Int Monetary Funds

Chapter 2
The
International
Monetary
System
History of Foreign Exchange Rates:
Learning Objectives
• Define terms that are used in reference to exchange rates
and currency regimes
• Define the differences between “devaluation” and
“depreciation”
• Learn how the international monetary system has evolved
from the days of the gold standard to today’s eclectic
currency arrangement
• Discover the origin and development of the Eurocurrency
market
• Analyze the characteristics of an ideal currency
• Explain the currency regime choices faced by emerging
markets
• Describe how the Euro was created and its effects
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History of Foreign Exchange Rates
• The increased volatility of exchange rates is

one of the main economic developments of the
past 42 years
• Although volatile exchange rates increase risk,
they also create profit opportunities for firms
and investors
• The international monetary system is the
structure within which foreign exchange rates
are determined, international trade and capital
flows are accommodated and balance of
payments adjustments made

Currency Terminology
• A foreign currency exchange rate, or

exchange rate, is the price of one country’s
currency in units of another currency or
commodity
– The system, or regime, is classified as a fixed,
floating, or managed exchange rate regime
– The rate at which the currency is fixed, or
pegged, is frequently referred to as its par value
– If the government doesn’t interfere in the
valuation of its currency, the currency is
classified as floating or flexible

• Spot exchange rate is the quoted price for the foreign

exchange to be delivered at once, or in two days for
interbank transactions
– Example: ¥114/$ is quote for 114 yen to buy one US
dollar for immediate delivery
• Forward rate is the quoted price for foreign exchange
to be delivered at a specified date in the future
– Assume the 90-day forward rate for the Japanese yen is
¥112/$
– No currency is exchanged today, but in 90 days it will
take 112 yen to buy one U.S. dollar
– This can be guaranteed by a forward exchange
contract

• Forward premium or discount is the

percentage difference between the spot and
forward exchange rate
• Devaluation of a currency refers to a drop in
foreign exchange value of a currency that is
pegged to gold or another currency
– In other words, the par value is reduced
– The opposite of devaluation is revaluation

• Weakening, deteriorating, or depreciation of

a currency refers to a drop in foreign exchange
value a floating currency. The opposite of
weakening is strengthening or appreciating,
which refers to a gain in the exchange value of
a floating currency
• Soft or weak describes a currency that we
expect to devalue or depreciate relative to
major currencies; hard or strong is the
opposite

History of the International
Monetary System
• The Gold Standard, 1876-1913
– Countries set par value for their currency in terms of gold
– This came to be known as the gold standard and gained
acceptance in Western Europe in the 1870s
– The US adopted the gold standard in 1879
– The “rules of the game” for the gold standard were
simple
• Example: US$ gold rate was $20.67/oz, the British pound
was pegged at £4.2474/oz
• US$/£ rate calculation is $20.67/£4.2472 = $4.8665/£

Monetary System
• Because governments agreed to buy/sell gold
on demand with anyone at its own fixed parity
rate, the value of each currency in terms of
gold, the exchange rates were therefore fixed
• Countries had to maintain adequate gold
reserves to back its currency’s value in order
for regime to function
• The gold standard worked until the outbreak of
WWI, which interrupted trade flows and free
movement of gold thus forcing major nations to
suspend operation of the gold standard

Monetary System
• The Inter-War years and WWII, 1914-1944
– During WWI, currencies were allowed to fluctuate over
wide ranges in terms of gold and each other, theoretically,
supply and demand for imports/exports caused moderate
changes in an exchange rate about an equilibrium value
• The gold standard has a similar function
– In 1934, the US devalued its currency to $35/oz from
$20.67/oz prior to WWI
– From 1924 to the end of WWII, exchange rates were
theoretically determined by each currency's value in terms
of gold.
– During WWII and aftermath, many main currencies lost
their convertibility. The US dollar remained the only major
trading currency that was convertible

Monetary System
• Bretton Woods and the IMF, 1944
– Allied powers met in Bretton Woods, NH and created a
post-war international monetary system
– The agreement established a US dollar based monetary
system and created the IMF and World Bank
– Under original provisions, all countries fixed their
currencies in terms of gold but were not required to
exchange their currencies
– Only the US dollar remained convertible into gold (at
$35/oz with Central banks, not individuals)

Monetary System
– Therefore, each country established its
exchange rate vis-à-vis the US dollar and then
calculated the gold par value of their currency
– Participating countries agreed to try to maintain
the currency values within 1% of par by buying
or selling foreign or gold reserves
– Devaluation was not to be used as a
competitive trade policy, but if a currency
became too weak to defend, up to a 10%
devaluation was allowed without formal
approval from the IMF

Monetary System
– The Special Drawing Right (SDR) is an international
reserve assets created by the IMF to supplement
existing foreign exchange reserves
• It serves as a unit of account for the IMF and is also the
base against which some countries peg their exchange
rates
• Defined initially in terms of fixed quantity of gold, the SDR
has been redefined several times
• Currently, it is the weighted average value of currencies of
5 IMF members having the largest exports
• Individual countries hold SDRs in the form of deposits at
the IMF and settle IMF transactions through SDR transfers

Monetary System
• Eurocurrencies
– Eurocurrencies are domestic currencies of one country
on deposit in a second country
– Any convertible (exchangeable) currency can exist in
“Euro-” form (do not confuse this term with the European
Euro)
– Eurocurrency markets serve two valuable purposes
• These deposits are an efficient and convenient money
market device for holding excess corporate liquidity
• This market is a major source of short-term bank loans to
finance corporate working capital needs

Monetary System
– The modern eurocurrency market was born
shortly after World War II
– Eastern European holders of dollars, including
state trading banks in the Soviet Union, were
afraid to deposit their dollar holdings in the
United States because they felt claims could be
made against these deposits by U.S. residents
– These currency holders then decided to deposit
their dollars in Western Europe
– While economic efficiencies helped spurn the
growth of this market, institutional events were
also important

Monetary System
• Eurocurrency Interest Rates: LIBOR
– In the eurocurrency market the reference rate of interest
is LIBOR- The London Interbank Offered Rate
– LIBOR is now the most widely accepted rate of interest
used in standardized quotations, loan agreements or
financial derivatives valuations
– LIBOR is officially defined by the British Bankers
Association
– For example, the U.S. dollar LIBOR is the mean of 16
multinational banks inter bank offered rates as sampled
at 11am London time in London
– Yen LIBOR, EURO LIBOR and all other LIBOR rates are
calculated the same way

Monetary System
• Fixed exchange rates, 1945-1973
– Bretton Woods and IMF worked well post WWII,
but diverging fiscal and monetary policies and
external shocks caused the system’s demise
• The US dollar remained the key to the web of
exchange rates
– Heavy capital outflows of dollars became
required to meet investors’ and deficit needs
and eventually this overhang of dollars held by
foreigners created a lack of confidence in the
US’ ability to meet its obligations

U.S. Dollar-Denominated Interest
Rates, February 2004
3-month maturities
4.00 % US Prime Rate
LIBOR
London Interbank Offer Rate Eurodollar Deposit
1.1300 % 1 1/8 = 1.12500 % Offer Rate
Eurodollar Spread
1.0300 % 1 1/32 = 1.03125 % Eurodollar Deposit

LIBID Bid Rate
London Interbank Bid Rate
London interbank rates apply to the buying

and selling of eurodollar deposits between 1.00 % US Federal Funds Rate (domestic)
banks in the international markets.
Eurodollar deposits are dollar-denominated
accounts in financial institutions outside of
Source: The Financial Times, Tuesday February 10, 2004, p. 27. the United States
Monetary System
– This lack of confidence forced President Nixon to
suspend official purchases or sales of gold on Aug. 15,
1971
– Exchange rates of most leading countries were allowed to
float in relation to the US dollar
– By the end of 1971, most of the major trading currencies
had appreciated vis-à-vis the US dollar; i.e. the dollar
depreciated
– A year and a half later, the dollar came under attack
again and lost 10% of its value
– By early 1973 a fixed rate system no longer seemed
feasible and the dollar, along with the other major
currencies was allowed to float
– By June 1973, the dollar had lost another 10% in value

© 2004 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada. Permission is granted to reproduce the
above image provided that the source and copyright are acknowledged. Time period shown in diagram: 1/Jan/1971 - 11/Aug/2004
Contemporary Currency Regimes
• The IMF today is composed of national

currencies, artificial currencies (such as the
SDR), and one entirely new currency (Euro)
• All of these currencies are linked to one
another via a “smorgasbord” of currency
regimes

• IMF Exchange Rate Regime Classifications

– Exchange Arrangements with No Separate
Legal Tender: Currency of another country
circulates as sole legal tender or member
belongs to a monetary or currency union in
which same legal tender is shared by members
of the union
– Currency Board Arrangements: Monetary
regime based on implicit national commitment to
exchange domestic currency for a specified
foreign currency at a fixed exchange rate

– Other Conventional Fixed Peg Arrangements:

Country pegs its currency (formal or de facto) at a fixed
rate to a major currency or a basket of currencies where
exchange rate fluctuates within a narrow margin or at
most ± 1% around central rate
– Pegged Exchange Rates w/in Horizontal Bands:
Value of the currency is maintained within margins of
fluctuation around a formal or de facto fixed peg that are
wider than ± 1% around central rate
– Crawling Peg: Currency is adjusted periodically in small
amounts at a fixed, preannounced rate in response to
changes in certain quantitative measures

– Exchange Rates w/in Crawling Peg: Currency is

maintained within certain fluctuation margins around a
central rate that is adjusted periodically
– Managed Floating w/ No Preannounced Path for
Exchange Rate: Monetary authority influences the
movements of the exchange rate through active
intervention in foreign exchange markets without
specifying a pre-announced path for the exchange rate
– Independent Floating: Exchange rate is market
determined, with any foreign exchange intervention
aimed at moderating the rate of change and preventing
undue fluctuations in the exchange rate, rather than at
establishing a level for it

• Fixed Versus Flexible Exchange Rates and why

countries pursue certain exchange rate regimes; based
on premise that all else equal, countries would prefer
fixed exchange rates
– Fixed rates provide stability in international prices for the
conduct of trade
– Fixed exchange rates are inherently anti-inflationary,
requiring the country to follow restrictive monetary and
fiscal policies
– Fixed exchange rates regimes necessitate that central
banks maintain large quantities of international reserves
for use in occasional defense of fixed rate
– Fixed rates, once in place, may be maintained at rates
that are inconsistent with economic fundamentals

Attributes of the “Ideal” Currency
• Exchange rate stability – the value of the currency would be

fixed in relationship to other currencies so traders and investors
could be relatively certain of the foreign exchange value of each
currency in the present and near future
• Full financial integration – complete freedom of monetary flows
would be allowed, so traders and investors could willingly and
easily move funds from one country to another in response to
perceived economic opportunities or risk
• Monetary independence – domestic monetary and interest rate
policies would be set by each individual country to pursue desired
national economic policies, especially as they might relate to
limiting inflation, combating recessions and fostering prosperity
and full employment

Full Capital Controls
Monetary Exchange Rate

Independence Stability
Increased Capital
Mobility
Pure Float Monetary Union

Full Financial
Integration
Economic and financial theory clearly states that a country cannot be on all three
sides of the triangle at once. It must give up one of the three ‘attributes’ if it is to
achieve one of the states described by the corners of the triangle.

• This is referred to as The Impossible Trinity

because a country must give up one of the
three goals described by the sides of the
triangle, monetary independence, exchange
rate stability, or full financial integration. The
forces of economics do not allow the
simultaneous achievement of all three

Emerging Markets & Regime
Choices
• Currency Boards – exist when a country’s
central bank commits to back its monetary
base, money supply, entirely with foreign
reserves at all times
– This means that a unit of the domestic currency
cannot be introduced into the economy without
an additional unit of foreign exchange reserves
being obtained first
• Example is Argentina in 1991 when it fixed the
Argentinean Peso to the US Dollar

Choices
• Dollarization – the use of the US dollar as the official currency of
the country
• Arguments for dollarization include
– Country removes possibility of currency volatility
– Theoretically eliminate possibility of future currency crises
– Greater economic integration with the US and other dollar
based markets
• Arguments against dollarization include
– Loss of sovereignty over monetary policy
– Loss of power of seignorage, the ability to profit from its ability
to print its own money
– The central bank of the country no longer can serve as lender
of last resort
• Examples include Panama circa 1907 and Ecuador circa 2000

Choices
Emerging Market High capital mobility is forcing emerging market
Country nations to choose between two extremes
Free-Floating Regime Currency Board or

Dollarization
•Currency value is free to

float up and down with •Currency Board fixes the
international market forces value of the local currency or
basket; Dollarization replaces
•Independent monetary policy currency with the US dollar
and free movement of capital
allowed, but at the loss of •Independent monetary policy
stability is lost; political influence on
monetary policy is eliminated
•Increased volatility may be
more than what a small •Seignorage, the benefits
financial market can accruing to a government
withstand from the ability to print its
own money, is lost

The Birth of a Currency: The Euro
• 15 Member nations of the European Union are also members
of the European Monetary System (EMS)
– Maastricht Treaty specified timetable and plan for replacing
currencies for a full economic and monetary union
– Convergence criteria called for countries’ monetary and fiscal
policies to be integrated and coordinated
• Nominal inflation should be no more than 1.5% above average for
the three members of the EU with lowest inflation rates during
previous year
• Long-term interest rates should be no more than 2% above
average for the three members of the EU with lowest interest rates
• Fiscal deficit should be no more than 3% of GDP
• Government debt should be no more than 60% of GDP
– European Central Bank (ECB) was established to promote
price stability within the EU

The Euro & Monetary Unification
• The euro, €, was launched on Jan. 4, 1999

with 11 member states
• Effects for countries using the euro currency
include
– Cheaper transaction costs,
– Currency risks and costs related to exchange
rate uncertainty are reduced,
– All consumers and businesses, both inside and
outside of the euro zone enjoy price
transparency and increased price-based
competition

The Euro & Monetary Unification
• Successful unification of the euro relies on two

factors:
– Monetary policy for the EMU has to be
coordinated via the ECB
• Focus should be on price stability of euro and
inflationary pressures of economies
– Fixing the Value of the euro
• On 12/31/1998, the national exchange rates were
fixed to the Euro
• On 1/4/1999 the euro began trading on world
currency markets and value has slid steadily
since its introduction

The U.S. Dollar/Euro Spot Rate,
1999-2004 (monthly average)

Tradeoffs Between Exchange Rate
Regimes
 Vertically, different exchange rate arrangements may dictate whether the country’s government
has strict intervention requirements - rules - or whether it may choose whether, when and to what
degree to intervene in the foreign exchange markets - discretion
Policy Rules
Non-cooperation Cooperation
Between Countries Between Countries
Discretionary Policy
Horizontally, the tradeoff for countries participating in a specific system is between
consulting and acting in unison with other countries -- cooperation -- or operating as
a member of the system, but acting on their own -- independence.

Exchange Rate Regimes: What Lies
Ahead?
Policy Rules
Bretton Woods
Pre WWII
Gold Standard
European
Monetary
System
1979-1999
Non-Cooperation Cooperation
Between Between
Countries Countries
US dollar, The Future?

1981-1985
Discretionary Policy
Summary of Learning Objectives
• A foreign currency exchange rate is the price of one country’s

currency in terms of another currency or commodity (typically gold
or silver)
• Spot exchange rate is the quoted price for foreign exchange to
be delivered at once, or in two days for interbank transactions
• Forward rate is the quoted price for foreign exchange to be
delivered at a specified date in the future
• Devaluation of a currency refers to a drop in the value of a
currency that is pegged, in other words, the par value is reduced.
The opposite of devaluation is revaluation
• Weakening, deterioration, or depreciation of a currency refers
to a drop in value of a floating currency. The opposite of
depreciation is appreciation

• The international monetary system has

evolved from the days of the gold standard to
today’s eclectic currency arrangement
– Gold Standard (1876 – 1913)
– Inter-war period (1914 – 1944)
– Bretton Woods (1944)
– Elimination of dollar convertibility into gold
(1971)
– Exchange rates began to float
• Eurocurrencies are domestic currencies of one
country on deposit in a second country

• If the ideal currency existed in today’s world, it

would have three attributes: a fixed value,
convertibility, and independent monetary policy
• Emerging market countries must often choose
between two extreme exchange rate regimes,
either free-floating or fixed regime such as a
currency board or dollarization

• The 15 members of the EU are also members of the EMS.

– Twelve members of this group have formed an island of fixed
exchange rates amongst themselves in a sea of floating
currencies
– They rely heavily on trade among themselves, so day-to-day
benefits are great
• The euro affects markets in three ways
– Countries within the zone enjoy cheaper transaction costs
– Currency risks and costs related to exchange rate uncertainty
are reduced,
– All consumers and businesses, both inside and outside of the
euro zone enjoy price transparency and increased price-based
competition

Mini Case: The Creation of
Eurodollars
• Assume a French Firm has $10 million in soon-
maturing certificate of deposit in a New York
bank earning 5%
• This firm wants to continue holding U.S.
dollars, but at a higher rate of interest
• A London bank offers 5.25% on dollar deposits
with a similar maturity
• The French firm requests the transfer, and a
Eurodollar deposit is created

Exhibit 2.1 U.S. Dollar– Denominated Interest
Rates, February 2004 (continues)

Exhibit 2.2 The U.S. Dollar– British
Pound Exchange Rate, 1971–2004

Exhibit 2.3 World Currency Events, 1971–
2004

Exhibit 2.3 (continued)

Exhibit 2.3 (continued)

Exhibit 2.4 The Impossible Trinity

Exhibit 2.5 The Ecuadorian Sucre
Exchange Rate, November 1998–March
2000

Exhibit 2.6 The Currency Regime
Choices for Emerging Markets

Exhibit 2.7 The U.S. Dollar/Euro Spot
Exchange Rate, 1999–2004
(Monthly Average)

Exhibit 2.8 The Tradeoffs Between
Exchange Rate Regimes

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Chapter 2

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-2

• The increased volatility of exchange rates is

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-3

• A foreign currency exchange rate, or

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-4

• Spot exchange rate is the quoted price for the foreign

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-5

• Forward premium or discount is the

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-6

• Weakening, deteriorating, or depreciation of

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4.00 % US Prime Rate

1.0300 % 1 1/32 = 1.03125 % Eurodollar Deposit

London interbank rates apply to the buying

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• The IMF today is composed of national

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• IMF Exchange Rate Regime Classifications

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– Other Conventional Fixed Peg Arrangements:

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– Exchange Rates w/in Crawling Peg: Currency is

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• Fixed Versus Flexible Exchange Rates and why

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• Exchange rate stability – the value of the currency would be

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Monetary Exchange Rate

Pure Float Monetary Union

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• This is referred to as The Impossible Trinity

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Free-Floating Regime Currency Board or

•Currency value is free to

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• The euro, €, was launched on Jan. 4, 1999

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• Successful unification of the euro relies on two

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US dollar, The Future?

• A foreign currency exchange rate is the price of one country’s

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• The international monetary system has

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• If the ideal currency existed in today’s world, it

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• The 15 members of the EU are also members of the EMS.