Chapter 10

Monetary System

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Monetary System

•Relationship between monetary system and foreign exchange rates•Historical development• Fixed vs floating exchange rates•Role of the IMF and World Bank• Implications for managers

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International Monetary System

• Currency exchange rates depend on the structure of the international monetary system

• In 2003 of all IMF members currencies

- Only 19% were free floating

- 25% were managed float

- 8% were adjustable peg

- 22% were fixed peg

- 4% were fixed by a currency board

- 22% were not currency of their own (use Euro, US Dollar)

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Evolution of the International Monetary System

• Gold Standard: currencies pegged to gold value- Convertibility guaranteed- By 1880 most on gold standard- Balance of trade equilibrium for all countries• Value of exports should equal value of imports• Flow of gold used to make up differences

- Abandoned in 1914• Failed resumption after WWI• Great Depression

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Bretton Woods (1944 - 1973)

• 44 countries met to design a new system in 1944

• Established:International Monetary Fund (IMF) and World Bank

- IMF: maintain order in monetary system

- World Bank: promote general economic development

- Fixed exchange rates pegged to the US Dollar

- US Dollar pegged to gold at $35 per ounce

- Countries maintained their currencies ± 1% of the fixed rate; buy/sell own currency to maintain level

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The Role of the IMF

• IMF maintained exchange rate - discipline

• National governments had to manage inflation through their money supply

- flexibility• Provides loans to help members states with temporary

balance-of-payment deficit; - Allows time to bring down inflation- Relieves pressures to devalue

• Excessive drawing from IMF funds came with IMF supervision of monetary and fiscal policies

- Allowed to 10% devaluations and more with IMF approval• 187 members by 2003

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The Role of the World Bank

• World Bank (IBRD) role(International Bank for Reconstruction & Development)- Refinanced post-WWII reconstruction and development- Provides low-interest long term loans to developing

economies• The International Development Agency (IDA), an arm of the

bank created in 1960- Raises funds from member states- Loans only to poorest countries- 50 year repayment at 1% per year interest

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Collapse of Bretton Woods

• Devaluation pressures on US dollar after 20 years- Lyndon Johnson policies• Vietnam war financing• Welfare program financing

- Nixon ended gold convertibility of US dollar in 1971- US dollar was devalued and dealers started

speculating against it for further devaluation- Bretton Woods fixed exchange rates abandoned in

January 1972

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Jamaica Agreement 1976

• Floating rates declared acceptable• Gold abandoned as reserve asset; - IMF returned gold reserves to members at

current prices- Proceeds placed in trust fund to help poor

nations- IMF quotas – member country contributions –

increased; membership now 182 countries- Less-develop, non-oil exporting countries given

more access to IMF• IMF continued its role of helping countries cope with

macroeconomic and exchange rate problems

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- Monetary policy autonomy- Trade balance adjustments helped

The Case for Fixed Exchange Rates- Monetary discipline- Speculation limited- Uncertainty reduced- Trade balance adjustment effects on inflation controlled

Who is right?

The Case for Floating Exchange Rates

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Recent Activities and the IMF

• Mexican Crisis 1995• Russian Ruble crisis1995• Asian crisis 1997/1998

- Events • The investment boom• Excess capacity• The debt bomb• Expanding imports• The crisis

• How does the IMF achieve results?- Inappropriate policies?- Moral Hazard?- Lack of accountability?

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Managerial Implications

• Currency management- Currency market does not always work as expected- Government intervention- Speculative activity

• Business strategy- Movements in exchange rates are difficult to predict- Forward market is imperfect predictor of exchange rate movements- Forward exchange rate market covers risk for months not years- Maintenance of strategic flexibility required

• Disperse manufacturing• Outsource

- Corporate-government relations