This is MoneyClub

Adapted from International Financial Markets, Amir Yaron of the Wharton School (Finance 219/719)
Part 1. Foundations of Int’l Financial Management

Chapter 1 Outline
-Evolution of the Int’l Monetary System
—-Before 1875: Bimetallism
—-1875 – 1914: Classical Gold Standard
—-1915-1944: Interwar Period
—-1945-1972: Bretton Woods System
—-1973-Present: The Flexible Exchange Rate Regime
-Current Exchange Rate Arrangements
—-European Monetary System
-Mexican Peso Crisis
-Asian Currency Crisis
-Argentine Peso Crisis
-Fixed v Flexible Regimes
-Summary

Chapter 1 Takeaways

-Evolution of the Int’l Monetary System
Defined as the institutional framework within which int’l payments are made, movements of capital are accommodated, and exchange rates determined.
—-Before 1875: Bimetallism
Free coinage of Gold and/or Silver in many countries incl US and UK, China, Germany. e.g. Official exchange rate btw Pound and franc determined by the actual gold content of the two currencies.
Gresham’s law: Since the exchange ratio between two metals was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation. Bad money drives out good money. When gold was found in California and Australia, gold became overvalued in the official ratio.
—-1875 – 1914: Classical Gold Standard
3 conditions: 1) gold alone is assured of unrestricted coinage, 2) there is 2 way convertibility btw gold and nat’l currencies at a stable ratio, and 3) gold may be freely exported or imported. BoE started issuing gold redeemable notes in 1821. During this period London became the center of the int’l financial system.
Under the gold standard, misalignment of the exchange rate will be corrected by cross-border flows of gold. Int’l imbalances of payment will also be corrected automatically. Net export from A to B will be accompanied by a net flow of gold in the opposite direction, raising relative price levels in A, slowing exports from A and ensuring the intial net export from A will disappear. This is known as Hume’s price-specie-flow mechanism.
**There are still supporters of gold standard today – it controls inflation well. However the growth in supply of gold would restrict today’s growth in world trade and investment, causing deflation instead. Additionally, governments can leave the standard easily.
—-1915-1944: Interwar Period
econmic nationalism. halfhearted restoration of gold. bank failures. WW1 ended the standard -> hyperinflation in all countries that suspended the GS. Countries also depreciated their currencies to gain an edge in world export. US now int’l financial center, led return to GS in 1919. However it was not followed by any party – countries followed a sterilzation of gold policy in matching flows of gold with changes in domestic money and credit, giving themselves control of domestic economies. It was finally dropped after the 1929 Depression.
—-1945-1972: Bretton Woods System (BWS)
July 1944 – Bretton Woods system launched IMF and IBRD (World Bank). IMF set rules about the conduct of int’l monetary policies and enforced them. BWS designed to prevent recurrence of economic nationalism. Each country established a par value to the USD which was in turn fixed at $35/ounce of gold, with responsiblity to maintain their currencies within 1% of that par. Because the USD was an intermediary, countries could use that as an international means of payment on top of gold, solving the problem of deflationary effects from limited gold supply. However, Prof. Robert Triffin warned of its inbuilt collapse. To satisfy growing need for reserves, the US had to run BOP deficits continuously, eventually triggering a run on the dollar and causing the downfall of the system. The Triffin paradox concluded as predicted in the 1970s. Defensive measures included the Kennedy Interest Equalization Tax (increasing cost of foreign borrowing), the Fed’s Foreign Credit Restraint Program (limted amount US banks could lend for FDIs), IMF’s Special Drawing Rights (an artificil int’l reserve and payment currency), and finally the Smithsonian Agreement (last minute, short-lived attempt at revaluation that was not bold enough to stabilize the situation).
—-1973-Present: The Flexible Exchange Rate Regime
Ratified in 1976 in the Jamaica Agreement: 1) Flexible rates were declared acceptable to IMF, and central bank intervention allowed, 2) Gold was formally demonetized as an int’l reserve, 3) Non-oil exporting countries and LDCs given greater access to IMF funds. IMF continued to extend assistance under conditions of economic policy prescriptions.
Rates were more volatile – Dollar rose from 1980-84 due to high interest rates in the US from Reagan era deficit spending, and fell from 85-88 because of its trade deficit and also the 1985 Plaza Accord. Its fall was stopped by the Louvre Accord in 1987, marking the inception of the managed-float system of the G7 countries.
-Current Exchange Rate Arrangements
the IMF classifies 8 regimes: Exchange arrangements with no separate legal tender e.g. Eurozone, and Ecuador, Panama using USD, Currency board arrangements e.g. HK and Estonia’s fixes by legislative commitment, Other conventional fixed peg arrangement, e.g. peg to a currency or basket of currencies as in Morocco, Saudi Arabia, and Ukraine, Pegged exchange rates within horizontal bands, maintained within margins wider than 1%, e.g. Denmark, Slovenia, and Hungary, Crawling pegs currency is adjusted at a preannounced rate or with indicators like Bolivia, Costa Rica, and Tunisia, Exchange rates within crawling bands, like Belarus and Romania where the bands as well as the peg crawl, Managed floating with no preannounced path, eg Algeria, China, Czech Rep, India, Russia, Singapore, Thailand, Independent float e.g. Australia, Brazil, Canada, Korea, Mexico, UK, Japan, Switz, and US.
—-European Monetary System
launched March 1979, with the Exchange Rate Mechanism based on a “parity grid system”, a system of par values among currencies. In the 1991 Maastricht Treaty, the EMS irrevocably fixed rates and introduced the Euro in 1999. The agreement was to achieve a convergence of economies: 1) keep ratio of govt deficits to GDP below 3%, 2) keep debts below 60% GDP, 3) achieve price stability, 4) maintain currency within ERM ranges. Modelled after the successful Bundesbank, the European Central Bank was guaranteed to not have political pressure, aiming for an inflation rate of less than 2%. The national central banks formed the European System of Central Banks similar to the Federal Reserve US System, charged with duties: 1) define and implement monetary policy, 2)conduct forex operations, 3) hold and manage official eurozone reserves. Euro has been appreciating against USD since 2002 reflecting a slowdown in US and fewer European investments in the US. The benefits of union were lower transaction costs, elimination of exchange rate uncertainty, promoting corss-border trade and mergers and indirectly international competitiveness of EU companies, creating capital markets as deep and liquid as US markets - a 2004 study confirmed that cost of capital in eurozone was lower, adding 17% to firm values. The cost is loss of national monetary and exchange rate policy independence, important if the country is trade dependent. In theory this should be moderated by free capital and labor flows.
Will the Euro overtake the USD? it is comparable in population, GDP, and international trade share, as well as in bond markets.

Crises
-Mexican Peso Crisis
Dec 20, 1994 – President Zedillo devalued peso by 14% sparking a run of 40%, forcing the govt to float the peso. This spilled over to other Latin American and Asian markets as investors reduced holdings across the board. Clinton administration and IMF and BIS bailed out Mexico with a $53bln package, though the crisis stabilized just before. Investors had built up $45 bln of hot money in Mexico in the 3 years prior. 2 lessons: 1) it is essential to have a multinational safety net; political processes cannot cope with rapidly changing mkt conditions and 2) one cannot depend too much on foreign portfolio capital – should save domestically and depend on long term rather than short term investments. The G-7 endorsed a $50b bailout fund for countries in distress in the future.
-Asian Currency Crisis
July 2 1997 Thai baht was suddenly devalued, sparked further crises in Korea, Brazil and Russia. Far more serious than the preceding Mexican or European crises – corporations with foreign currency debt were driven to default. Economies went into a deep longlasting recession. Investors suffered large capital losses. Factors responsible: weak domestic financial system, free capital flows, contagion effects of changing market sentiment, and inconsistent economic policies. Lessons: liberalization of markets combined with a weak domestic system tends to create an environment susceptible to crises. Measures include strengthening system of financial sector regulation and supervision (e.g. Basel/Basle), prioritizing objective, not crony, lending, transparency, Tobin taxes. Countries also need to make choices about the “incompatible trinity”: only two out of the three of 1)fixed exchange rate, 2) free capital flows, and 3)independent monetary policy can be achieved at the same time.
-Argentine Peso Crisis
January 2002 – currency board arrangement also vulnerable to collapse, unless it is backed by political will and economic discipline. Factors – lack of financial discipline, labor market inflexibility, contagion from financial crises in Russia and Brazil. The govt encountered difficulty in raising debts, strong unions made it hard to lower costs, and the fixed rate disallowed the govt from restoring competitiveness thru depreciation. Argentina is still in default of over $100b in debt.
-Fixed v Flexible Regimes
For flexible: 1) easier external adjustments, 2) national policy autonomy. Against flexible: Uncertainty hampers trade and investment.
-Summary
A good int’l monetary system should provide 1) liquidity, 2) adjustment, and 3) confidence. it should provide the economy with sufficient monetary reserves to support the growth of int’l trade and investment. it should also provide an effective m echanism that restores the BOP equilibrium whenever it is distrubed. Last, it should offer a safeguard to prevent crises of confidence.