Week 1 Lecture 1 Ch2 International Monetary System

Topics: Monetary policy, Bretton Woods system, Currency Pages: 30 (1213 words) Published: July 28, 2015

to accompany

FIN 302 Finance (International)

Lecture 1:

Learning objectives
1. Exchange rate related concepts
2. Types of Exchange Rate Systems
3. The concept of ideal currency or the
impossible trinity.
4. Fixed rates vs. Floating rates
5. Brief History of International Monetary System
6. Monetary policy and Exchange Rates in

Exchange rate related concepts
• Exchange rate = the price of one currency in terms
of another.
• Two Expressions of Exchange Rate
domestic currency/foreign currency
indirect: foreign currency/domestic currency
• If you can buy a US dollar for AUS$0.9261, what is
the relevant exchange rate?
direct: AUS/US = 0.9261
indirect: US/AUS = 1/0.9261 = 1.0798

Exchange rate related concepts
Change in
exchange rate

Fixed exchange
rate system

Floating exchange
rate system

Increase in the
value of domestic
currency per
foreign currency



Decrease in the
value of domestic
currency per
foreign currency



Attributes of the “Ideal” Currency
• Thee Impossible Trinity:
– Exchange rate stability
– Full financial integration
– Monetary independence

• The economic forces do not allow the
simultaneous achievement of all three

Attributes of the “Ideal” Currency

(Page 36)

Types of Exchange Rate Systems

Managed Floating
Pegged or Crawling (3 subtypes)
Currency Boards
Exchange arrangement with no separate legal tender

Fixed Versus Flexible Exchange Rates
• Factors affecting to a nation’s choice of currency

interest rate levels,
trade balances, and
economic growth.

• The choice between fixed and flexible rates may
change over time as priorities change.

Fixed Versus Flexible
Exchange Rates
• Benefits of fixed rate regime
– stability in international prices
– inherent anti-inflationary nature of fixed prices

• Problems of fixed rate regime
– Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate
– Fixed rates can be maintained at rates that are inconsistent with economic fundamentals

History of the International
Monetary System
• The Gold Standard (1876 – 1913)
– Gold has been a medium of exchange since
3000 BC
– Each country set the rate at which its currency
unit could be converted to a weight of gold
– Currency exchange rates were in effect “fixed”
– Expansionary monetary policy was limited to a
government’s supply of gold

History of the International
Monetary System
• The Inter-War Years & WWII (1914-1944)
– Currencies were allowed to fluctuate over a fairly wide
range in terms of gold and each other
– Increasing fluctuations in currency values became
realised as speculators sold short weak currencies
– The US adopted a modified gold standard in 1934

History of the International
Monetary System
• Bretton Woods and the International Monetary
Fund (IMF) (1944)
– established a US dollar based international
monetary system and
– created two new institutions the International
Monetary Fund (IMF) and the World Bank

History of the International
Monetary System
– The International Monetary Fund (IMF)
• IMF helps countries defend their currencies against
cyclical, seasonal, or random occurrences
• IMF assists countries having structural trade problems if they promise to take adequate steps to correct these
– The International Bank for Reconstruction and
Development (World Bank)
• help fund post-war reconstruction and has since then
support general economic development

History of the International
Monetary System
• Fixed Exchange Rates (1945-1973)
– Factors which control the IMF and Bretton
Woods arrangements
• Widely diverging monetary and fiscal policies,
• differential rates of inflation and
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