The Economics of Foreign Exchange: International Payments

International Payments And The International Monetary System The current international monetary system allows exchange rates to be influenced by market forces. However, government and central banks also influence exchange rates as they intervene in foreign exchange markets in an attempt to control the macroeconomic effects of exchange rate fluctuations on their economies. We're now ready to discuss the evolution of the current international monetary system. As you'll see, flexible foreign exchange rates have been the exception rather than the rule throughout much of history. This section gives you a quick tour of the way the international monetary system has changed since 1900. The Gold Standard For much of the time prior to the 1930s, the international payments system was based on a gold standard, under which currencies were required to be convertible into gold at fixed prices. The gold convertibility established fixed exchange rates as long as nations kept the value of their currency constant in terms of units of gold. For example, the U.S. dollar was worth ½o ounce of gold While the British pound was worth ¼ ounce of gold until the beginning of World War I. Therefore it took $5 to buy a British pound because $5 was necessary to buy %0 = ¼ ounce of gold. It's easy to see how the system worked. Suppose the price of a case of Scotch whiskey was 100 British pounds. It would take $500 to purchase the case at the fixed exchange rate. Suppose, however, the British pound appreciated so that it took $6 to buy each British pound. Under the gold standard, no one would buy pounds for dollars at any exchange rate significantly higher than $5, because they could just as easily arrange to buy ¼ ounce of gold for each pound. The ¼ ounce of gold would cost only $5 plus a modest fee for transferring it to British ownership. Under the gold standard, currencies could fluctuate only in narrow bands that depended on the costs of transferring ownership of gold between nations. There were some important consequences of international changes in gold owner-ship. Each nation used gold as an international reserve that constituted its monetary base. When a nation lost gold, its money supply usually decreased because of the decline in bank reserves. This decrease tended to reduce the price level in that nation in the long run. Similarly, when a nation gained gold, its money supply increased, tending to increase its price level in the long run. Under the gold standard, changes in relative price levels among nations caused by gold flows tended to keep currencies from appreciating or depreciating in the long run. Under the gold standard, few nations played the game strictly according to the rules. Nations hesitated to let their price levels fall for fear that reductions in the money supply would cause short-run unemployment and recessions because of inflexible wages. To avoid changes in their price levels, nations commonly changed the official quantity of gold that could be exchanged for their currency. By devaluing their currency in terms of gold, the nations allowed their currency to officially depreciate. For example, if the pound were devalued to be worth ⅛ ounce of gold, it would take only $2.50 to purchase each pound. Such a devaluation would stimulate demand for British exports without the need for the price level to fall through an outflow of gold. The Bretton Woods System In 1944, representatives of the United States and other industrial nations met at Bretton Woods, New Hampshire, to develop a new international monetary system. This system was also based on fixed exchange rates. However, the Bretton Woods system tied the value of foreign currencies not to gold but to the U.S. dollar! The United States had accumulated a great deal of foreign exchange and gold and was in a strong financial position compared to most European nations, many of which were shattered as a result of the war. The dollar was directly convertible into gold by foreign governments and central banks at the fixed price of $35 per ounce. Central banks agreed to intervene in foreign exchange markets to buy or sell currencies whenever the currencies appreciated or depreciated. Few of these nations had any gold and instead held dollars as their international reserves. Of course, such purchases and sales of currencies would alter the money supplies within nations just as gold flows did under the old gold standard. The United States, on the other hand, had the responsibility to buy and sell gold under the system to keep the price at $35 per ounce. The Bretton Woods agreement also established the International Monetary Fund (IMF), which set rules for the international monetary system to make loans to nations that lacked international reserves of dollars. The system allowed countries to devalue (officially depreciate) or revalue (officially appreciate) their currency in terms of dollars. Nations would devalue or revalue their currencies on occasion to affect net exports in ways designed to stabilize their economies. Dissatisfaction with the Bretton Woods system developed in the 1960s. Nations whose currencies were undervalued relative to the equilibrium exchange rate in terms of dollars were unwilling to allow the international price of their currencies to rise because the resulting decline in net exports would have decreased aggregate demand in those nations. Another problem was that, under the Bretton Woods rules, the United States could not devalue its currency to stimulate net exports. In 1971 the United States suspended convertibility of the dollar into gold, and by 1973 the United States and other nations in the Bretton Woods system abandoned fixed exchange rates in favor of a system of flexible or floating rates determined in part by market forces. The Current System The current international monetary system allows free-market determination of exchange rates but also allows central banks to buy and sell currencies to stabilize exchange rates. In effect the current system is a managed float in which central banks affect the supply of and demand for currencies in ways that influence equilibrium in foreign exchange markets. Under the system, central banks frequently buy their own nation's currency on international foreign exchange markets to keep it from depreciating. They often resist currency depreciation because it makes imported goods, such as those from the United States, more expensive for their citizens. However, when central banks buy their own currency they lose reserves of foreign currency such as dollars. The loss of reserves by debtor nations is a matter for concern. When nations like Mexico lose their dollar reserves of foreign exchange, the only way they can acquire more dollars is by running a balance of trade surplus with the United States in the future. A loss in dollar reserves combined with a decline in net exports means these nations run the risk of defaulting on their international loans. This reduces the profitability of U.S. banks that hold those loans as assets. The current system also has a paper substitute for gold called a special drawing right (SDR), which is created by the International Monetary Fund. SDRs are distributed to member nations to use as international reserves that nations can use to make international payments. SDRs fulfill the role previously played by gold in settling international debts when a nation lacked the foreign exchange to do so. Gold is now completely demonetized because no major currency is convertible to gold. It can be bought and sold on the free market like any good or service.