Lecture 1 – The International Monetary System
International Finance
• Costs of Globalisation
o Contending with unpredictable exchange rate movements o Political uncertainty
o Complying with local regulations
• International Monetary System is a set of rules that governs international payments
Fixed, Managed or Floating Exchange Rates.
The Gold Standard (1873-‐1913)
• Countries fixed an official gold price and allowed free convertibility between domestic money and gold at that price “mint parity”
• National currency is only issued with gold backing
• Arbitrage opportunities
• Misalignment in exchange rates and imbalances of payment corrected by the price-‐specie flow mechanism
o Cross-‐border flows of gold would automatically correct exchange rates
• Link to gold kept prices stable (inflation low)
• Outbreak of WWI interrupted trade flows and the free movement of gold
Bretton-‐Woods (1944-‐1973)
• Fixed exchange regime
• USD was fixed in terms of gold à other countries fixed their currency relative to the USD
• Countries agreed to maintain currency values within 1% of par by buying or selling foreign or gold reserves
• Triffin paradox: conflict between economic growth (growing need for reserves) and credibility of convertibility.
• Collapsed in 1973 due to diverging fiscal and monetary policies and external shocks.
The Floating Rate Standard (1973-‐1984)
• Exchange rate determined entirely by forces of supply and demand
• Central banks had the obligation to intervene to prevent ‘disorderly conditions’
FIXED VS. FLOATING
• Fixed
o Reduce transactions costs and exchange rate risk (these factors discourage trade)
o Provide credible nominal anchor for monetary policy o Transparency
• Float
o Independent (tailored monetary policy) Ideal Currency:
European Monetary Union
• Creation of the European Monetary System
• 11 members initially
• Benefits
o Cheaper transaction costs o Currency risks and costs reduced o Euro zone price transparency
o E.g. financial integration and exchange rate stability
• Costs
o Coordinated monetary and fiscal policy rules
o i.e. no monetary independence
