Rules of the Game

Rules of the game

Over the past century, we had seen a evolution in international monetary policy, from the classic gold standard of the 19th century, to the pegged exchange rate known as Bretton Woods in 1944, and now to the floating exchange rate system that began in the early 1970.

The floating rate system was the only system compatible with the separate macro economics of nation and financial markets. Countries tend to place domestic economics priorities ahead of external economics means that exchange rates needs to be more flexible to equilibrate international capital movements.

After a decade of floating exchange rates, policymakers reduce exchange rates volatility either by intervention to keep rates within target zones, or by forming regional currency such as the euro. A well international financial system may be beneficial for gains from international trades, it also may be able to transfer macroeconomics shocks from one nation to another.

Below is seven separate international financial systems of the last century, each with their own set of rules:

1. International Gold Standard, 1879 - 1913
2. Bretton Woods Agreement, 1945
3. Fixed Rate Dollar Standard, 1950 - 1970
4. Floating Rate Dollar Standard, 1973 - 1984
5. Plaza Louvre Intervention Accords and Floating Rate Dollar Standard, 1985 - 1996
6. European Monetary System, 1979
7. The European Monetary System as a "Greater DM" Area, 1979 - 1992

Exchange rates were too important to be left to market forces, so intervention was deemed appropriate to smooth disorderly markets. Better policy coordination was required. As a results, since 1985 a new set of rules has evolved, commonly known as "Rules of the Game".These rules emphasizin the role of exchange markets intervention and macroeconomic policy coordination.

The international Gold Standard, 1879 - 1913
- Fix an official gold price and allow free convertibility between domestic money and gold at that price.

Bretton Woods Agreement, 1945
- Fixed an official par value for domestic currency in terms of gold.
- Keep the exchange rate pegged within 1 percent of its par value.
- Offset payments imbalances by use of country reserves
- Each member to pursues its own price level

Fixed Rate Dollar Standard, 1950 - 1970
- Fix an official par value for domestic currency in terms of USD and keep the exchange rate within 1 percent.

US
- Remain passive in the foreign exchange market and practice free trade.
- Pursue an independent monetary policy that establishes a stable price level for tradable goods.

Floating Rate Dollar Standard, 1973 - 1984
- Smooth short term variability in the dollar exchange rate, but do not commit to an official or long term exchange rate
- Modify domestic monetary policy to support major exchange rate interventions, reducing the money supply when the national currency is weak against USD and expanding the money supply when the national currency is strong
- Set long run national monetary and price level targets independently of US. Let the exchange rate adjust over the long run to offset these differences.

US
- Remain passive in the foreign exchange market. Practice free trade without balance of payments or exchange rate target.
- Pursue a monetary policy independent of the exchange rate or policies in other countries, thereby not striving for a common, stable price level for tradable goods.

Plaza Louvre Intervention Accords and Floating Rate Dollar Standard, 1985 - 1996

Germany, Japan, US
- Set broad target zones for USD/DM and USD/JPY exchange rates . Do not announce the agreed upon central rates, and allow for flexible zonal boundaries
- Central banks intervene collectively but infrequently to reverse short run exchange rate trends that threaten a zonal boundary. Signal the collective intent by anouncing rather then hiding intervention
- Sterilize the immediate impact of exchange market intervention by not adjusting short term interest rates
- Each G3 country aim its monetary policy toward stable price, which anchorts world price level and reduce drift in exchange rate target zones.

Other countries
- Support and do not oppose interventions by the G3 to keep the USD within its target zone limits.

European Monetary System, 1979
All member countries
- Fix a value for each exchange rate in terms of the European Currency Unit
- Keep exchange rates stable in the short run by limiting movements within 2.25% on either side of the central rates
- When an exchange rates threatens to break a limit, the strong currency bank must lend freely to the weak curreny central bank to support the exchange rates
- Adjust the par value only if necessary to realign national price levels, and with the collective agreement of the EMS countries
- Work towards national maroeconomic polices that leads to stable values for exchange rates

The European Monetary System as a "Greater DM" Area, 1979 - 1992
All Members
- Intervene inside the parity bands to stabilize currency values
- Adjust national monetary growth and interest rates to support exchange market interventions.
- Remains passive in the foreign exchange market with respect to other EMS countries
- Sterilize the effect of official intervention. Set German monetary policy as anchor for EMS price level.

If we want to be profitable in the FX markets, we need to understand internation money markets and how they evoled. By studying history we will have a much clearer picture.

Source: Adapted from Ronald I Mckinnon, "The Rules of the Game: International money in Historical Perspective, "Journal of Economic Literature 31 (Mar 1993) Page 32