International Monetary Regimes and their Characteristics - Essay Example

International Monetary Regimes and their Characteristics International Monetary Regimes and their Characteristics Governments of any country are responsible for the welfare of their people and the economy and the social and financial institutions that make these functions possible. Money supply and the interest rate existing in the economy are two of the most important controls for the promotion of growth and stability within the country. Governments control these important factors through the application of a carefully designed “Monetary Policy” that allows the regulation of supply to money; the end goals for the people are stable prices and low unemployment. The policies are designed according the needs and ideologies of particular countries and though the desired outcomes are similar, the nature of implementation may differ. In the past monetary policy was mostly related with interest rates and availability of credit, along with issuing of new coins and printing of paper money. The modern form of monetary control came with the larger trading networks and enforceability of prices from market to market. The creation of Bank of England in 1699 introduced the idea of having exclusive monetary authority with just body of organization and the idea had become in commonplace in most countries, with the US Federal Reserve coming into function in 1913. Along the same time, economic understanding brought the importance of interest rates and need of proper policies to control it into focus. These different policies are grouped under the “Monetary Regime” of a country, formally defined as a “set of rules governing the institutions and organizations which finally determine the amount of money supplied” (Bernholz, 2003). The laws and decrees that state all these official rules are then termed as the “monetary constitution”. The success of any monetary regime is dependent on discretionary policy making as suited to the economic climate of the country. Each different type of regime however, makes use of a central nominal anchor that acts as a constriction on the value of domestic money and guides the political policy making towards long term goals. The anchor helps to determine the unique price levels and provides a standard point for inflation expectations; the currency of a country may be anchored to the currency of another larger, low-inflation country and allowed to depreciate at a fixed target rate (Mishkin, 1999). The different types of monetary regimes make use of different anchor standards. The monetary authority achieves control through the buying or selling of financial assets (usually government obligations). There are two broad categories of the policies which include the expansionary or contractionary. These basically indicate that whether the government in attempting to impact the economy through increasing the total money supply existing in the markets or attempting to slow the growth of or shrink the existing volume (thereby increasing the real value of the money). Expansionary policies usually find more favor in the political arena as they produce higher growth and lower the unemployment very quickly in the short run and can be seen as a quick sign of any new government’s success. However these effects are short lived due to the self-sustaining nature of the markets which match their wage and price expectations to the new policy. Contractionary policies favoring long run economic growth and stable inflation rates (to avoid diminishing asset values) are then supported by the nominal anchors that are adopted by the country. The paper will now discuss the different types of regimes that exist in the world today along with their background, unique characteristics and advantages as well as the emerging frameworks of international banking and its impact on the world economies. Metallic Standards and discretionary paper money The world has moved away from different type of monetary regimes as befitting the times and economic pace. The earlier governments favored Metallic standards like the gold, silver or copper standard with the population using coins of these metals in normal circulation. The coins had a face value similar to that of the metal it was forged of, so the gold coins would be more valuable than the silver ones. When the increase in trade volumes and economic could no longer be supported by this system, the countries moved towards the “Weakened Metallic standard” more commonly understood as the “Gold Standard”. The Gold standard system works by tagging the value of national currency in units of valued gold bars and under promise of the government to exchange in trade of gold only through a fixed price in terms of the base currency. This would allow the price of the currency to remain stable and connected to the gold value. This could be understood as a specific type of “commodity price level targeting” (Bernholz, 2003).. This system, though widely used through the mid 19th century was eased out of national policies by the end of 1960s. Adopting the gold standard meant that all the countries using the system had a relatively fixed regime towards each other’s currencies and had a floating retime against all others. Even though it was a relatively straightforward and transparent system that could be understood by the layman the Gold Standard’s biggest disadvantage was that the gold supply could not keep up with the growing economies leading to a condition of deflation. As the economy would grow faster than the overall money supply the excessive deflation could lead to instances of lengthened recessions and financial crises. As a result of this major flaw, most countries moved away from the system, as they attempted to support their economies after the great depression of 1930s. The last country to discontinue the system was the United States of America which had been using the Bretton Wood System which still allowed foreign central banks to exchange dollar notes in return for gold at the American Treasury at the dollar parity. This sytem lasted till 1971; by this most of the other economies of the world had adopted the “Discretionary paper money standard”. This third form of monetary regime usually (but not necessarily) involves a Central Bank that has the monopoly issued by the government to be the sole authority responsible for printing and issuing banknotes (Wrightand and Quadrini, 2011). This “Fiat money” has value associated with it due to the people’s trust in the government and the economic activity of the country. The term discretionary is used as the monetary authorities can independently decide the supply of base money required in the economy only restricted to some extent by laws of the country. Discretionary monetary standards can be different with respect to two specific characteristics. Firstly is the role of Central Bank in the system, whether the monetary policy is decided by the bank completely independent from political control or if the government officials can intervene in that” (Bernholz, 2003). Secondly is the factor that if the country is participating in a “Fixed oreign Exchange” regime where unlike in flexible or floating exchange rate system, the authorities do not have complete control over their domestic monetary policies but are subjected to international variables and policies. Fixed Exchange rate regimes Controlling the Exchange rates of a currency (in relation to foreign currencies) has been a monetary policy regime in use for a long time. Historically the two main fixed exchange rate regimes were the gold standard (which pegged the currency to a global standard of gold value) and the Bretton Woods system. In the past years the UK pound and later the US dollar have the main currencies to which other countries fixed theirs. This was dues to the perceived strength of these currencies as backed by their countries’ robust economies and political clout. The basic premise of the system is that every unit of local currency has to be backed by a unit of foreign currency (after the exchange rate has been corrected) and it requires maintaining a fixed exchange rate with the anchor country. The anchor countries are mostly chosen for their large and economies and low inflation rates (Foerster, 2013). The degree of the fixed rate can vary from country to country depending on how rigidly the rate has been decided upon. Often in such economies the foreign currency can be used easily as an exclusive or alternative medium of exchange along with the domestic currency. Under the system local governments or monetary authority (e.g Central Bank) cannot directly influence the rate by selling or buying local currency; instead the rate is forced through non-convertibility measures such as import/export licenses and capital controls). The system provides several advantages for the country employing the fixed exchange rate especially if the country has gone through some economic turbulence in the recent times (Wrightand and Quadrini, 2011). The system is easily understood and it demands transparency in the implementation which supplies extra information to the markets and economy. The fixed inflation rate for international goods resulting from the agreement is also helpful for local traders and consumers. The bigger effect comes from the increased confidence in the market place, as inflation expectations are now correlated with expectations of the anchor country and it also guides the future monetary policy of the country away from potentially short term advantageous plans. It was because of these benefits that both France and the United Kingdom tied the value of their currencies to the German Mark (In 1987 and 1990 respectively) to control inflation and were highly successful in their attempts. The UK was able to lower its inflation rate from a 10% to 3% within a span of two years. For emerging market countries without the developed monetary or political institutions to successfully implement discretionary monetary policies, the Fixed exchange system can help them adopt the policies of a more well off economy like the United States. However, the same system can be disadvantageous for countries that are already in stage of development as it can reduce their response to domestic variables and potentially curb economic growth. The exchange rate target in open capital markets leads to a loss in independence of monetary policy as the domestics interest rates become closely intertwined with the anchor country’s and the targeting country cannot quickly change its own monetary policy to counter domestic economic shocks. The other effect of the joint variables is the fact that any shocks experienced by the anchor country are also transferred back to the target country and given the size and strength of the local economy, the country may not be able to deal with these shocks in a timely manner. Emerging countries with this system can experience financial insecurity or even a full blown financial meltdown as a result of a foreign exchange crisis. This may lead to economic contraction and a breakdown of financial mobility in the marketplace. After Germany reunified in 1990, a financial crises occurred causing UK to pull out of their Exchange rate mechanism. France which chose not to develop their own monetary policy had to suffer from economic downturn and raising unemployment rates. The artificial confidence induced by system can also lead to deterioration in the balance sheets of the banking sector which go into a lending boom as the local currency depreciates. Southeast Asia and Mexico are two countries where speculative attacks and a weak banking sector led the economies into financial crises which could have been avoided if the country’s monetary authorities had elected to go for tighter control instead of lax policies mirroring those of their anchor countries (Mishkin, 1999). Monetary Targeting Regime Exchange-rate targeting is not an option for economies which are too large or do not have comparable economies to act as anchors. Therefore, entities like United States, Japan or the European Monetary Union have adopted different “monetary targeting regimes” which allow them to monitor their own economic growth and interest rates (Foerster, 2013). This regime allows the Central Bank to monitor and adjust the monetary policies according to the domestic factors and signal to the public and markets about the government’s stance on inflation expectations. These signals themselves may be enough to keep inflation rates in control. Within these monetary policies the main difference is between the set of tools used and the chosen variables that are manipulated to achieve the policy goals. The policy can only be successful if there is a strong and dependable connection between the goal variable (inflation or nominal income) and the targeted aggregate (e.g. money supply). There also has to be strong control by the Central Bank on the targeted aggregate. USA, Canada and the UK all failed to achieve a lot of success with their monetary target policies because the relationship between target and goals became weak and the three governments were not consistent with their monetary policies (Mishkin, 1999). On the other hand, Germany and Switzerland both adopted the system at the end of 1974 and achieved their goals successfully. The reasoning behind this was an effective communication strategy that made correct use of the necessary signals to the market place and consistent policies focused on long-term control of inflation. However, even in this case maintaining monetary targeting was more difficult in the case of Switzerland indicating that the system is not easy to be implemented in small open economies undergoing institutional and structural change in the money markets. After there was a 40% trade-weighted appreciation of the Swiss franc moving from the year of 1977 to 1978 (Mishkin, 1999), it was decided by the Swiss National Bank to abandon the monetary regime as the exchange rate for the country was too high and the economy shifted to an exchange-rate system for almost a year. The previous system was brought back once the economy had stabilized and better control was confirmed. In other practices, the USA (and several other countries) the monetary regime followed a “Monetary aggregates” approach in the 1980s which involves a steady growth in the money supply. Instead of focusing on a price signal through inflation or interest rates the policy instead controls monetary quantities which play an important part in the economy and business cycles as depended on household spending patterns. The policy also sometimes adds ‘money’ in the central banks reaction function. Inflation Targeting A separate monetary regime which comes under the discretionary paper money standard is the ‘Inflation Targeting’ policy where the money aggregates or the price level are impacted in order to achieve a target inflation rate. The rate which may be defined by a tool such as the Consumer Price Index is kept under a desired range to make economic activity more predictable and stable. This may be achieved by making timely adjustments to the interest rate target set by the Central Bank; the overnight rate at which banks lend to each other is the primary target of manipulation. These changes to the interest rate are made in response to the various market indicators that can foretell the coming marking conditions; this allows the policy makers to provide forecasts relating to market operations in the coming future. The main advantage of the system is in its ability to provide stability and constant factors for the continuous and controlled growth of economy which in turn helps to keep unemployment levels down. Inflation targeting also makes usual velocity shocks irrelevant as the policy strategy is not dependent upon a stable money-inflation relationship as was the case in both Fixed Exchange and Monetary Targeting regimes. In a way it provides real control to the monetary authorities. The relative simplicity of the execution of the system has made it favorable with many countries around the world. Some of these include Australia, United Kingdom, Brazil, Canada, Chile, New Zealand, Norway, Iceland the Czech Republic, Hungary and India. These countries often chose a mid-point for their inflation targets which his greater than zero as that is a more realistic expectation and they also include estimates of possible upward bias in the estimated measurements as derived from the Consumer Price Index. Like Monetary Targeting regimes this policy also requires a strong communication and transparency strategy from the government. While keeping the traditional stabilization goals in mind the government also has a sense of responsibility towards the citizens and the economy as a whole. The system requires intensive involvement of the Central Bank which his responsible for taking the actions to maintain desired inflation rates as such they are to be held at high level of accountability or the system will be prone to problems (Wrightand and Quadrini, 2011). New Zealand is one of the countries which has strict laws on board to prevent the Central bank from making any mistakes with regards to the inflation targets. The criticisms leveled against this system usually target the perceived rigidity imposed on policy makers as they are bound to respond according to the targeted variables. However, as the variables can also be decide by the authorities they simply act as guiding points and not restrictions. Another concern states that the policy initially leads to lead to low and unstable growth in output and employment during the disinflationary phases but this only occurs until the inflation rates become stabilized at the desired level. There is some evidence that the system can actually contribute to economic growth not just in providing stable inflation rates (Mishkin, 1999). In the international arena Targeting inflation leads to a floating exchange rate between any two countries unless both the countries are manipulating the same variables to manage their currencies. Comparison and Conclusion Each of the Monetary Regime discussed above have their advocates and successful examples but their adoption also seems to be in phases. The economic trends of the world define which of the policy would be suited for each country in consideration. While Fixed Exchange rate policy can be disastrous for emerging economies in need of complete control of their policies, it can provide economic unity to industrialized neighbors. Similarly, Monetary Targeting policies can be beneficial for companies with already strong banking systems and trust but may not work as well for others. The final system adopted by any country has to be correlated with the long term future plans of the government and the economic growth they want to achieve. It might be possible that the policy regime that finally develops may not be a part of any of the previously defined categories but may combine aspects of several given the specific needs of the economy (Foerster, 2013). Considering the level of international integration it is also possible that in the future international banks will have a greater role to play in the monetary regimes of sovereign states, in any case it is not possible that the systems will remain stationary for a long time, modifications will come as monetary authorities try to move with the demands of the 21st century. . References Mishkin, F.S., (1999). International Experiences with different monetary policy regimes. National Bureau of Economic Research, Working paper, 6965. Cambridge, MA. Bernholz, P., (2003). Monetary Regimes and Inflation, History, Economic and Political Relationships. Centre for Economics, University of Basle, Switzerland. Wright, R.E, and Quadrini, V., (2011). Money and Banking- Chapter 19. International Monetary Regimes. Flat World Education. Available at: http://saylor.org/site/wp- content/uploads/2011/07/ECON302-5.2.pdf Foerster, A. T., (2013). Monetary Policy Regime Switches and Macroeconomic Dynamics. Federal Reserve Bank of Kansas City, Working Paper No. 13-04. Available at SSRN: http://ssrn.com/abstract=2307702 orhttp://dx.doi.org/10.2139/ssrn.2307702 Read More