THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 562

530 PA R T V I International Finance and Monetary Policy Managed Float Although most exchange rates are currently allowed to change daily in response to market forces, central banks have not been willing to give up their option of intervening in the foreign exchange market Preventing large changes in exchange rates makes it easier for firms and individuals purchasing or selling goods abroad to plan into the future Furthermore, countries with surpluses in their balance of payments frequently not want to see their currencies appreciate because it makes their goods more expensive abroad and foreign goods cheaper in their country Because an appreciation might hurt sales for domestic businesses and increase unemployment, surplus countries have often sold their currency in the foreign exchange market and acquired international reserves Countries with balance-of-payments deficits not want to see their currency lose value because it makes foreign goods more expensive for domestic consumers and can stimulate inflation To keep the value of the domestic currency high, deficit countries have often bought their own currency exchange in the foreign exchange market and given up international reserves The current international financial system is a hybrid of a fixed and a flexible exchange rate system Rates fluctuate in response to market forces but are not determined solely by them Furthermore, many countries continue to keep the value of their currency fixed against other currencies, as was the case in the European Monetary System (to be described shortly) Another important feature of the current system is the continuing de-emphasis of gold in international financial transactions Not only has the United States suspended convertibility of dollars into gold for foreign central banks, but also since 1970 the IMF has been issuing a paper substitute for gold, called special drawing rights (SDRs) Like gold in the Bretton Woods system, SDRs function as international reserves Unlike gold, whose quantity is determined by gold discoveries and the rate of production, SDRs can be created by the IMF whenever it decides that there is a need for additional international reserves to promote world trade and economic growth The use of gold in international transactions was further de-emphasized by the IMF s elimination of the official gold price in 1975 and the sale of gold by the U.S Treasury and the IMF to private investors in order to demonetize it Currently, the price of gold is determined in a free market Investors who want to speculate in it are able to purchase and sell at will, as are jewellers and dentists who use gold in their businesses European Monetary System (EMS) In March 1979, eight members of the European Economic Community (Germany, France, Italy, the Netherlands, Belgium, Luxembourg, Denmark, and Ireland) set up an exchange rate union, the European Monetary System (EMS), in which they agreed to fix their exchange rates vis- -vis one another and to float jointly against the U.S dollar Spain joined the EMS in June 1989, the United Kingdom in October 1990, and Portugal in April 1992 The EMS created a new monetary unit, the European currency unit (ECU), whose value was tied to a basket of specified amounts of European currencies The exchange rate mechanism (ERM) of the European Monetary System worked as follows The exchange rate between every pair of currencies of the participating countries was not allowed to fluctuate outside narrow limits around a fixed exchange rate (The limits were typically *2.25% but were raised to *15% in August 1993.) When the exchange rate between two countries currencies moved outside these limits, the central banks of both countries were supposed to intervene in the foreign exchange market If, for example, the French franc depreciated below its lower limit against the German mark, the Bank of France was