IFM - Chapter 2

What is the International Monetary System?

A set of agreements, rules, and mechanisms regarding exchange rates, international payments, and capital flow

In international monetary system: the framework is

where international payments are made, movements of capital are accommodated , and exchange rates among currencies are determined

Bimetallism was a…….. and exchange rates

“double standard" in which free coinage was maintained for both gold and silver;

exchange rates among currencies were determined by their gold or silver contents.

Greshams law is

since the exchange ratio between two metals was officially fixed, the abundant metal was used as money while the scarce metal was driven out of circulation.

an international gold standard exists when: list 3

• Gold alone is assured of unrestricted coinage

• there is two-way convertibility between gold and national currencies at a stable ratio

• Gold can be freely exported or imported

Under the gold standard, the ____

exchange rate between any two currencies will be determined by the gold contents

In the Gold standard, London became ___

the center of the international financial system

Classical Gold Standard: Advantages

• Highly stable exchange rates conducive to international trade

• Money supply cannot get out of control/cause inflation because gold is naturally scarce

• No country can have a persistent trade deficit/surplus bc countries balance payments will be regulated automatically via the movements of gold

Classical Gold Standard: shortcomings

• lack of sufficient monetary reserves due to the restricted supply of newly minted gold that can hamper the growth of world trade and investment

• no mechanism to compel each major country to abide by the rules of the game

What years did the Interwar Period cover, and what ended the classical gold standard?

• 1915 - 1944

• WWI ended the classical gold standard in August 1914

What characterized the Interwar Period?

• Failed attempts to restore the gold standard

• the great depression, economic/political instablility

• no coherent international monetary system, which hurt international trade and investment

What years did the Bretton Woods system cover and what was it named after?

• 1945 - 1972

• named for the July 1944 meeting of 44 nations at Bretton Woods, New Hampshire

what was the purpose of the Bretton Woods system?

to design a postwar international monetary system that would provide exchange rate stability w/o the gold standard

What was the result of Bretton Woods (the dollar-based gold exchange standard)?

• The U.S. dollar was pegged to gold (the only currency fully convertible to gold) and other currencies were pegged to the U.S. dollar

• this established U.S. dollar dominance as the global currency

• created the (international monetary fund ) IMF and the World Bank.

the design of the gold-exchange system

List the 4 advantages of the Bretton Woods System

1. Economizes on gold

2. Countries can earn interest on FX holdings

3. Lower transaction costs (no gold transportation)

4. Stable exchange rates.

what is the Triffin Paradox?

• it led to the collapse of the system in the early 1970s

• The reserve currency country has to run a balance of payments deficit to satisfy the growing need for reserves from the rest of the world

• which decreases confidence in the reserve currency and can lead to the downfall of the system;

The trilemma is an economic theory, which

posits that countries may choose from three options when making fundamental decisions about their international monetary policy agreements

In the Trilemma, only ___ option of the trilemma____

ONE option of the trilemma is achievable at a given time, as the 3 options are mutually exclusive

Bretton Woods Breakdown: list steps 1-6

Step 1 — Pressure on the USD: a large budget deficit in the U.S. leading to a lack of confidence

Step 2 — West Germany (May 1971) & Switzerland (August 1971) broke from the fixed exchange rate; their currencies strengthened in the market.

Step 3 — Nixon ends the gold standard (August 1971), aiming to curb speculation and protect gold reserves.

Step 4 — Smithsonian Agreement (December 1971): achieved stable exchange rates.

Step 5 — Final devaluation (February 1973) & move to floating FX (March 1973): Japan, UK, France, Italy, and Canada joined West Germany and Switzerland in letting their currencies free float.

Step 6 — Jamaica Accord (January 1976): formal adoption of floating exchange rates.

What years does the Flexible Exchange Rate Regime cover, and when was it ratified?

• 1973 to present

• ratified in January 1976 when IMF members met in Jamaica (the Jamaica Agreement).

List the 4 rules of the Jamaica Agreement

1. Flexible exchange rates declared acceptable to IMF members

2. Central banks could intervene in exchange markets to iron out unwarranted volatility

3. Gold was officially abandoned (demonetized) as an international reserve asset

4. Non-oil-exporting and less-developed countries were given greater access to IMF funds.

How many separate exchange rate regimes does the IMF currently classify arrangements into?

10

No separate legal tender: and list ex

currency of another country circulates as the sole legal tender

• ex: ecuador, el salvador, panama

currency board

An extreme form of fixed exchange rate regime under which local currency is fully backed by a foreign currency at a fixed rate, leaving little room for discretionary monetary policy

• ex :Hong Kong, Bulgaria, Brunei

Conventional peg

A country formally pegs its currency at a fixed rate to another currency or basket of currencies

• ex: Jordan, Saudi Arabia, Nepal

Stabilized arrangement

A spot market exchange rate that remains within a margin of 2% for 6 months or more

• ex: Vietnam, Nigeria, Lebanon

Crawling peg

The currency is adjusted in small amounts at a fixed rate or in response to changes in selected indicators

• ex: Honduras, Nicaragua

Crawl-like arrangement

Exchange rate must remain within a narrow margin of 2% relative to a statistically identified trend for 6 months or more, and cannot be considered floating

• ex: Singapore, Romania, Tunisia

Pegged exchange rate with horizontal bands

Currency value maintained within margins of fluctuation of at least +/- 1% around a fixed central rate, or the max-min margin exceeds 2%

Other managed arrangement:

Residual category used when the exchange rate arrangement does not meet the criteria for any of the other categories

• ex - (China <managed float>, Argentina, and Kuwait).

Floating: and example

Exchange rate is largely market determined, without an ascertainable or predictable path

• for example - Brazil, Korea, Turkey, India, South Africa, and Thailand

Free floating: and example

Intervention occurs only exceptionally to address disorderly market conditions, limited to at most 3 instances in the previous 6 months, each lasting no more than 3 business days

• ex - Australia, Canada, Mexico, Japan, U.K., U.S., euro zone

What is a fiat currency?

A currency put into circulation by governments with no intrinsic value backed by claims on underlying real assets like gold

What is a cryptocurrency?

A digital currency designed to function as a medium of exchange through a decentralized network of computers that keep public records of transactions using cryptographic technology, without government or central bank involvement

What is a Central Bank Digital Currency (CBDC)?

Essentially a digital version of the fiat currency issued by the central bank

Which three countries have fully launched a CBDC?

Bahamas, Jamaica, and Nigeria

When was the first cryopto, Bitcoin introduced, and as what?

• January 2009,

• Introduced as open-source software (followed by Ethereum, Litecoin, etc.).

What are the 3 functions of money Bitcoin was found unsuitable for?

1. Unit of accounting

2. Medium of exchange

3. Storage of value
   
   
   Instead, Bitcoin has been used as a highly speculative asset class

Which countries adopted Bitcoin as legal tender, and when?

• El Salvador (September 2021)

• Central African Republic (April 2022)

When was the EMS launched, and what were its 3 goals?

Launched 1979

goals -

1. Establish a "zone of monetary stability" in Europe

2. Coordinate exchange rate policies vis-à-vis non-EMS currencies

3. Pave the way for eventual European monetary union.

2 main instruments of the EMS were

• European Currency Unit (ECU, precursor of the euro)

• Exchange Rate Mechanism (ERM).

The EMS went through a series of realignments and __

paved the way for the European Monetary Union (EMU)

When did the euro launch and how many EU countries adopted it initially?

• January 1, 1999

• 11 of 15 EU countries adopted the euro, creating the EMU.

When were euro notes and coins introduced into circulation?

January 1, 2002

• while national bills/coins were gradually withdrawn

the first time sovereign countries voluntarily have

given up their monetary independence to foster economic integration

Who conducts monetary policy for the euro zone, where is it headquartered, and what is its objective?

• The European Central Bank (ECB)

• headquartered in Frankfurt

• primary objective is price stability and its independence is legally guaranteed.

Eurosystem is made up of

the ECB and central banks of the euro-zone countried

Eurosystem is designed to:

• define and implement common monetary policy of the union

• conduct foreign exchange operations

• hold and manage official foreign reserves of euro member states

List the 5 key benefits of monetary union

1. Reduced transaction costs

2. Elimination of exchange rate uncertainty

3. Enhanced efficiency/competitiveness of the European economy

4. Development of continental capital markets comparable to the U.S.

5. Political cooperation and peace in Europe.

what is the main cost of monetary union?

Loss of national monetary and exchange rate policy independence, making it hard to deal with asymmetric shocks

What is the relevant criterion for an "optimum currency area"?

the degree of factor mobility within the zone

About what percent of foreign trade of euro-zone countries is intra-euro-zone trade?

about 60%

Name the 3 major currency crises taht revealed the fragility of the international monetray system (IMS):

• Mexican peso crisis (1994–1995)

• Asian currency crisis (1997–1998)

• Argentine peso crisis (2002).

What triggered the Mexican Peso Crisis, and when?

• On December 20, 1994

• the Mexican government announced a plan to devalue the peso against the dollar by 14 percent

• causing pesos, Mexican stocks, and bonds to be sold rapidly

By early January 1995, how much had the peso fallen, and what did this force?

• Fallen against the U.S. dollar by as much as 40 percent

• forcing the Mexican government to float the peso.

What makes the Mexican Peso Crisis unique?

its the First serious international financial crisis touched off by cross-border flight of portfolio capital.

What are the 2 lessons of the Mexican Peso Crisis?

1. Essential to have a multinational safety net to safeguard the world financial system

2. Mexico excessively depended on foreign portfolio capital instead of prioritizing domestic saving.

What triggered the Asian Currency Crisis, and when?

• On July 2, 1997, the Thai baht (largely fixed to the U.S. dollar) was suddenly devalued

• and triggered a panicky flight of capital from other Asian countries.

What was the impact of the Asian Currency Crisis on East Asia?

Escalated into a global financial crisis more serious than the EMS and Mexican peso crises, leading to a deep, widespread, long-lasting recession in a region that had enjoyed rapid growth.

List the 5 origin factors of the Asian Currency Crisis

•Weak domestic financial system with poor risk management and supervision.

•Free international capital flows that resulted in a credit boom and speculations in real estate and stock markets.

•Fixed or stable exchange rates encouraged unhedged financial transactions and excessive risk–taking by both borrowers and lenders.

•Booming economy with a fixed exchange rate also brought about an appreciation of the real exchange rate, which led to a slowdown in export growth.

•Japan’s long–lasting recession (and yen depreciation) hurt neighboring countries too.

What is the "Incompatible Trinity"?

Very difficult, if not impossible, to have all three of:

• a fixed exchange rate

• free international flows of capital

• independent monetary policy.

What happened in the Argentine Peso Crisis, and when?

• In February 1991,

• Argentina passed the Convertibility Law, linking the peso to the U.S. dollar at parity.

in the Argentine Peso Crisis, The initial economic effects were positive

• Argentina’s chronic inflation was curtailed dramatically, and foreign investment began to pour in, leading to an economic boom.

As the U.S. dollar became increasingly stronger in the second half of the 19 90s, _____

peso appreciated against most currencies.

A strong peso hurt exports from Argentina and caused a

protracted economic downturn that led to the abandonment of peso–dollar parity in January 2002.

List the 3 factors related to the collapse of Argentina's currency board

1. Lack of fiscal discipline

2. Labor market inflexibility

3. Contagion from Brazil and Russia's financial crises.

What has limited the RMB from achieving international prominence?

The limited openness of China's capital markets.

Since what year has the IMF included the RMB in the SDR?

2016

List the 3 conditions China needs to meet for the RMB to become a global currency

1. Full convertibility of its currency

2. Open capital markets with depth and liquidity

3. Rule of law and protection of property rights.

Arguments in favor of flexible exchange rates: list 2

•Easier external adjustments

•National policy autonomy

Arguments against flexible exchange rates: list 2

•Exchange rate uncertainty may hamper international trade and investment

No safeguards to prevent crises

List the 3 things a "good" international monetary system should provide

• liquidity

• adjustment

• confidence

sufficient liquidity __

to support the growth of international trade and investment.

Mechanism for adjustment______

that restores the balance of payments disequilibrium.

Safeguard to prevent crises of confidence

in the system