Gold has served as a medium of exchange and a store of value. The increase in trade led each country to set a par value for its currency in terms of gold. The gold standard as an international monetary system gained acceptance in Western Europe in the 1980s. The U.S. adopted the gold standard in 1879. Under the gold standard, each country set the rate at which its currency unit (paper or coin) could be converted to a weight of gold. The gold standard worked adequately until the outbreak of World War I interrupted trade flows and the free movement of gold.

The interwar years and World War II, 1914-1944:

During the World War I and the early 1920s, currencies were allowed to fluctuate over fairly wide ranges in terms of gold and in relation to each other. Theoretically, supply and demand for a country's exports and imports caused moderate changes in an exchange rate about a central equilibrium value. Unfortunately, such flexible exchange rates did not work in an equilibrating manner. On the contrary, international speculators sold the weak currencies short, causing them to fall further in value than warranted by real economic factors. The reverse happened with strong currencies.

The U.S. adopted a modified gold standard in 1934 when the U.S. dollar was devalued to $35 per ounce of gold from the $20.67 per ounce price in effect prior to World War I. During the World War II, many of the trading currencies lost their convertibility into other currencies, except the U.S. dollar.

Bretton Woods and the International Monetary Fund, 1944:

The Allied Powers of the World War II met at Bretton Woods, New Hampshire to created a new postwar international monetary system. The Bretton Woods established a U.S. dollar-based international monetary system and provided for two new institutions: the International Monetary Fund (IMF) and the World Bank. IMF aids countries with balance of payments and exchange rate problems. The International Bank for Reconstruction and Development (World Bank) helped fund postwar reconstruction and since then has supported general economic development.

 

Under the original provisions of the agreement, all countries fixed the value of their currencies in terms of gold but were not required to exchange their currencies for gold. Only the dollar remained convertible into gold (at $35 per ounce).Therefore, each country established its exchange rate vis-à-vis the dollar, and then calculated the gold par value of its currency to create the desired dollar exchange rate. Participating countries agreed to try to maintain the value of their currencies within 1% (later expanded to 2.25%) of par by buying and selling foreign exchange or gold as needed. If a currency became too weak to defend, a devaluation of up to 10% was allowed without formal approval of IMF. Larger devaluations required IMF approval which became known as the gold-exchange standard.

The Special Drawing Rights (SDR) is an international reserve asset created by the IMF to supplement existing foreign exchange reserves that serves as a unit of account for the IMF and other international and regional organizations. It is also the base against which some countries peg the exchange rate for their currencies. SDR is currently the weighted average of four major currencies: the U.S. dollar, the euro, the Japanese yen, and the British pound. The weights are updated every five years by the IMF. Individual countries hold SDRs in the form of deposits in the IMF. These holdings are part of each country's international monetary reserves, along with official holdings of gold, foreign exchange, and its reserve position at the IMF.

Fixed Exchange Rates, 1945-1973:

Widely diverging national monetary and fiscal policies, different rates of inflation, and various unexpected external shocks eventually resulted in the system's demise. The U.S. dollar was the key to the web of exchange rate values. Unfortunately, the U.S ran persistent and growing deficits in its balance of payments. The heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the U.S. to meet its commitment to convert dollars to gold. This lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the U.S. Treasury in 1971. By the end of 1971, most of the major trading currencies had appreciated vis-à-vis the dollar which was a devaluation of the dollar. In 1973, another devaluation occurred by 10% to $42.22 per ounce of gold. A fixed-rate no longer appeared feasible, and the major foreign exchange markets were closed for several weeks. When they reopened, most currencies were allowed to float to levels determined by market forces.

An Eclectic Currency Arrangement, 1973-Present:

Since 1973, exchange rates have become much more volatile and less predictable than they were during the "fixed" exchange rate period, when changes occurred infrequently. The important shocks in recent years have been the European Monetary System (EMS) restructuring in 1992 and 1993; the emerging market currency crises, including that of Mexico in 1994, Thailand (and a number of other Asian currencies) in 1997, Russia in 1998, and Brazil in 1999; the introduction of the euro in 1999; the economic crisis in Turkey in 2001; and the currency crises and changes in Argentina and Venezuela in 2002.

 

Contemporary Currency Regimes

Today, the international monetary system is composed of national currencies, artificial currencies (such as the SDR), and one entirely new currency (euro) that replaced the 11 national European Union currencies on January 1, 1999. All of these currencies are linked to one another via a "smorgasbord" of currency regimes.

The IMF classifies all exchange rate regimes into eight specific categories: (1) The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union; (2) A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligations; (3) The country pegs its currency 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 a central rate; (4) The value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that are wider than ±1% around a central rate; (5) The currency is adjusted periodically in small amounts at a fixed, preannounced rate or in response to changes in selective quantitative indicators; (6) The currency is maintained within a certain fluctuation margins around a central rate that is adjusted periodically at a fixed preannounced rate or in response to changes in selective quantitative indicators; (7) The monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying, or precommitting to, a preannounced path for the exchange rate; (8) The 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 establishing a level for it.

Although the contemporary international monetary system is typically referred to as a floating regime, it is clearly not the case for the majority of the world's nations.

Fixed versus Flexible Exchange Rates:

A nation's choice as to which currency regime to follow reflects national priorities including inflation, unemployment, interest rate levels trade balances, ad economic growth. The choice of fixed and flexible rates is subject to change overtime.

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.

Attributes to the "Ideal" Currency:

If the ideal currency existed in today's world, it would possess three attributes: (1) Exchange rate stability; (2) Full financial integration; (3) Monetary independence. These qualities are termed the impossible trinity because a country must give up one of the three goals described by the sides of the triangle.

 

Emerging Markets and Regime Choices:

Currency Boards:

A currency board exists when a country's central bank commits to back its monetary base -its money supply- entirely with foreign reserves at all times. This means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first.

Dollarization:

Dollarization is the use of the U.S. dollar as the official currency of the country. A country that dollarizes removes any currency volatility and would theoretically eliminate the possibility of future currency crises. Additional benefits are expectations of greater economic integration with the U.S. and other dollar-based markets, both product and financial.

However, three arguments exists against dollarization: (1) The loss of sovereignty over monetary policy; (2) Loss of power of seignorage, the ability to profit from its ability to print its own money; (3) The central bank of the country no longer has the ability to create money within its economic and financial system.

 

The Birth of a European Currency: The Euro:

The original 15 members of the European Union (EU) are also members of the European Monetary System (EMS). This group tried to form an island of fixed rates among themselves in a sea of major floating currencies.

The Maastricht Treaty:

In December 1991, the members of the EU met at Maastricht, the Netherlands, and concluded a treaty: (1) The Maastricht Treaty specified a timetable and a plan to replace all individual ECU currencies with a single currency called the euro. The official symbol of the euro is €, and the official abbreviation is EUR. (2) The Maastricht Treaty called for the integration and coordination of the member countries' monetary and fiscal policies. Before becoming a full member of EMU, each member country was originally expected to meet the following convergence criteria: (a) Nominal inflation should be no more than 1.5% above the average for the three members of the EU with the lowest inflation rates during the previous year; (b) Long-term interest rates should be no more than 2% above the average for the three members with the lowest interest rates; (c) The fiscal deficit should be no more than 3% of gross domestic product; (d) Government debt should be no more than 60% of gross domestic product. (3) A strong central bank, called the European Central Bank (ECB) has been established in Frankfurt, Germany.

The euro affects markets in three ways: (1) countries within the euro zone enjoy cheaper transaction costs; (2) currency risks and costs related to exchange rate uncertainty are reduced; and (3) all consumers and businesses both inside and outside the euro zone enjoy price transparency and increased price-based competition.

Achieving monetary unification:

The primary driver of a currency's value is its ability to maintain its purchasing power. The single largest threat is inflation.

Monetary policy for the EMU is conducted by the ECB. The ECB's independence allows it to focus on the stability of the currency.

The December 31, 1998, fixing of the rates of exchange between national currencies and the euro were permanent fixes for these currencies The U.K., Sweden, Denmark, and Norway does not participate the euro system.

Since the introduction of the euro, the U.S. has experiences severe balance of payments deficits on the current account. The biggest deficits were with China and Japan. In order to protect their export competitiveness, both China and Japan intervene in the foreign exchange market by buying massive amounts of U.S. dollars while selling corresponding amounts of their own currencies.

The use of the euro continued to expand. As of January 2011, the euro was the official currency for 17 of the 27 member countries in the EU, and Montenegro, Andorra, Monaco, San Marino, and the Vatican.

 

Exchange Rate Regimes: What Lies Ahead?

All exchange rate regimes must deal with the trade-off between rules and discretion, as well as between cooperation and independence. On page 76, Exhibit 3.7 illustrates these trade-offs.

Different exchange rate arrangements may dictate whether a country's government has strict intervention requirements or whether it may choose whether, when, and to what degree to intervene in the foreign exchange markets.

The trade-off for countries participating in a specific system is between consulting and acting in unison with other countries or operating as a member of the system, but acting on their own.

The gold standard required no cooperative policies among countries. The Bretton Woods Agreement required more in the way of cooperation, in that gold was no longer the "rule," and countries were required to cooperate to a higher degree to maintain dollar-based system. Exchange rate systems were hybrids of these cooperative and rule regimes.

The present international monetary system is characterized by no rules, with varying degrees of cooperation.

 

Having covered these topics, please answer the following:

Describe the "rules of the game" under the Gold Standard. Why did the Gold Standard breakdown?

After 1944, what postwar international monetary system was established? What were the two new institutions and their purpose under this system?

What are the IMF's exchange rate regime classifications? Briefly describe each.

What are the attributes of the "ideal" currency? Explain why it is also termed "impossible trinity."

What is a currency board? How did the eight countries utilize currency boards to fix their exchange rates?

Why did Argentina's experience with dollarization a failure while Panama's a success?

What were the convergence criteria for the creation of EMU?

Give a brief evolution of the Euro since its birth in 1999. While achieving monetary union was a success, can we say the same for forming a fiscal union? (for this question, you may want to use the internet)