Chapter 11

The Bretton Woods System

-A new international monetary system was designed in 1944 in Bretton Woods, New Hampshire -The goal was to build an enduring economic order that would facilitate postwar economic growth -The Bretton Woods Agreement established two multinational institutions --The International Monetary Fund (IMF) to maintain order in the international monetary system --The World Bank to promote general economic development

The Collapse of the Fixed System

-The collapse of the Bretton Woods system can be traced to U.S. macroeconomic policy decisions (1965 to 1968) -During this time, the U.S. financed huge increases in welfare programs and the Vietnam War by increasing its money supply which then caused significant inflation -Speculation that the dollar would have to be devalued relative to most other currencies forced other countries to increase the value of their currencies relative to the dollar -The Bretton Woods system relied on an economically well managed U.S. -So, when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point -The Bretton Woods Agreement collapsed in 1973

Jamaican Agreement:

-floating rates were declared acceptable -gold was abandoned as a reserve asset - total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion (today, this number is $300 billion)

Under the Bretton Woods Agreement:

-the US dollar was the only currency to be convertible to gold, and other currencies would set their exchange rates relative to the dollar. -Devaluations were not to be used for competitive purposes -A country could not devalue its currency by more than 10% without IMF approval.

Criticism of IMF's Policies

1. Inappropriate Policies -The IMF has been criticized for having a "one-size-fits-all" approach to macroeconomic policy that is inappropriate for many countries 2. Moral Hazard -The IMF has also been criticized for exacerbating moral hazard (when people behave recklessly because they know they will be saved if things go wrong) 3. Lack of Accountability -The final criticism of the IMF is that it has become too powerful for an institution that lacks any real mechanism for accountability

Fixed

1. Monetary Discipline -Because a fixed exchange rate system requires maintaining exchange rate parity, it ensures that governments do not expand their money supplies at inflationary rates 2. Speculation -A fixed exchange rate regime prevents destabilizing speculation 3. Uncertainty -The uncertainty associated with floating exchange rates makes business transactions more risky 4. Trade Balance Adjustments -Floating rates help adjust trade imbalances

fixed exchange rate system

countries fix their currencies against each other at a mutually agreed upon value -prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

pegged exchange rate

countries peg the value of their currency to that of other major currencies -popular among the world's smaller nations -there is some evidence that adopting a pegged exchange rate regime moderates inflationary pressures in a country

floating exchange rate system

exists in countries where the foreign exchange market determines the relative value of a currency -The world's 4 major trading currencies are floating currencies: U.S. dollar, European Union's euro, Japanese yen, British pound

international monetary system

institutional arrangements that countries adopt to govern exchange rates

. currency crisis

occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates

. banking crisis

refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits

The gold standard

refers to the practice of pegging currencies to gold and guaranteeing convertibility -under the gold standard one U.S. dollar was defined as equivalent to 23.22 grains of "fine (pure) gold The exchange rate between currencies was based on the - gold par value - the amount of a currency needed to purchase one ounce of gold

dirty float

the value of a currency is determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency -China adopted this policy in 2005

pegged exchange rate system

the value of a currency is fixed to a reference country and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate -Popular in developing countries

Floating

1. Monetary Policy Autonomy -removal of the obligation to maintain exchange rate parity restores monetary control to a government -with a fixed system, a country's ability to expand or contract its money supply is limited by the need to maintain exchange rate parity 2. Trade Balance Adjustments -The balance of payments adjustment mechanism works more smoothly -under the Bretton Woods system (fixed system), IMF approval was needed to correct a permanent deficit in a country's balance of trade that could not be corrected by domestic policy alone

Currency Boards

A country with a currency board commits to converting its domestic currency on demand into another currency at a fixed exchange rate -The currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued -additional domestic notes and coins can be introduced only if there are foreign exchange reserves to back it

IMF

IMF is responsible for avoiding a repetition of the chaos that occurred between the wars through a combination of: 1. Discipline -a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment -a fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation 2. Flexibility -A rigid policy of fixed exchange rates would be too inflexible -So, the IMF was ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficits -A country could devalue its currency by more than 10 percent with IMF approval

World Bank

The World Bank Group includes 5 institutions: the International Bank for Reconstruction and Development (IBRD); the International Development Association (IDA); the International Finance Corporation (IFC); the Multilateral Investment Guarantee Agency (MIGA); and the International Centre for Settlement of Investment Disputes (ICSID). The World Bank lends money in two ways: -under the IBRD scheme, money is raised through bond sales in the international capital market and borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses. -under the International Development Association scheme, resources to fund IDA loans come from wealthy members (US, Japan, Germany) and go only to the poorest countries (50 years to repay at 1% p.y. interest)

foreign debt crisis

a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt. Two crises that are particularly significant are: -the 1995 Mexican currency crisis -the 1997 Asian currency crisis