CHAPTER 2 The International Monetary System The international monetary system can be defined as the institutional framework within

which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined. It is a complex whole of agreements, rules, institutions, mechanisms, and policies regarding exchange rates, international payments, and the flow of capital. The international monetary system consists of laws, rules, institutions, instruments, and procedures, which involve international transfers of money. These elements affect foreign-exchange rates, international trade and capital flows, and balance-of-payments adjustments. Foreign exchange rates determine prices of goods and services across national boundaries. These exchange rates also affect international loans and foreign investment. Hence the international monetary system plays a critical role in the financial management of multinational business and economic policies of individual countries. This chapter has five major sections. The first section provides an overview of a successful foreign-exchange system. The second section presents a history of the international monetary system, from the gold standard of the late nineteenth century to the hybrid exchange system that prevails today. The third section describes the International Monetary Fund and special drawing rights. The fourth section discusses the European Monetary System. The fifth section examines proposals for further international monetary reform. A Successful Foreign-Exchange System A successful exchange system is necessary to stabilize the international payment system. To be successful, an exchange system should meet three conditions: Balance-of-payments deficits or surpluses by individual countries should not be too large or prolonged.

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 Such deficits or surpluses should be corrected in ways that do not cause unacceptable inflation or physical restrictions on trade and payments for either individual countries or the whole world. The maximum sustainable expansion of trade and other international economic activities should be facilitated.

History of International Monetary System The international monetary system has evolved over time and will continue to do so in the future as the fundamental business and political conditions underlying the world economy continue to shift. The international monetary system went through several distinct stages of evolution. These stages are summarized as follows:

Bimetallism: Before 1875. The international monetary system before the 1870s can be characterized as bimetallism in the sense that both gold and silver were used as international means of payment and that the exchange rates among currencies were determined by either their gold or silver contents. The exchange rate between the British pound, which was fully on a gold standard, and the French franc, which was officially on a bimetallic standard, was determined by the gold content of the two currencies. On the other hand, the exchange rate between the franc and the German mark, which was on a silver standard, was determined by the silver content of the currencies. The exchange rate between the pound and the mark was determined by their exchange rates against the franc. Countries that were on the bimetallic standard often experienced the wellknown phenomenon referred to as Greshams law. Since the exchange ratio between the two metals was fixed officially, only the abundant metal was

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used as money, driving more scarce metal out of circulation. This is Greshams law, according to which bad (abundant) money drives out good (scarce) money. The more desirable, superior form of money is hoarded and withdrawn from circulation, and people use the inferior or bad money to make payments. The bad money circulates, the good money is hoarded.

Classical Gold Standard Classical Gold Standard is a monetary system in which a country's government allows its currency unit to be freely converted into fixed amounts of gold and vice versa. The exchange rate under the gold standard monetary system is determined by the economic difference for an ounce of gold between two currencies. Under the gold standard, countries used gold as a medium of exchange and a store of value. Under the gold standard, the exchange rate between any two currencies will be determined by their gold content. Advantages It is an objective system and is not subject to the changing policies of the government or the whims of the currency authority. Gold standard enables the country to maintain the purchasing power of its currency over long periods. This is so because the currency and credit structure is ultimately based on gold in possession of the currency authority. It preserves and maintains the external value of the currency (rate of exchange) within narrow limits. As a matter of fact, within the gold standard system, it provides fixed exchanges, which is a great boon to traders and investors.

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It is further claimed that gold standard helps to adjust the balance of payments between countries automatically due to price-specie-flow mechanism

Ultimate hedge against inflation. Because of its fixed supply, gold standard creates price level stability, eliminates abuse by central bank/hyperinflation.

Disadvantages Under the gold standard, currency cannot be expanded in response to the requirements of trade. The supply of currency depends on the supply of gold. But the supply of gold depends on the success of the mining operations, which may have nothing to do with the factors affecting the growth of trade and industry in the country. Gold standard is costly and the cost is unnecessary. We only want a medium of exchange, why should it be made of gold? It is a luxury. Ultimate hedge against inflation. Because of its fixed supply, gold standard creates price level stability, eliminates abuse by central bank/hyperinflation. Whenever the government finds it politically necessary to pursue national objectives that are inconsistent with maintaining the gold standard, it can abandon the gold standard. In other words, the international gold standard per se has no mechanism to compel each major country to abide by the rules of the game. For such reasons, it is not very likely that the classical gold standard will be restored in the foreseeable future. Note: Gold Standard exists when most countries: Use gold coins as the primary medium of exchange.

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 Have a fixed ex-rate between ounce of gold and currency. Allow unrestricted gold flows - gold can be exported/imported freely. Banknotes had to be backed with gold to assure full convertibility to gold. Domestic money stock had to rise and fall with gold flows

Bretton Woods System The Bretton Woods Agreement was signed by representatives of 44 countries at Bretton Woods, New Hampshire, in 1944, to establish a system of fixed exchange rates. Under this system, each currency was fixed by government action within a narrow range of values relative to gold or some currency of reference. The International Monetary Fund (IMF) and the World Bank were created as part of a comprehensive plan to start a new IMS. The IMF was to supervise the rules and policies of a new fixed exchange rate regime, promote foreign trade and to maintain the monetary stability of countries and therefore that of the global economy; the World Bank was responsible for financing development projects for developing countries (power plants, roads, infrastructure investments). It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was pegged to gold at USD 35/ounce. What this meant was that the value of a currency was directly linked with the value of the U.S. dollar. So if you needed to buy Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. To simplify, Bretton Woods led to the formation of the following: A method of fixed exchange rates; The U.S. dollar replacing the gold standard to become a primary reserve currency; and

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 The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade (GATT)

The main features of the system were: -

One of the main features of Bretton Woods is that the U.S. dollar
replaced gold as the main standard of convertibility for the worlds currencies; and furthermore, the U.S. dollar became the only currency that would be backed by gold. (This turned out to be the primary reason that Bretton Woods eventually failed.)

A system of fixed exchange rates on the adjustable peg system was

established. Exchange rates were fixed against gold but since there were fixed dollars of gold (35 per ounce) the fixed rates were expressed relative to the dollar.

Governments were permitted by IMF rules to alter the pegged rate in

effect to devalue or revalue the currency but only if the country was experiencing a balance of payments deficit/surplus of a fundamental nature.

The dollar became the principal international reserve asset. Only the
USA undertook to convert their currency into gold if required. What caused the collapse of the system?

The system relied on period revaluations/devaluations to ensure that

exchange rates did not move too far out of line with underlining competitive. However countries were reluctant to alter their pegged exchange rates. Surplus countries were under no pressure to revalue since the accumulation of foreign exchange reserves posed no real economic problems. Deficit countries regarded devaluation as an indicator of the failure of economic policy. Thus the deficit countries

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were forced into deflationary policy to protect overvalued exchange rates. As Inflation rates accelerated and diverged the problem became more serious and countries became less willing to accept the deflationary price of a fixed exchange rate system.

The system became vulnerable to speculation since speculation was a

one way bet. A deficit country might devalue or not. Thus pressure grew on deficit countries especially as capital flows in creased with the development of the Eurocurrency markets.

Since the system had adopted the dollar as the principal reserve
currency, it had an inherent flaw. As world trade expanded more dollars would be needed to provide sufficient internationally liquid assets to finance that trade. A steady supply of dollars to the world required that the USA ran a balance of payment deficit and financed it by exporting dollars. But eventually the world held move dollars than the value of the USAs holdings of gold. The ability to convert dollars into gold was called in doubt. Thus confidence in the dollar declined. The Flexible Exchange Rate Regime The flexible exchange rate regime that followed the demise of the Bretton Woods system was ratified after the fact in January 1976 when the IMF members met in Jamaica and agreed to a new set of rules for the international monetary system. The key elements of the Jamaica Agreement include:

Flexible exchange rates were declared acceptable to the IMF

members, and central banks were allowed to intervene in the exchange markets to iron out unwarranted volatilities.

Gold was officially abandoned (i.e., demonetized) as an

international reserve asset. Half of the IMFs gold holdings were returned to the members and the other half was sold, with the proceeds to be used to help poor nations.

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 Non-oil-exporting countries and less-developed countries were

given greater access to IMF funds. The IMF continued to provide assistance to countries facing balance-ofpayments and exchange rate difficulties. The IMF, however, extended assistance and loans to the member countries on the condition that those countries follow the IMFs macroeconomic policy prescriptions. This conditionality, which often involves deflationary macroeconomic policies and elimination of various subsidy programs, provoked resentment among the people of developing countries receiving the IMFs balance-of payments loans. During this period of volatilities, dollar was in sometimes appreciating and sometimes depreciating, just the same way as other currencies. As the dollar continued its decline, the governments of the major industrial countries began to worry that the dollar may fall too far. To address the problem of exchange rate volatility and other related issues, the G-7 economic summit meeting was convened in Paris in 1987.6 The meeting produced the Louvre Accord, according to which: The G-7 countries would cooperate to achieve greater exchange rate stability.

The G-7 countries agreed to more closely consult and coordinate

their macroeconomic policies. The Louvre Accord marked the inception of the managed-float system under which the G-7 countries would jointly intervene in the exchange market to correct over- or undervaluation of currencies. Since the Louvre Accord, exchange rates became relatively more stable for a while. During the period 19962001, however, the U.S. dollar generally appreciated, reflecting a robust performance of the U.S. economy fueled by the technology boom. During this period, foreigners invested heavily in the United States to participate in the booming U.S. economy and stock markets. This helped the dollar to appreciate. The European Monetary System After the collapse of the Bretton woods systems, several European countries started to move towards a system in which there was increasing stability

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between their national currencies, even though there might still be volatility in their exchange rates with currencies of non member states. This objective was eventually incorporated into the European monetary system (EMS) of the European Union. The EMS was established in 1979. As part of this system, there was an exchange rate mechanism for achieving stability in the exchange rates of member currencies, by restricting exchange rate movements within certain limits or bands The objectives of the EMS were:

Exchange rate stability; Members agreed to stabilize exchange rates within the narrow bands of the exchange Rate Mechanism (ERM). The main features of ERM were:

Each country had a central rate in the system expressed in

terms of a composite currency, the European currency unit (ECU) Currencies were only allowed to fluctuate within specified bands

Within these there were narrower limits, measured in ECU and

acting as trigged for policy action by governments to limit further exchange rate movement.

To promote convergence and economic performance in member states especially in terms of inflation rates, interest rates and public borrowing. This is seen as necessary step in the move to a single currency.

In long-term to achieve a single European currency as part of a wider economic and monetary Union.

THE EURO

Main Advantages of Euro (Common Currency/ Monetary Union)

Significant reduction in transaction costs for consumers, businesses, governments, etc If you travel through all 15 countries and exchange

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money in each country but don't spend it, you end up with 1/2 of the original amount! Once countries use the same currency, transactions costs will be reduced substantially. These savings will accrue to practically all economic agents, benefiting individuals, companies, and governments.

Elimination of currency risk, which will save companies hedging costs. Economic agents should also benefit from the elimination of exchange rate uncertainty. Companies will not suffer currency loss anymore from intraeuro zone transactions. Companies that used to hedge exchange risk will save hedging costs.

Increased price transparency will promote Europe-wide competition, exerting a downward pressure on prices. Reduced transaction costs and the elimination of currency risk together will have the net effect of promoting cross-border investment and trade within the euro zone.

By furthering economic integration of Europe, the single currency will promote corporate restructuring via mergers and acquisitions, encourage optimal business location decisions, and ultimately strengthen the international competitive position of European companies. Thus, the enhanced efficiency and competitiveness of the European economy can be regarded as the third major benefit of the monetary union.

The advent of the common European currency also helps create conditions conducive to the development of continental capital markets with depth and liquidity. The common currency and the integration of European financial markets pave the way for a European capital market in which both European and non-European companies can raise money at favorable rates.

Sharing a common currency should promote political cooperation and peace. Envisioning a new Europe in which economic interdependence and cooperation among regions and countries replace nationalistic rivalries which so often led to calamitous wars in the past. If the euro proves to be successful, it will advance the political integration of

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Europe in a major way, eventually making a United States of Europe feasible. Main Disadvantage of Euro (Common Currency/ Monetary Union) Loss of control over domestic monetary policy and exchange rate determination. If a country experiences sudden drop in its export prices, its economy could go into recession, unemployment could increase and it can take no measure to lower the value of its currency. If independent, it could use monetary stimulus to lower interest rates and lower the value of its currency, to stimulate the domestic economy and increase exports. In other words, a common monetary policy dictated in Frankfurt cannot address asymmetric economic shocks that affect only a particular country or sub-region; it can only deal with euro zonewide shocks.
EXCHANGE RATE REGIME

There are various exchange rate systems that countries might adopt. The two broad alternatives are: Fixed exchange rate system Floating exchange systems.

Fixed exchange rate Under a fixed exchange rate system the government and the monetary authorities would have to operate in the foreign exchange market to ensure that the market rate of exchange is kept at its fixed (par) rate or changes within a predetermined band. A government (through central banks) would have to maintain official reserves. The reserves are required for: -

Financing any current account deficit (fall in reserve) or surplus

(rise in reserves) that occur.

Intervening in the foreign exchange market to maintain the par

value of the currency. The currency would be bought with

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reserves if the exchange rate fell and sold in exchange for reserves when the exchange rate rose. No exchange rate system is truly fixed for all time. The issue is the degree of fixity:

Under the gold standard system it was held that, for all practical
purposes, the rates of exchange were fixed.

Under the Breton woods system, exchange rates were fixed

within narrow limits but with the possibility of occasional changes of the par value (an adjustment peg system). Advantages of Fixed Rate System

It provides stability in the foreign exchange markets and

certainty about the future course of exchange rate and it eliminates risks caused by uncertainty, hence encouraging international trade.

Creates conditions for smooth flow international capital. Simply

because it ensures a certain return on the foreign investment.

It eliminates the possibility of speculation, where by it removes

the dangers of speculative activities in the foreign exchange market.

Disadvantages

The absence of flexibility in exchange rates means that balance of

Payments (BOP) deficits on current account will not be automatically corrected; smile deficits cannot be financed forever (because reserves are limited). Governments would have to use deflationary policies to depress the demand for imports. This is likely to cause unemployment and slow down the growth of output in the country. The stability of exchange rates may be too rigid to take care of major upheavals such as wars, revolutions, and widespread disasters.

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 Central banks need to maintain large international reserves to defend a fixed exchange rate. Fixed exchange rates may result in destabilizing speculation that causes the exchange rate to overshoot its natural equilibrium level. Overshoot (beyond fair value) is natural after devaluation.

Floating/Flexible Exchange Rate System It is a system in which exchange rate fluctuates according to market forces. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. Under a system of floating exchange rate the government has no obligation to maintain the rate of exchange at some declared level and leaves its determination to market forces (demand & supply). However there degree to which governments will allow market forces to determine the rate of exchange for their currency hence: o Free Floating Exchange Rate Under this system, governments leave the deterring of the exchange rate entirely to the market forces. No official intervention in the foreign exchange markets and hence no need of keeping any official reserves. In practice it is unlikely that governments would have no interest in the rate of exchange, for large changes in the rate have important domestic Implications especially for economies Currency appreciation reduces international competitiveness and has employment and output implications and currency depreciation raises import prices and has Implication for the rate of inflation

Managed Floating

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Under managed floating, governments allow markets to determine day to day movements in the exchange rates but may intervene to prevent very large changes. This system of managed float is also known as a dirty float. Either the governments may allow the rate of exchange to fluctuate between very large bands (which are often not publicly stated) but intervene if the currency looks like moving outside of these bounds or governments may allow the market to determine the trend, in the exchange rate but intervene to limit fluctuation around the trend.

Although governments do not attempt to prevent fundamental changes in the exchange rate between their own currency and other currency, they typically attempt to maintain orderly trading conditions in the market. A flexible exchange system has a number of advantages: Countries can maintain independent monetary and fiscal policies.

It serves as a barometer of the actual purchasing power and strength

of a currency in the foreign exchange market. It serves as a useful parameter in the formulation of the domestic economic policies

It is self-adjusting and therefore, it does not devolve on the

government to maintain an adequate foreign exchange reserve. Flexible exchange rates permit a smooth adjustment to external shocks. Under floating exchange rate systems balance of payments deficits/surpluses are, in principle, automatically corrected by movements in the exchange rate. Central banks do not need to maintain large international reserves to defend a fixed exchange rate. However, flexible exchange system has several disadvantages. Exchange rates under a pure version of this system are highly unstable, thereby discouraging the flow of world trade and investment.

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 Flexible exchange rates are inherently inflationary, because they remove the external discipline on government economic policy.

There is high possibility of currency exchange risks. This might lead to

a lower volume sequences. The lower volume of trade implies a reduced level of economic welfare.

Current Exchange System

Most governments employ one of the following three exchange rate systems that are still used today: Dollarization This occurs when a country decides not to issue its own currency and adopts a foreign currency as its national currency. Although dollarization usually enables a country to be seen as a more stable place for investment, the drawback is that the countrys central bank can no longer print money or make any sort of monetary policy. An example of dollarization is El Salvador's use of the U.S. dollar, recently decision of Zimbabwe to use South African Rand ( SAR). Pegged Rates Pegging occurs when one country directly fixes its exchange rate to a foreign currency so that the country will have somewhat more stability than a normal float. More specifically, pegging allows a countrys currency to be exchanged at a fixed rate with a single or a specific basket of foreign currencies. The currency will only fluctuate when the pegged currencies change. Managed Floating Rates This type of system is created when a currencys exchange rate is allowed to freely change in value subject to the market forces of supply and demand. However, the government or central bank may intervene to stabilize extreme fluctuations in exchange rates.

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Note: An appreciation is a rise in the value of a currency against other currencies under a floating-rate system. Under a system of floating rates, a countrys exchange rate will appreciate if it raises interest rates to attract capital. A depreciation is a decrease in the value of a currency against other currencies under a floating-rate system. Similarly, its exchange rate will depreciate if it reduces interest rates. A revaluation is an official increase in the value of a currency by the government of that currency under a fixed-rate system. It may revalue or upvalue its exchange rate by setting a higher intervention price. A devaluation is an official reduction in the par value of a currency by the government of that currency under a fixed-rate system. Under a system of fixed rates, a country may devalue its exchange rate by setting a lower intervention price at which it will intervene in the foreign-exchange market. The International Monetary Fund The IMF was created in 1944 by 30 countries. The IMF was created at the Bretton Woods conference as a weak kind of central banks central bank, to

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make the new monetary system feasible and workable. Its major purpose was to assist members that would have structural trade problems or currencies that were highly unstable in value. The IMF permitted its deficit members to buy with their local currencies some of its own holdings of convertible currencies. These deficit countries were expected to buy back, with gold or other convertible currencies, the local currencies they had sold to the IMF after they had improved their balance of payments. Thus, the IMFs major weapon is the power to declare its members ineligible to utilize its holdings of international reserves. Its objectives are: To promote international monetary cooperation. To facilitate the balanced growth of international trade. To promote exchange stability. To eliminate exchange restrictions.

To create standby reserves.

Review 1. Explain Greshams law. 2. Explain the mechanism that restores the balance-of-payments equilibrium when it is disturbed under the gold standard. 3. Discuss the advantages and disadvantages of the gold standard. 4. What were the main objectives of the Bretton Woods system? 5. Discuss the criteria for a good international monetary system. 6. List the advantages of the flexible exchange rate regime. 7. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed exchange rate regime.

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