The International Monetary System Chapter 3 Chapter Objectives Lecture Notes FINA 5500 Chapter Objectives FINA 5500 Chapter 3 The International Monetary System 1 To be able to compare and contrast the mechanics of the fixed and floating exchange rate systems 2 To be able to explain in your own words the effects of changes in one country s inflation and unemployment rates on the economies of other countries under a fixed exchange rate system 3 To be able to explain in your own words the effects of changes in one country s inflation and unemployment rates on the economies of other countries under a floating exchange rate system 4 To be able to compare and contrast the strengths and weaknesses of the fixed and floating exchange rate systems 5 To be able to relate in your own words the historical evolution of the European Union and the events leading to the adoption of a Single European Currency the Euro 6 To be able to explain in your own words the pros and cons of having a Single European Currency 7 To be able to explain in your own words how a pegged exchange rate system works 8 In a three country case when Country A has its currency pegged to the currency of Country B while the currency of Country C is floating against the currencies of both Countries A and B you should be able to analyze the effects of an appreciation and depreciation of the floating currencies on the levels of export and import between each pairs of the countries AB BC and AC CHAPTER 3 OVERVIEW z Various Types of Exchange Rate Systems Fixed Rate Floating Rate Managed Float Pegged Exchange Rate z z z Comparing advantages disadvantages of fixed and floating rate systems The European Union and Euro Implications of pegged exchange rate systems and its impact on international trade 1 Fixed Exchange Rate Systems History z z z z Gold Standard 1821 1914 Gold Exchange Standard 1925 1931 Bretton Woods System 1946 1971 Smithsonian Agreement 1971 to 1973 2 1 Fixed Exchange Rate System Mechanics z z z z z z The price of a country country ss currency is fixed in terms of gold or other currency A country s money supply is constrained by its gold or other currency reserve A change in the price level in one country will affect its balance of payments BOP Th resulting The lti change h in i BOP will ill affect ff t its it reserve The change in reserve will affect its money supply and price levels Supposed to provide price stability and promote international trade 3 Floating Exchange Rates System History Mechanics z z z z z 1973 to present Major currencies float continuous adjustment The U S actually has a dirty float due to informal Exchange Rate Target Zones Minor currencies are pegged to major currencies Exception European Monetary System has fixed rates within but floating outside 4 2 Comparison of Fixed and Floating Exchange Rate Systems z The Impact of Rise in Inflation in the US Fixed Exchange Rate System Floating Exchange Rate System z The Impact of a Rise in Unemployment in the US Fixed Exchange Rate System Floating Exchange Rate System 5 The Impact of Rise in Inflation US Fixed Exchange Rate System UK goods cheaper in the US Import from UK increases Excess demand for goods in UK Price levels inflation in UK also go up Fixed Exchange Rate System 6 3 The Impact of Rise in Inflation US Floating Exchange Rate System UK goods cheaper in the US Import from UK increases increased demand for pounds Export to UK decreases decreased supply for pounds Value of Pound Dollar increases decreases UK goods become more expensive because of currency appreciation only to US buyers Domestic inflation in UK is not affected 7 Comparison of Fixed Floating Exchange Rate Systems Inflation z Floating Rate Exchange Rate System Advantage Inflation in one country does not necessarily lead to inflation in other countries Disadvantage Since prices of UK goods are high due to appreciation of BP domestic producers can get away with higher prices in the US less international competition 8 4 The Impact of Rise in Unemployment US Fixed Exchange Rate System Import from UK decreases Reduced demand for goods in UK Lower productivity in the UK Higher unemployment in UK 9 The Impact of Rise in Unemployment US Floating Exchange Rate System Import from UK decreases decreased demand for pounds Value of Pound Dollar decreases increases UK goods now become less expensive because of pound depreciation to US buyers goods is Some of the demand reduction for UK g offset because of pound depreciation Unemployment rate in the UK does not rise 10 5 Comparison of Fixed and Floating Exchange Rate Systems Unemployment z Floating Exchange Rate System Advantage High unemployment in one country does not necessarily lead to high unemployment in other countries Disadvantage High unemployment in US decreased imports from UK Reduced demand for pounds pound depreciates UK goods becomes cheaper in the US increased imports from UK Unemployment in US goes up even further 11 Comparison of Fixed and Floating Exchange Rate Systems A Summary z Fixed Exchange Rate System Disadvantage Economic problems inflation inflation unemployment in one country can infect other countries Advantages Built in price stability mechanism Promotes international trade z Floating Exchange Rate System Advantage Economic problems inflation inflation unemployment are generally contained within the country where they originate Disadvantage Economic problems can become more pronounced in the country of origin 12 6 European Union Historical Landmarks z European Economic Community 1957 France West Germanyy Italy y Belgium g Netherlands Luxembourg z European Union 1970 1990 s Enlargement Great Britain Ireland Denmark 1973 Greece 1981 Spain Portugal 1986 Austria Finland Sweden 1995 z A Single European Market Reduction or elimination of tariffs and duties for trades among member countries z z z Single European Act 1987 European Currency Unit 1990 s and its failure Maastricht Treaty Establish criteria for euro membership 13 The Maastricht Criteria The Maastricht Treaty stipulated five criteria that European countries had to meet to become eligible for Euro Price Stability A country s inflation rate must not exceed the average inflation rate of the 3 best performing member states by more than 1 5 The Level of Government Deficit The government s budget deficit must not be more than 3 of its gross domestic product The Level of Government Debt The government s total debt must not be more than 60 of its gross domestic product