History Shows Us That Attempts to Fix Exchange Rates or Create Monetary Unions Between Different Countries Usually End in Failure. Therefore, We Should Not Be Surprised by the Current Problems in the Euro Zone.

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Essay question: History shows us that attempts to fix exchange rates or create monetary unions between different countries usually end in failure. Therefore, we should not be surprised by the current problems in the Euro Zone. Discuss

Introduction

“A monetary system is a set of policy tools and institutions through which a government provides money and controls the money supply in an economy”. The world has evolved through a variety of international monetary system since the 19th century. There have been three different international monetary system:

The Gold Standard
The Bretton-Woods system
Floating exchange rate

The Gold Standard

The Gold Standard last from1870 to 1914 and from 1918 to1939. Under this system the countries fixed the price of their currency in terms of gold. All the currency's prices were fixed in relation to the official gold reserve. The Gold Standard faced its first crisis during the first World War. Most of the countries to finance the cost of the war abandoned the gold standard and by doing so caused an increase in inflation to unsustainable levels. Because this system limited the power of the central banks to supply money in an economy and therefore lower the interest rate, is easy to understand why the gold standard was blamed for prolonging the Great Depression during the interwar.

The Bretton-Woods system

The Bretton-Woods system or fixed exchange rates (1958-73) is based on the reserve currency hold by the central bank which fixes its currency exchange rate against the reserve currency by trading domestic for foreign asset when necessary. In this case the central bank fixed the dollar exchange rate of its currency by trading domestic currency for dollar assets. In the foreign exchange market, the central bank fixed the currency's dollar price, and so the exchange rate was automatically fixed through arbitrage.

The Floating Exchange Rate

The floating exchange rate system (since 1973) is called the “non-system” because is characterized by less international policy coordinator than the other two system. Many countries under this system practise a managed floating exchange rate by buying currency and asset expecially during period characterized for high instability. In a floating exchange rate system the value of each currency is determined by the foreign exchange market without any intervention. An example is the European monetary system.

The Central Bank Intervention and the Money Supply

Many countries peg their exchange rate to a currency or group of currencies by intervening in the foreign exchange markets. Many instead, with a flexible or “floating” exchange rate. This event is made possible by the central bank intervention and the money supply.

A purchase or a sale of any asset by the central bank will be paid for with check or currency. Any purchase/sale of domestic/foreign bonds will increase/decrease the domestic money supply causing the amount of money in circulation to shrink. Any transaction leads to a decrease or an increase of asset and liabilities in the central's balance sheet:

Asset = Liabilities + Net Worth

where Net Worth is costant.

So an increase/decrease in asset lead to an increase/decrease in liabilities. A change in the central bank’s balance sheet lead to an equal change in currency in circulation or changes in deposits of banks, which lead to changes in the money supply.

How the Central Bank Fixes the exchange Rate

The foreign exchange market is in equilibrium when the domestic interest rate R is equal to R*, plus (Ee-E)/E, the expected rate of depreciation of the domestic currency against foreign currency. If the central bank do not intervene, the interest rate will rise above the foreign rate R* to balance the demand for money. So, for example, to maintain the domestic interest rate at R* the central bank must intervene in the foreign exchange market adjusting the money supply by buying...
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