary Balance of Payments Needs Strengthening the International Monetary System Combating Poverty Mobilizing External Financing

During The Gold Exchange Standard, the main functions of IMF were: Financing Temporary Balance of Payments Needs Surveillance over Members Economic Policy Guaranteeing the exchange rates stability. The country members of the Bretton Woods System paid a year quota as IMF capital reserve with the aim to finance the Countries imbalances of payments account. Each Country quota was: 25% in gold and 75% in domestic currency In 1969 The IMF introduced the Special Drawing Rights (SDRs), they were intended to be an asset held in foreign exchange reserves under the Bretton Woods system of fixed exchange rates.

When the Bretton Woods System fell in 1971, the main functions of IMF was: The world economic stability and growth The IMF constrains the loans system to Structural Adjustment Programs (SAPs); The IMF implemented its interventions to help the Developing Countries (50 millions of gold ounces to increase of money supply); During the 80s, IMF adopted the Washington Consensus, it s a set of rules to face the macroeconomic instability; The Pillars of WC are: Austerity, Privatizations and Markets Liberalization.

The early 2000s found the IMF sinking into irrelevancy Between 2001 and 2008, the number of new arrangements declined precipitously (see Figure 17.4) This reflected booming private capital markets and the accumulation of large foreign reserve balances in many Asian countries Because the IMF s operating budget depends on its loan charges, this proved to be difficult Kenneth A. Reinert, Cambridge University Press 2012

The IMF was unprepared for the global financial crisis that began in 2007 The IMF s 2007 World Economic Outlook stated: Notwithstanding the recent bout of financial volatility, the world economy still looks well set for robust growth in 2007 and 2008 The crisis, however, put the IMF back into business with agreements increasing substantially in 2009, many to European countries 2008 was also a year when the quotas reported in Figure 17.2 were established Kenneth A. Reinert, Cambridge University Press 2012

The analysis of the political economy of IMF lending takes place in terms of two variables The value of loans (L) The number and strength of conditions (C) These are depicted in Figure 17.5 in terms of a hard bargaining line and an easy bargaining line IMF member country governments weigh the (marginal) benefits and costs of approaching the IMF for a loan Sovereignty costs are part of these calculations Kenneth A. Reinert, Cambridge University Press 2012

Newer thinking and research suggests that, in some cases, country governments might prefer points along line B in Figure 17.5 to points along line A This would be to push reforms through in the face of domestic political opposition Here blame is shifted to the IMF This research also suggests that country government failures to abide by conditionality agreements can simply be the result of a change in the benefit-cost calculations of member country governments Kenneth A. Reinert, Cambridge University Press 2012

The IMF was originally designed to support the Bretton Woods system, a system the no longer exists It is now operating in an era of unforeseen capital mobility and has an uneven record of success International financial arrangements are often evaluated in terms of their contributions to liquidity and adjustment The IMF has never had the resources necessary to contribute substantially to global liquidity By only penalizing debtor members (no matter what the source of the adjustment problem) and not creditor members, it has also been limited in its ability to facilitate adjustment Kenneth A. Reinert, Cambridge University Press 2012

Options for radical reform of the IMF fall into two categories Reconstitution in the form of a global central bank Reaffirming the SDR as a reserve asset Giving the IMF responsibility for regulating global liquidity Spreading adjustment requirements over both debtor and creditor members This was the original vision of the Keynes plan of 1941 Kenneth A. Reinert, Cambridge University Press 2012