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Macroeconomics 1: Week 13

The international Monetary system


1. Exchange Rate Systems
a) Freely floating – flexible – exchange rate regimes
b) Fixed exchange rates
2. History of International Monetary Systems
a) The Gold Standard
b) Bretton Woods
c) Managed floats
3. Australia’s Exchange rate history

Reading: Jackson & McIver pp. 95-98 Chapter 18


Exchange rate systems
• Two types of exchange rate system:
• Flexible or floating exchange rates
– The exchange rate is determined by demand
and supply
• Fixed exchange rates
– Government intervention in the foreign
exchange market offsets the changes in
exchange rate caused by the demand and
supply factors
Freely floating exchange rates
• Determined by the unimpeded forces of
supply and demand
• Depreciation and appreciation
– Depreciation in the exchange rate is an increase
in the number of units of a country’s currency
required to buy a single unit of some foreign
currency
– Appreciation is a reduction in the number of units
of a country’s currency required to buy a single
unit of some foreign currency
Flexible rates and the balance
of payments
• Flexible exchange rates automatically
adjust so as to eliminate balance of
payments deficits or surpluses
Adjustments under flexible, fixed & the gold
standard
P
D1 S1
Dollar price of one pound
D0

C
3
X B
2
A D1
1 S1
D0
Q
Pounds
Flexible exchange rates
Disadvantages of floating exchange rates
• Uncertainty and diminished trade
– Uncertainty on prices due to movements in the
exchange rate and discourage the flow of trade
• Terms of trade
– A decline in the international value of a country’s
currency will result in worsening terms of trade
• Destablising nature of capital flows
Flexible exchange rates (cont.)
Disadvantages of floating exchange rates
• Instability in the macroeconomic environment
– Destablising effects on the domestic economy
arising from shifts in net exports brought about
by changes in the exchange rate
– Complicates the use of domestic monetary and
fiscal policies
Fixed exchange rates
• Exchange rate for which the values are
determined by government decision
• Nations have often fixed or pegged the
exchange rate to overcome the
disadvantages of floating exchange rates
• Fixed exchange rates require adequate
reserves to accommodate periodic
balance of payment deficits
Fixed exchange rates (cont.)
• Trade policies
– To maintain a fixed exchange rate, a country
may enact protectionist trade policies to increase
net exports
• Exchange controls: rationing
– Restricting imports to the amount of foreign
exchange earned by exports
• Domestic macroeconomic adjustments
– Use fiscal and monetary policies to adjust GDP
to a level consistent with the fixed exchange rate
International monetary system:
the gold standard
• A system under which the value of a nation’s
monetary unit was backed by gold rather than
fiat
• Gold standard conditions
– Define the monetary unit in terms of a certain
quantity of gold
– Fixed relationship between stock of gold and the
domestic currency
– Allow gold to be freely exported and imported
The gold standard (cont.)
• Gold flows
– This would result in exchange rates that are fixed
• Domestic macro adjustments
– The gold standard implies changes in the domestic
money supply of nations, which affects prices,
real output and employment
• Advantages of gold standard
– Stable exchange rates resulting from the gold
standard reduces uncertainty and risk
– The flow of gold between countries caused shifts
in the supply and demand curves and automatically
corrects balance of payments deficits or surpluses
The gold standard (cont.)
• Disadvantages of gold standard
– Nations must accept domestic adjustments in
the form of higher unemployment or inflation
– Countries must have sufficient reserves of
gold
• Demise of the gold standard
– During the Depression years of the 1930s
Bretton Woods monetary system
• Bretton Woods conference 1944
• Adjustable peg system of exchange rate
emerged
– A system by which members of the IMF were
obligated to define their monetary units in terms
of gold (or US dollars), establishing par rates of
exchange between the currencies of all other
members, and to keep their exchange rates within 1
per cent of these par values
– US Dollar the main international currency
– Capital flows were believed to be destabilizing,
prewar controls were left in place.
IMF and pegged exchange rates
• The main aim of the agreement to encourage
world trade in goods and services
• Stabilisation funds
– Suppliers of both foreign and domestic moneys
and gold held with the central bank or treasury for
the purpose of intervention in the foreign exchange
market to maintain the par value of the exchange
rate
• IMF credit
– Provided short-term loans to nations with temporary
or short-term balance of payments deficits out of
currencies and gold contributed by member nations
Bretton Woods monetary system

• Fundamental imbalances: adjusting the peg


– Countries running persistent balance of payments
deficits ran out of reserves and were unable to
maintain its fixed exchange rate
• Demise of the Bretton Wood
– Dilemma: dollars and the deficits
– Emergence of floating rates
Managed float
• An exchange rate system where central banks
buy and sell foreign exchange to smooth out
short-run or day-to-day fluctuations in rates
• Encourages international trade and finance,
while allowing for trend or long-term exchange
rate flexibility to correct fundamental payments
disequilibria
• Liquidity and special drawing rights
– Special drawing rights are bookkeeping entries
at the IMF, available to IMF members in proportion
to their IMF quotas, that may be used to settle payments deficits
or satisfy reserve needs in place of foreign exchange or gold
Managed float (cont.)
Demonetisation of gold
• Further reform of the international monetary
system led to the downgrading of the role
of gold
• Gold has now ceased to function as an
international money
Managed float: an evaluation
Arguments for managed float
• Trade growth
• Managing turbulence
Arguments against
• Volatility and adjustment
• Reinforcement of inflation
Exchange rate history: Australia
From 1931 to December 1971 the Australian currency
dollar was tied to the pound sterling.
• In 1971 major devaluation of the $US → link between
the $Aus and Pound Sterling severed. $Aus pegged to
the US dollar 1971–1974
– Was revalued in 1972 and 1973
• Pegged to the trade-weighted index 1974–1976
– An index of the ‘average’ exchange rate comprised
of the basket of currencies of Australia’s major
trading partners, weighted to reflect their share of
trade
Exchange rate history:
Australia (cont.)
• From 1976 till December 1983 operated on a
managed float with the exchange rate set by
the Governor of the Reserve Bank, the
Secretary of the Treasury and the Secretary
of the Department of the Prime Minister and
Cabinet, rate announced every morning.
• The floating of the exchange rate (1983) most
existing exchange rate controls being
removed, including controls on capital flows
Exchange rate history: Australia
• Initially clean float.
• Substantial volatility in the exchange rate, and the large
depreciations of the currency in the years up to 1986,
especially in 1985 -about a 25% depreciation in the value of the
$Aus → the Reserve Bank stepped up its intervention in the
foreign exchange market → period of dirty or managed float
⇒RBA intervenes in currency markets to influence either the
volatility or the value of the currency.
• The current situation: the value of the $Aus determined in the
exchange markets by supply and demand. However, the
Reserve Bank and federal government can intervene in a
number of ways:
1. Reserve Bank can try to manipulate the exchange rate by
buying and selling Australian dollars.
2. Reserve Bank can influence the exchange rate by manipulating
domestic interest rates → influence capital flowsand the current
account
3. Indirect methods through deflationary policy, ie. tight fiscal and
monetary policy.
Exchange rate history: Australia
• Floating and the current account crisis
• Recovery during the late 1980s
• The early 1990s and the 1990 recession
• The late 1990s and the Asian crisis
• Into the 2000s