Money and Banking Chapter 19 International Monetary Regimes

Chapter 19 International Monetary Regimes CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Define the impossible trinity , or trilemma , and explain its importance . Identify the four major types of international monetary regimes and describe how they differ . Explain how central banks manage the foreign exchange ( rate . Explain the benefits of fixing the rate , or keeping it within a narrow band . Explain the costs of fixing the rate , or keeping it in a narrow band . URL books 397

The Trilemma , or Impossible Trinity LEARNING OBJECTIVES . What is the impossible trinity , or trilemma , and why is it important ?

What are the four major types of international monetary regimes and how do they differ ?

The foreign exchange ( or ) market described in Chapter 18 Foreign Exchange is called the free regime because monetary authorities allow world markets ( via interest rates , and expectations about relative price , productivity , and trade levels ) to determine the prices of different currencies in terms of one another . The free , as we learned , was characterized by tremendous exchange rate volatility and unfettered international capital mobility . As we learned in Chapter 13 Central Bank Form and Function Chapter 17 Monetary Policy Targets and Goals , it is also characterized by national central banks with tremendous discretion over domestic monetary policy . The free is not , however , the only possible international monetary regime . In fact , it has pervaded the world economy only since the early , and many nations even today do not embrace it . Between World War II and the early , much of the world ( the , or free , world ) was on a managed , regime called the Woods System ( Before that , many nations were on the gold standard ( as summarized in Figure The trilemma , or impossible trinity , of international monetary regimes . Figure The trilemma , or impossible trinity , of international monetary regimes URL books 393

Note that those were the prevailing regimes . Because nations determine their monetary relationship with the rest of the world individually , some countries have always remained outside the prevailing system , often for strategic reasons . In the nineteenth century , for example , some countries chose a silver rather than a gold standard . Some allowed their currencies to in wartime . Today , some countries maintain exchange rates ( usually against ) or manage their currencies so their exchange rates stay within a band or just as no country can do away with scarcity or asymmetric information , none can escape the trilemma ( a dilemma with three components ) also known as the impossible trinity . Figure Strengths and weaknesses of international monetary regimes As Figure The trilemma , or impossible trinity , of international monetary regimes shows , only two of the three holy of international monetary policy , exchanged rates , international capital mobility , and domestic monetary policy discretion , can be at once . Countries can adroitly change regimes when it suits them , but they can not enjoy capital mobility , exchange rates , and discretionary monetary policy all at once . That is because , to maintain a exchange rate , a monetary authority ( like a central bank ) has to make that rate its sole URL books 399

consideration ( thus giving up on domestic goals like or domestic product ) or it has to seal off the nation from the international system by cutting off capital . Each component of the trilemma comes laden with costs and , so each major international policy regime has strengths and weaknesses , as outlined in Figure Strengths and weaknesses of international monetary regimes . Stop and Think Box From 1797 until 1820 or so , Great Britain abandoned the specie standard it had maintained for as long as anyone could remember and allowed the pound sterling to quite freely . That was a period of almost nonstop warfare known as the Napoleonic Wars . The United States also abandoned its specie standard from 1775 until 1781 , from 1814 until 1817 , and from 1862 until essentially 1873 . Why ?

Those were also periods of warfare and their immediate aftermath in the United Revolution , War of 1812 , and Civil War , respectively . Apparently during wartime , both countries found the specie standard costly and preferred instead to with free mobility of capital . That allowed them to borrow abroad while simultaneously gaining discretion over domestic monetary policy , essentially allowing them to fund part of the cost of the wars with a currency tax , which is to say , KEY TAKEAWAYS The impossible trinity , or trilemma , is one of those aspects of the nature of things , like scarcity and asymmetric information , that makes life difficult . Specifically , the trilemma means that a country can follow only two of three policies at once international capital mobility , fixed exchange rates , and discretionary domestic monetary policy . To keep exchange rates fixed , the central bank must either restrict capital flows or give up its control over the domestic money supply , interest rates , and price level . This means that a country must make difficult decisions about which variables it wants to control and which it wants to give up to outside forces . The four major types of international monetary regime are specie standard , managed fixed exchange rate , free float , and managed float . They differ in their solution , so to speak , of the impossible trinity . URL books 400

Specie standards , like the classical , maintained fixed exchange rates and allowed the free flow of financial capital internationally , rendering it impossible to alter domestic money supplies , interest rates , or inflation rates . Managed fixed exchange rate regimes like allowed central banks discretion and fixed exchange rates at the cost of restricting international capital flows . Under a free float , free capital flows are again allowed , as is domestic discretionary monetary policy , but at the expense of the security and stability of fixed exchange rates . With a managed float , that same solution prevails until the rate moves to the top or bottom of the desired band , at which point the central bank gives up its domestic discretion so it can concentrate on appreciating or depreciating its currency . URL books eh 401

Two Systems of Fixed Exchange Rates LEARNING OBJECTIVE . What were the two major types of fixed exchange rate regimes and how did they differ ?

Under the gold standard , nations defined their respective domestic units of account in terms of so much gold ( by weight and fineness or purity ) and allowed gold and international checks ( known as bills of exchange ) to between nations unfettered . Thanks to , the spot exchange rate , the market price of bills of exchange , could not stray very far from the exchange rate implied by the of each nation unit of account . For example , the United States and Great Britain their units of account roughly as follows oz . gold oz . gold . Thus , the implied exchange rate was roughly ( or ) It was not costless to send gold across the Atlantic , so Americans who had payments to make in Britain were willing to buy bills of exchange for something more than per pound and Americans who owned sterling bills would accept something less than per pound , as the supply and demand conditions in the sterling bills market dictated . If the dollar too far , however , people would stop buying bills of exchange and would ship gold to Britain instead . That would decrease the US . money supply and appreciate the dollar . If the dollar appreciated too much , people would stop selling bills of exchange and would order gold shipped from Britain instead That increased the money supply and the dollar . The system was , functioning without government intervention ( after their initial ofthe domestic unit ) Figure ) classical gold URL books ?

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eF You As noted in Figure Strengths and weaknesses of international monetary regimes and shown in Figure exchange during the classical gold standard , the great strength of the was exchange rate stability . One weakness of the system was that the United States had so little control of its domestic monetary policy that it did not need , or indeed have , a central bank . Other countries , too , suffered from their inability to adjust to domestic shocks . Another weakness of the was the annoying fact that gold supplies were rarely in synch with the world economy , sometimes lagging it , thereby causing , and sometimes exceeding it , hence inducing . Stop and Think Box Why did the United States find it prudent to have a central bank ( the . and the . during the late eighteenth and early nineteenth centuries , when it was on a specie standard , but not later in the nineteenth century ?

Hint Transatlantic transportation technology improved dramatically beginning in the . As discussed in earlier chapters , the . and . had some control over the domestic money supply by regulating commercial bank reserves via the alacrity of its note and deposit redemption policy . Although the United States was on a de facto specie standard ( legally but de facto silver , then gold ) at the time , the exchange rate bands were quite wide because transportation costs ( insurance , URL books 403

freight , interest lost in transit ) were so large compared to later in the century that the monetary regime was more akin to a modern managed . In other words , the central bank had discretion to change the money supply and exchange rates within the wide band that the costly state of technology created . The Woods System adopted by the world countries in the final stages of World War II was designed to overcome ofthe while maintaining the stability exchange rates . By making the dollar world reserve currency ( basically substituting gold ) it ensured a more elastic supply reserves and also allowed the United States to earn seigniorage to help the costs it World War II , the Korean War , and the cold war . The US . government promised to convert into gold at a rate ( 35 per oz . essentially rendering the United States the banker to more than half of the world economy . The other countries in the system maintained exchange rates with the dollar and allowed for domestic monetary policy discretion , so the had to restrict international capital . Little wonder that the period after World War II witnessed a massive shrinkage of the international financial system . Under the , if a country could no longer defend its rate with the dollar , it was allowed to devalue its currency , or in other words , to set a newer , weaker exchange rate . As Figure sterling exchange under reveals , Great Britain devalued several times , as did other members of the . But what ultimately destroyed the system was the fact that the banker , the United States , kept issuing more without increasing its reserve of gold . The international equivalent of a bank run ensued because major countries , led by France , exchanged their for gold . Attempts to maintain the in the early failed . Thereafter , Europe created its own fixed exchange rate system called the exchange rate mechanism ( ERM ) with the German mark as the reserve currency . That system morphed into the European currency union and adopted a common currency called the euro . Figure ' un ( URL books ' 404

. SIN sue , Yul Most countries today allow their currencies to freely or employ a managed strategy . With international capital mobility restored in many places after the demise of the , the international system has waxed ever stronger since the early . KEY TAKEAWAYS The two major types of fixed exchange rate regimes were the gold standard and Woods . The gold standard relied on retail convertibility of gold , while the relied on central bank management where the stood as a sort of substitute for gold . URL books ( 405

The Managed or Dirty Float LEARNING OBJECTIVE . How can central banks manage the rate ?

The managed ( aka dirty ) is perhaps the most interesting attempt to , if not eliminate the impossible trinity , at least to blunt its most pernicious characteristic , that of locking countries into the disadvantages outlined in Figure Strengths and weaknesses of international monetary regimes . Under a , the central bank allows to determine ( in exchange rates but intervenes ifthe currency grows too weak or too strong . In other words , it tries to keep the exchange rate range bound . Those ranges or bands can vary in size from very wide to very narrow and can change levels over time . Central banks intervene in the foreign exchange markets by exchanging international reserves , assets currencies , gold , and special drawing rights ( for domestic currency ) Consider the case of Central Bank selling 10 billion of international reserves , thereby soaking up 10 billion of ( the monetary base , or currency in circulation or reserves ) The would be ( Bunk Assets Liabilities International reserves 10 billion Currency in circulation or reserves ( 10 billion If it were to buy 100 million of international reserves , both and its holdings of foreign assets would increase Central Assets Liabilities International reserves 100 million Monetary base 100 million Such transactions are known in the biz as unsterilized foreign exchange interventions and they the rate via changes in . Recall from Chapter 18 Foreign Exchange that increasing the money supply ( causes the domestic currency to depreciate , while decreasing the causes URL , or books 406

it to appreciate . It does so by both the domestic interest rate ( nominal ) and expectations about Eek , the future exchange rate , via price level ( expectations . There is also a direct effect on the , but it is too small in most instances to be detectable and so it can be safely ignored . Intuitively , however , increasing the money supply leaves each unit of currency less valuable , while decreasing it renders each unit more valuable . Central banks also sometimes engage in exchange interventions when they the purchase or sale reserves with a domestic sale . For example , a central bank might offset or sterilize the purchase of 100 million of international reserves by selling 100 million of domestic government bonds , or vice versa . In terms of a Central Assets Liabilities International reserves million Government bonds 100 million Monetary base million Monetary base 100 million Because there is no net change in , a sterilized intervention should have no impact on the exchange rate . Apparently , central bankers engage in sterilized interventions as a ruse ( where central banks are not transparent , considerable asymmetric information exists between them and the markets ) or to signal their desire to the market . Neither go very far , so for the most part central banks that wish to manage their nation exchange rate must do so via unsterilized interventions , buying international reserves with domestic currency when they want to depreciate the domestic currency , and selling international domestic currency when they want the domestic currency to appreciate . The degree management can a hard peg , where a country tries to keep its currency to another , anchor currency , to such wide bands that intervention is rarely undertaken . Figure Thai exchange rate , clearly shows that Thailand used to maintain a hard peg against the dollar but gave it up during the Southeast Asian financial crisis of 1997 . That big spike was not pleasant for Thailand , especially for economic agents within it that had debts in foreign currencies , which suddenly became much more difficult to URL books 0791 ) 407

repay . In June 1997 , it took only about 25 baht to purchase a dollar . By the end of that year , it took over 50 baht to do so . Clearly , a major downside of maintaining a hard peg or even a tight band is that it simply is not always possible for the central bank to maintain or defend the peg or band . It can run out of international reserves in a fruitless attempt to prevent a depreciation ( cause an appreciation ) Or maintenance of the peg might require increasing or decreasing the counter to the needs of the domestic economy . Figure Thai exchange rate , I 530000 ( new . a Dali Figure Intervening in the market under exchange rate regime URL books IQ , 408

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Expected Return 35 ) in domestic currency terms ) a ) in the ( Intervention in the case of an overvalued case of an undervalued exchange rate exchange rare A graph , like the one in Figure in the market under a fixed exchange rate regime , might be useful here . When the market exchange rate ( is equal to the , pegged , or desired central bank rate ( Em ) everything is hunky dory . When a currency is overvalued ( by the central bank ) which is to say that is less than Em ( measuring as foreign domestic currency ) the central bank must soak up domestic currency by selling international reserves ( foreign assets ) When a currency is undervalued ( by the central bank ) which is to say that when is higher than Em , the central bank must sell domestic currency , thereby gaining international reserves . Stop and Think Box In 1990 , interest rates rose in Germany due to West Germany with formerly communist East Germany . Recall from Chapter 18 Foreign Exchange that when exchange rates are fixed , the interest parity condition collapses to ii ) iF because Ea ) Therefore , interest rates also rose in the other countries in the ERM , including France , leading to a slowing of economic growth there . The same problem could recur in the new European currency union or euro zone if part of the zone needs a high interest rate to stave off while another needs a low interest rate to stoke employment and growth . What does this analysis mean for the likelihood of creating a single world currency ?

URL books 409 It means that the creation of a world currency is not likely anytime soon . As the European Union has discovered , a common currency has certain advantages , like the savings from not having to convert one currency into another or worry about the current or future exchange rate ( because there is none ) At the same time , however , the currency union has reminded the world that there is no such thing as a free lunch , that every comes with a cost . The cost in this case is that the larger the common currency area becomes , the more difficult it is for the central bank to implement policies to the entire currency union . It was for that very reason that Great Britain opted out of the euro . KEY TAKEAWAYS Central banks influence the rate via unsterilized foreign exchange interventions or , more specifically , by buying or selling international reserves ( foreign assets ) with domestic currency . When central banks buy international reserves , they increase and hence depreciate their respective currencies by increasing inflation expectations . When central banks sell international reserves , they decrease and hence appreciate their respective currencies by decreasing inflation expectations . URL books 410

The Choice of International Policy Regime LEARNING OBJECTIVE . What are the costs and benefits of fixing the rate or keeping it within a narrow band ?

Problems ensue when the central bank runs out , as it did in Thailand in 1997 . The International Monetary Fund ( IMF ) often provides loans to countries attempting to defend the value of their currencies . It doesn really act as an international lender of last resort , however , because it doesn follow Hamilton Law . It simply has no mechanism for adding liquidity quickly , and the longer one waits , the bigger the eventual bill . Moreover , the IMF often forces borrowers to undergo austerity programs ( high government taxes , decreased expenditures , high domestic interest rates , and so forth ) that can create as much economic pain as a rapid depreciation would . Finally , it has created a major moral hazard problem , repeatedly lending to the same few countries , which quickly learned that they need not engage in responsible policies in the long run because the IMF would be sure to help out if they got into trouble , Sometimes the medicine is indeed worse than the disease ! Trouble can also arise when a central bank no longer wants to accumulate international reserves ( or indeed any assets ) because it wants to squelch domestic , as it did in Germany in . Many fear that China , which currently owns over trillion in international reserves ( mostly ) will itself in this conundrum soon . The Chinese government accumulated such a huge amount of reserves by fixing its currency ( which confusingly goes by two names , the yuan and the , but one symbol , at the rate of per . Due to the growth of the Chinese economy relative to the economy , exceeded Em , inducing the Chinese , per the analysis above , to sell for international reserves to keep the yuan permanently weak , or undervalued relative to the value the market would have assigned it . You should recall from Chapter 18 Foreign Exchange that undervaluing the yuan helps Chinese exports by making them appear cheap to foreigners . If you don believe me , walk into any Mart , Target , or other discount store . Many people think that China peg is unfair , a monetary form of dirty pool . Such folks need to realize that there is no such thing as a free lunch . To maintain its peg , URL books 411

the Chinese government has severely restricted international capital mobility via currency controls , thereby injuring the efficiency of Chinese financial markets , limiting foreign direct investment , and encouraging mass loophole mining . It is also stuck with a trillion bucks of relatively international reserves that will decline in value when the yuan ( and probably appreciates strongly ) as it eventually must . In other words , China is setting itself up for the exact opposite of the Crisis , where the value ofits assets instead ofthe value ofits liabilities skyrocketing . In China defense , many developing countries it advantageous to peg their exchange rates to the dollar , the yen , the euro , the pound sterling , or a basket of such important currencies . The peg , which can be thought a monetary policy target similar to an or money supply target , allows the developing nation central bank out whether to increase or decrease and by how much . A hard peg or narrow band ties the domestic rate to that ofthe anchor country , instilling in the developing country performance . Indeed , in extreme cases , some countries have given up their central bank altogether and have , adopting or other currencies ( though the process is still called ) as their own . No international law prevents this , and indeed the country whose currency is adopted earns seigniorage and hence has little grounds for complaint . Countries that want to completely outsource their monetary policy but maintain seigniorage revenue ( the profits from the issuance of money ) adopt a currency board that issues domestic currency but backs it 100 percent with assets in the anchor currency . The board invests the reserves in assets , the source of the seigniorage . Argentina from just such a board during the , when it pegged its peso with the dollar , because it finally got , which often ran over 100 percent per year , under control . Fixed exchange rates not based on commodities like gold or silver are , however , because relative changes in interest rates , trade , and productivity can create persistent imbalances over time between the developing and the anchor currencies . Moreover , speculators can force countries to devalue ( move EM down ) or revalue ( move Em up ) when they hit the bottom or top of a band . They do so by using the derivatives markets to place big bets on the future exchange rate . URL books 412

Unlike most bets , these are because the speculators lose little money if the central bank successfully defends the peg , but they win a lot if it fails to . Speculator George , for example , is reported to have made billion speculating against the pound sterling during the ERM balance of payments crisis in September 1992 . Such crises can cause tremendous economic pain , as when Argentina found it necessary to abandon its currency board and peg with the dollar in due to speculative pressures and fundamental misalignment between the Argentine and economies . Basically , the United States was booming and Argentina was in a recession . The former needed higher interest rates slower money growth and the latter needed lower interest rates money growth . Developing countries may be best what is called a crawling target or crawling peg . Generally , this entails the developing country central bank allowing its domestic currency to depreciate or appreciate over time , as general conditions ( the variables discussed in Chapter 18 Foreign Exchange ) dictate . A similar strategy is to recognize imbalances as they occur and change the peg on an ad hoc basis accordingly , perhaps first by allowing the band to widen before permanently moving it . In those ways , developing countries can maintain some rate stability , keep in check ( though perhaps higher than in the anchor country ) and hopefully avoid exchange rate crises . Stop and Think Box What sort of international monetary regimes are consistent with Figure exchange rate , and Figure Hong exchange rate , Figure , rate , 1997 2007 URL books ' 413

II ' i am Figure exchange rate , URI 785 . DIE Figure exchange rate , certainly is not a fixed exchange rate regime , or a managed with a tight band . It could be consistent with a fully free , but it might also represent a managed with wide bands between about to per dollar . URL books 414

It appears highly likely from Figure Hong exchange rate , that Hong Kong monetary authority for most of the period from 1984 to 2007 engaged in a managed within fairly tight bands bounded by about and to the dollar . Also , for three years early in the new millennium , it pegged the dollar at before returning to a looser but still tight band in 2004 . KEY TAKEAWAYS A country with weak institutions ( a dependent central bank that allows rampant inflation ) can essentially on the monetary policy of a developed country by fixing or pegging its currency to the dollar , euro , yen , pound sterling , or other anchoring currency to a greater or lesser degree . In fact , in the limit , a country can simply adopt another country currency as its own in a process called . If it wants to continue earning seigniorage ( profits from the issuance of money ) it can create a currency board , the function of which is to maintain 100 percent reserves and full convertibility between the domestic currency and the anchor currency . At the other extreme , it can create a crawling peg with wide bands , allowing its currency to appreciate or depreciate day to day according to the interaction of supply and demand , slowly adjusting the band and peg in the long term as conditions dictate . When a currency is overvalued , which is to say , when the central bank sets Em higher than ( when is expressed as foreign currency ) the central bank must appreciate the currency by selling international reserves for its domestic currency . It may run out of reserves before doing so , however , sparking a rapid depreciation that could trigger a financial crisis by rapidly increasing the real value of debts owed by domestic residents but in foreign currencies . When a currency is undervalued , which is to say , when the central bank sets Em below , the central bank must depreciate its domestic currency by exchanging it for international reserves . It may accumulate too many such reserves , which often have low yields and which could quickly lose value if the domestic currency suddenly appreciates , perhaps with the aid of a good push by currency speculators making big bets . URL books 415

As noted in Chapter 18 Foreign Exchange , however , not all goods and services are traded internationally , so the rates will not be exactly equal URL books , 415 Suggested Reading , Michael , and Barry . A Retrospective on the Woods Lessons for International Monetary Reform . Chicago , IL University of Chicago Press , 1993 . Barry . Capital A History of the International Monetary System . Princeton , Princeton University Press , 2008 . Giulio . The Anatomy ofan International Monetary Regime The Classical Gold Standard , New York Oxford University Press , 1995 . Moosa , Exchange Rate Regimes Fixed , Flexible or Something in Between . New York Macmillan , 2005 . Michael . Exchange Rate Determination Models and Strategies for Exchange Rate Forecasting . New York , 2003 . URL books 417