the international monetary system

Chapter 34
The international monetary system
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
34.1
Key issues
 Exchange rate regimes and their
implications for the world economy
 Possibilities of policy co-ordination
 Policy co-ordination in Europe
34.2
Exchange rate regimes
Exchange rate Forex intervention
Fixed
Floating
Free
float
None
Gold standard
currency board
Automatic
Adjustable peg
Managed
float
Some discretion
34.3
The gold standard
 Characteristics of the gold standard:
– The government of each country fixes the
price of gold in terms of its domestic currency.

– The government maintains convertibility of
domestic currency into gold.
– Domestic money creation is tied to the
government's holding of gold.
 Adjustment to full employment is via
domestic wages and prices
– creating vulnerability to long and deep
recessions.
34.4
The adjustable peg and the dollar standard
 In an adjustable peg regime,
exchange rates are normally fixed,
but countries are occasionally
allowed to alter their exchange rate.
 Under the Bretton Woods system,
each country announced a par value
for their currency in terms of US
dollars
– the dollar standard.
34.5
The dollar standard
 Faced with a balance of payments deficit
under the dollar standard
 countries could try to avoid monetary
contraction by running down foreign
exchange reserves
 but devaluation could not be postponed
for ever, given finite reserves
 expansion of US money supply began to
spread inflation world-wide

34.6
Floating exchange rates
 Under pure/clean floating, forex markets
are in continuous equilibrium
 the exchange rate adjusts to maintain
competitiveness
 but in the short run, the level of floating
exchange rates is determined by
speculation
– given that capital flows respond to interest rate
differentials.
34.7
Fixed versus floating exchange rates
 Robustness
– Bretton Woods system was abandoned because it could
not cope with real and nominal strains
– a flexible rate system is probably more robust
 Volatility
– fixed rate system offers fundamental stability
– flexible rate system is potentially volatile
– but instability must be accommodated in other ways
under a fixed rate system
 Financial discipline
– fixed rate system imposes discipline and policy
harmonization.
34.8
International policy co-ordination
 Can a concerted attempt by a group of
countries to co-ordinate their policy bring
benefits to the group?

 Externality argument:
– non-co-operative policy can impose costs that
can be avoided by agreement between
governments
 Reputation argument
– co-ordination may allow individual
governments to pre-commit to policies that
would otherwise not be credible
34.9
The European Monetary System
 Established by members of the European
Community (including the UK) in 1979
 A system of monetary and exchange rate
co-operation.
 Included the Exchange Rate Mechanism (ERM)
– which the UK did not join until 1990
– and it left again in 1992.
 The system had some success in reducing
exchange rate volatility
– through co-ordination of monetary policy
– plus exchange rate controls
– even if it did not work for the UK.
34.10
Chapter 35
European integration
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
35.12
Some key issues

 The European Single Market
– what difference did it make?
 Economic and Monetary Union (EMU)
– why did it happen?
– What difference will it make?
 Reform in Eastern Europe
– how are these countries faring in their
transition from central planning to
market economies?
35.13
The Single Market
 Established under the
Single European Act
of 1987
 with December 1992
as the target date for
completion
– which was met
0
1000
2000
3000
4000
5000
6000
EU USA Japan
billions of ECUs
0
50
100

150
200
250
300
350
400
millions
GDP (LH scale)
Population (RH scale)
35.14
Objectives of the Single Market
 Abolition of remaining foreign exchange
controls on capital flows
 removal of non-tariff barriers within the EU
 elimination of bias in public sector
provisioning
 removal of frontier controls
– with some provisos
 progress towards harmonization of tax
rates
35.15
Benefits of the Single Market
 Improved resource allocation
– removal of non-tariff barriers allows more exploitation of
comparative advantage
 Scale economies
– larger potential market increases the scope for
economies of scale
 Intensified competition
– may stimulate greater cost efficiency

 Factor mobility
– enables greater efficiency through mobility of labour
and capital
35.16
Gains from the Single Market
0
5
10
15
20
25
% of initial GDP
Low
2
2
3
4
4
5
19
High
3
5
4
5
10
16
20
F, D, I,
UK

Den
NL, Sp
B,Lux
Ire
Gr
Port
Source: Allen, Gasiorek and Smith (1998)
35.17
From EMS to EMU
 A monetary union has
– permanently fixed exchange rates within the
union
– an integrated financial market
– a single central bank setting the single interest
rate for the union.
 The Maastricht Treaty set criteria for EMU entry
– to define ‘convergence’
 The single currency area began in January 1999
with 11 member countries.
35.18
The Maastricht criteria
 Inflation rate
– no more than 1.5% above the average of the inflation
rate of the lowest 3 countries in the EMS
 Long-term interest rate
– no more than 2% above the average of the lowest 3 EMS
countries
 Exchange rate
– in the narrow band of ERM for 2 years
 Budget deficit

– no larger than 3% of GDP
 National debt
– no greater than 60% of GDP
35.19
Sterling and Europe
0
10
20
30
40
50
60
% of UK
trade
EU
North America
Rest of world
UK trade patterns
1972 1998
UK membership of ERM/EMU?
North Sea oil made the UK different
The UK is less integrated
with the rest of Europe
– but this is changing
The UK has a greater tradition of
macroeconomic sovereignty.
Black Wednesday and the ERM crisis
The UK’s business cycle was out
of phase with the rest of Europe.
35.20

The economics of EMU
 Optimal currency area
– a group of countries better off with a
common currency than keeping
separate national currencies
 3 key attributes (Mundell)
– countries that trade a lot with each
other
– countries with similar economic and
industrial structures
– flexibility in labour markets
35.21
So is Europe an optimal currency area?
 Europe is ‘quite’ but not very closely
integrated
 Some countries are more closely
integrated than others
 but the act of joining may itself feed
the process of integration
35.22
Macroeconomic policy
for a small member of Euroland
IS
0
LM
r
0
Y
0
A small Euroland member

faces a horizontal LM curve,
given that interest rates are
fixed by the ECB.
If the country is too small
to influence the ECB to alter
interest rates, either the
country must wait for wage &
prices to shift IS back via
improved competitiveness,
Y
1
IS
1
Suppose an external shock
moves the IS curve to IS
1
or fiscal policy will be required to
enable more rapid adjustment.
35.23
Central and Eastern Europe
0 5000 10000 15000 20000
US$
E Ger
Czech.
Hun
Bulg
Pol
Rom
EC
W Ger

Port
GDP per capita in 1988/89
35.24
Eastern Europe:
some key issues
 On the eve of transition
– low per capita income
– high international debt
 Supply-side reforms
– crucial for prices to reflect true scarcity
 Trade and foreign investment
– markets needed for products
– and physical capital/management skills
 Macroeconomic conditions
– firm and credible macro policy needed
– especially to avoid excessive inflation.