THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 562

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PA R T V I

International Finance and Monetary Policy

Managed Float Although most exchange rates are currently allowed to change daily in response
to market forces, central banks have not been willing to give up their option of
intervening in the foreign exchange market. Preventing large changes in
exchange rates makes it easier for firms and individuals purchasing or selling
goods abroad to plan into the future. Furthermore, countries with surpluses in
their balance of payments frequently do not want to see their currencies appreciate because it makes their goods more expensive abroad and foreign goods
cheaper in their country. Because an appreciation might hurt sales for domestic
businesses and increase unemployment, surplus countries have often sold their
currency in the foreign exchange market and acquired international reserves.
Countries with balance-of-payments deficits do not want to see their currency
lose value because it makes foreign goods more expensive for domestic consumers
and can stimulate inflation. To keep the value of the domestic currency high, deficit
countries have often bought their own currency exchange in the foreign exchange
market and given up international reserves.
The current international financial system is a hybrid of a fixed and a flexible
exchange rate system. Rates fluctuate in response to market forces but are not
determined solely by them. Furthermore, many countries continue to keep the
value of their currency fixed against other currencies, as was the case in the
European Monetary System (to be described shortly).
Another important feature of the current system is the continuing de-emphasis
of gold in international financial transactions. Not only has the United States suspended convertibility of dollars into gold for foreign central banks, but also since
1970 the IMF has been issuing a paper substitute for gold, called special drawing rights (SDRs). Like gold in the Bretton Woods system, SDRs function as international reserves. Unlike gold, whose quantity is determined by gold discoveries
and the rate of production, SDRs can be created by the IMF whenever it decides
that there is a need for additional international reserves to promote world trade
and economic growth.

The use of gold in international transactions was further de-emphasized by the
IMF s elimination of the official gold price in 1975 and the sale of gold by the U.S.
Treasury and the IMF to private investors in order to demonetize it. Currently, the
price of gold is determined in a free market. Investors who want to speculate in it
are able to purchase and sell at will, as are jewellers and dentists who use gold in
their businesses.

European
Monetary
System (EMS)

In March 1979, eight members of the European Economic Community (Germany,
France, Italy, the Netherlands, Belgium, Luxembourg, Denmark, and Ireland) set
up an exchange rate union, the European Monetary System (EMS), in which they
agreed to fix their exchange rates vis- -vis one another and to float jointly against
the U.S. dollar. Spain joined the EMS in June 1989, the United Kingdom in October
1990, and Portugal in April 1992. The EMS created a new monetary unit, the
European currency unit (ECU), whose value was tied to a basket of specified
amounts of European currencies.
The exchange rate mechanism (ERM) of the European Monetary System
worked as follows. The exchange rate between every pair of currencies of the
participating countries was not allowed to fluctuate outside narrow limits around
a fixed exchange rate. (The limits were typically *2.25% but were raised to *15%
in August 1993.) When the exchange rate between two countries currencies
moved outside these limits, the central banks of both countries were supposed to
intervene in the foreign exchange market. If, for example, the French franc depreciated below its lower limit against the German mark, the Bank of France was