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2. The International Monetary System

2. The International Monetary System. Start by looking at a typical domestic monetary system. Domestic Monetary Systems. Central Bank. Typically, the government establishes a central bank to…. Retail Banks. Government.

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2. The International Monetary System

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  1. 2. The InternationalMonetary System Start by looking at a typical domestic monetary system

  2. Domestic Monetary Systems Central Bank Typically, the government establishes a central bank to…. Retail Banks Government And ultimately, of course, money flows between the government, retail banks, people and businesses. businesses people

  3. Domestic Monetary Policy Monetary policy determines how, and how much money, the central bank inserts into, or takes out of, the economy. The central bank typically does this by raising or lowering the interest rate it charges retail banks; and/or buy buying or selling government debt. The objective(s) of monetary policy may be…

  4. Exchange Rates An exchange rate is simply the price of one currency against another. For example… 30 1 = 1 0.0333 30 30 30 Thai baht per 1 US dollar Or, 1 Thai baht = 1/30 US dollar Exchange rates are necessary to fund international trade and investment.

  5. Trade Flows Example: A Thai exported sells some shoes to an American customer for Bt 3,000. The exchange rate is 30 baht per dollar. $100 Depending upon the payment method, the dollars could be changed into Thai baht in the USA, in Thailand, or through the Bank of International Settlements (BIS) in Switzerland. Bt 3,000 Bt 3,000 / (Bt30/$) = $100

  6. Discussion Questions Consider the baht/dollar exchange rates $1 = ThB 25; $1 = ThB 30, $1 = ThB 40 Q2: From Thailand’s point of view, which is the best exchange rate? Q1: Which exchange rate above indicates a “stronger” baht? A stronger dollar? A2: Generally, a weak currency benefits exporters and the economy; but a strong currency benefits importers and lowers inflation. A1: $1 = ThB 25 makes the dollar weak and therefore the baht strong. Rewriting the exchange rates as ThB 1 = $.04, ThB 1 = $0.0333, ThB 1 = $.025, we can see that the first exchange rate $1 = ThB 25 makes the baht the strongest. But what is also important is the volatility of the exchange rate. Generally, a stable exchange rate is better than a volatile one.

  7. History of Monetary Regimes How exchange rates are determined depends in large part upon the international monetary regime under which it operates.

  8. Gold Standard 1875-1914 Importantly, trade imbalances are funded indirectly by flows of gold reserves! 1. Each country’s central bank holds gold reserves. 3. Exchange rates are determined by the currencies convertibility into gold. 2. Each country sets its own domestic convertibility ratio between gold and its own currency. If England exports goods to France… …gold reserves will flow from France to England. 1 ounce gold = £6 = FFr12…. so £6 = FFr12 or £1 = FFr2. £6 = 1 ounce gold FFr12 = 1 ounce gold gold reserves gold reserves Bank of France Bank of England

  9. Discussion Questions Q1: What is the equillibriating (adjusting) mechanism here for trade imbalances? Q3: What’s bad about this system? Q2: What’s good about this system? A3: For net importers (gold reserve exporters), a temptation to adjust downward the currency/gold exchange rate. A2: Stability. Generally speaking, we’ll see below that fixing a currency to gold – or to anything else, including another currency – can lead to trouble for net importing countries. A1: Flows of gold reserves between countries….causing domestic prices to adjust which should restore trade balances. A2: Legitimacy of currency & low inflation. A3: Systemic problems if equillibriating mechanisms don’t work and reserves get too low.

  10. Bretton Woods 1945-72 The post-WWII international monetary system, created along with the International Monetary Fund (IMF) and the World Bank.

  11. A dollar-based gold standard Participating countries wanted… stable exchange rates. a gold-based system without the need for gold reserves. The eventual solution was….

  12. A dollar-based gold standard UK pound sterling German D-mark French franc Par value Par value Par value Bretton Woods System: The US Dollar fixed to gold; and other currencies fixed at “par” to the US dollar. As a result, the US dollar became the defacto world reserve currency. Gold pegged at $35/ounce

  13. A dollar-based gold standard UK pound sterling German D-mark French franc Eventually, falling demand for US$, coupled with expansionary US monetary policy, forced the US Government to suspend convertibility of dollars for gold…. …and the free-floating, flexible exchange rate regime was born. To increase their reserves, other countries exported heavily to the US, getting dollars in return. Persistent trade deficits weakened faith in the dollar, and encouraged exchanging dollars for gold.

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