The International

Monetary System

Chapter objective
Understand the development of the
international monetary system and different
exchange rate system including some
experiences.

Outline
1.Introduction
2.Evolution

of the International Monetary

System
3. Asian Currency Crisis
4.The Exchange Rate System

1.Introduction
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.

1.Introduction
It

is a complex whole of agreements,roles,

institutions, mechanisms, and policies
regarding exchange rates, international
payments , and the flow of capital.
It 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.

1.Introduction
A good

or idea international monetary

system should provide:
1)liquidity: the amount of international
reserve assets available to settle temporary
balance-of-payments disequilibria. To
correct BP without deflating or inflating.

1.Introduction
2)adjustment:the

process by which balanceof-payment disequilibria are corrected. To

minimize the cost of and the time required
for adjustment.
3)Confidence:the knowledge that
adjustment mechanism is working
adequately and the international reserves
will retain their absolute and relative values.

1.Introduction
In

other words ,a good IMS should able to provide

the world economy with sufficient monetary
reserves to support the growth of international
trade and investment.
an efficient mechanism that restores the balanceof-payments equilibrium wherever it is disturbed.
A safeguard to prevent crises of confidence in the
system that result in panicked flights from one
reserve asset to another.

2.Evolution of the international

monetary system
(1)Bimetallism:before

1875
(2)Classical gold standard:1875-1914
(3)Interwar period:1915-1944
(4)Bretton Woods system :1945-1972
(5)Flexible exchange rate regime:since1973

(1).Bimetallism:Before1875
A double

standard in that free coinage was

maintained for both gold and silver. Both gold and
silver were used as international means of payment
and that the exchange rates among currencies were
determined by either gold or silver contents.
The exchange ratio between the two metals was
fixed officially, only the abundant metal was used as
money, driving more scarce metal out of circulation.
Bad money drives out good money.

(2).Classic Gold Standard:1875-1914

During

this period London became the center of

the international financial system.
Exist:1)gold alone is assured of unrestricted
coinage
2)there is two-way convertibility between gold
and national currencies at a stable ratio
3)gold may be freely exported or imported
The domestic money stock should rise and fall
as gold flows in and out of the country.

(2).Classic Gold Standard:1875-1914

Under

the gold standard, the exchange rate

between the two currencies will be determined by
their gold content. 1ounce=6 1ounce=12 francs
1=2Fr
The pound and the franc remain the pegged to
gold at given prices,the exchange rate between the
two currencies will remain stable.

(2).Classic Gold Standard:1875-1914

Under

this standard, international imbalances of

payment will also be corrected automatically.
The adjustment mechanism is referred to as the
price-specie-flow mechanism, which is attributed to
David Hume,a Scottish philosopher.
Since each nations money supply consisted of
either gold itself or paper currency back by gold,the
money supply would fall in the deficit nation and
rise in the surplus nation.

(2).Classic Gold Standard:1875-1914

Cause

internal prices to fall in the deficit nation

and rise in the surplus one.
Result: the export of the deficit nation would be
encouraged and its import discouraged until its
balance-of payments deficit was eliminated. The
opposite would occur in the surplus nation.If gold
is used as sole international means of
payment,then countriesbalance of payments will
be regulated automatically via the movements of
gold.

(2).Classic Gold Standard:1875-1914

Shortcomings:
1)the world economy can face deflationary
pressures
2)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 that has no
mechanism to compel each major country to abide
by the rules of the game.

(3).Interwar Period:1915-1944
World

War ended the gold standard in Aug.

1914,as major countries such as
Britain,France, Germany suspended
redemption of banknotes in gold and
imposed embargoes on gold export.
As major countries began to recover from
the war and stabilized their economies,they
attempted to restore the gold standard.

(3).Interwar Period:1915-1944
The

U.S replaced Great Britain as the dominant

financial power, and with only mild inflation ,was in
an effort to restore the gold standard.
The international gold standard of the late 1920s was
not much more than a faade.
Most major countries gave priority to stabilization of
domestic economies and systematically followed a
policy of sterilization of gold by matching inflows
and outflows of the gold respectively with reductions
and increases in domestic money and credit.

(3).Interwar Period:1915-1944
Following

the stock market crash and the onset of the

Great Depression in 1929, Britain experienced a
massive outflow of gold and their gold reserves
continued to fall to the point where it was impossible
to maintain the gold standard. In 1931,the British
government suspended gold payments and let the
pound float. Canada,Sweden,Austria,Japan also
followed.
The U.S got off gold in April 1933.Paper standards
came into being when the gold standard was
abandoned.

(4).Bretton Woods System:19451972

In

July 1944, representatives of 44 nations

gathered at Bretton Woods, New
Hampshire,to discuss and design the postwar
international monetary system.
The Articles of Agreement of the
International Monetary Fund(IMF), IMF
embodied an explicit set of rules about the
conduct of international monetary policies
and was responsible for enforcing these rules.

(4).Bretton Woods System

The

International Bank for Reconstruction and

Development (IBRD),the World Bank,that was chiefly
responsible for financing individual development
projects.
The British delegates proposed an international clearing
union that would create an internationa reserve asset
called bancor.
The American delegates proposed a currency pool to
which member countries would make contributions and
from which they can might borrow to tide themselves
over during shot-term balance-of-payments deficits.

(4).Bretton Woods System

The American

proposal was largely incorporated

into the Articles of the Agreement of the IMF.
Under the Bretton Woods System, each country
established a par value in relation to the U.S
dollar,which was pegged at $35 per ounce. Each
country was responsible for maintaining their
exchange rate within 1% of the adopted par value
by buying or selling foreign exchanges as
necessary.

(4).Bretton Woods System

The

Bretton Woods system can be described as a

dollar-based gold-exchange standard, because the
U.S dollar was the only currency that was fully
convertible to gold.

British

pound
Par value

German
mark

French
franc

U.S dollar
pegged at $35/oz.
gold

(4).Bretton Woods System

1)Advantage

of the gold-exchange system:

Not only gold but also foreign exchanges as
an international means of payment
Earn interest on the foreign exchange
holdings, gold holdings yield no returns
Save transaction costs associated with
transporting gold across countries

(4).Bretton Woods System

2)Triffin

paradox
The reserve-currency country should run
balance-of-payments deficits to supply
reserves,but if such deficits are large and
persistent,they can lead to a crisis of
confidence in the reserve currency
itself,causing the downfall of the system.

(4).Bretton Woods System

3)SDRs
The

creation of a new reserve asset,special

drawing rights,by IMF in1970. It is a basket
currency comprising major individual
currencies,was allocated to the members of
the IMF,who could then use it for transactions
among themselves or with the IMF. Besides
gold and foreign exchanges, counties could
use SDR to make international payment.

(4).Bretton Woods System

It

is used as a reserve asset and a

denomination currency for
international transaction.

SDR

is a portfolio of currencies ,its value

is more stable than that of any individual
currency include in the SDR.

(4).Bretton Woods System

4)Smithsonian Agreement
In

the early 1970s,it became clear that the dollar was

over-valued,especially to the mark and yen. German and
Japanese central banks had to make massive
intervention in the foreign exchange market to maintain
their par values, but could not solve the problem. The
foundation of the Bretton Woods cracked under the
strain.
In 1971, the Group of Ten, met at the Smithsonian
Institution in Washington,D.C.,reached the Smithsonian
Agreement.

(4).Bretton Woods System

the

price of gold was raised to $38 per ounce; Each of

the other countries revalued its currency against the
U.S dollar by up to 10%; The band within which the
exchange rate were allowed to move was expanded
from 1% to 2.25% in either direction.
But the devaluation of the dollar was not sufficient to
stabilize the situation.In Feb.1973 the price of gold
was further raised from $38 to $42 per ounce. By
march European and Japanese currencies were allowed
to float, completing the decline and fall of the Bretton
Woods system.

(5).the Flexible Exchange Rate

Regime
1)

Jamaica Agreement
In Jan. 1976 the IMF members met in Jamaica
and agreed to a new set of rules for the
international monetary system. The key elements
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.

(4).Bretton Woods System

Gold

was officially abandoned as an international

reserve asset.Half of the IMFs gold holdings were
returned to the members and the other were sold to be
used to help poor nations.
Non-oil-exporting countries and less-developed
countries were given great access to IMF funds.
The IMF provided assistance to countries facing
balance-of-payments and exchange rate difficulties.But
to the member countries on the condition that those
countries follow the IMFs macroeconomic policy
prescriptions.

(4).Bretton Woods System

2)in

Sept. 1985, Plaza Accord, G-5

The dollar to depreciate against most major
currencies and intervene in the market
3)in Paris in1987, Louvre Accord, G-7
Cooperate to achieve greater exchange rate
stability, more closely consult and coordinate
macroeconomic policies
Louvre Accord marked the inception of the
managed-float system.

2.The Asian Currency Crisis

(1)Origins
A weak

domestic financial system

Free international capital flows
The contagion effects of changing market
sentiment (panicky)
Inconsistent economic policies

 (2)Lessons
Counties

first strengthen their domestic financial system

and then liberalize.
The government should strengthen its system of financialsector regulation and supervision.
Banks should be encouraged to base their lending decisions
solely on economic merits rather than political
considerations.
Firms,financial institutions ,and government should be
required to provide the public with reliable financial data in
a timely fashion.

(2)Lessons
A country

should encourage foreign direct investments

and equity and long-term bond investments not shortterm. As Chile has successfully implemented Tobin tax
on the international flow of hot money.
A fixed but adjustable exchange rate is problematic in
the face of integrated international financial markets.
Trilemma: a fixed exchange rate, free international
flows of capital, an independent monetary policy.
China and India,capital controls segment their capital
markets from the rest of the world.

3.the Exchange Rate System

(1)Introduction
Arrangements

of the exchange rate, the

dollar, the pound, the yen fluctuating against
each other ,the majority of the worlds
currencies are pegged to single currencies
particularly the U.S dollar,the French franc
or baskets of currencies such as SDR

 Classified

by the IMF in 1999:

48countries including Japan,U.K currencies
float,exchange rate determined by market
force,
25 including the Czech Republic,Singapore
adopt some forms of managed floating
system

 37

have no national currencies,fixed to the

euro through the French franc
8 including Hong Kong fixed to such hard
currencies as the U.S dollar or German
mark
The remain countries adopted a mixture of
fixed and floating exchange rate regime.

 (2).Classification
Fixed

exchange rate system

Flexible exchange rate system
Adjustable peg system
Crawling pegs
Managed-float system

Fixed exchange rate system

The

gold standard is a typical fixed one and

the others like EU. The exchange rate can
fluctuate above and below the parity. Under
the gold standard,the exchange rate was
determined within the gold points by the
forces of demand and supply and was
prevented from moving outside the gold
points by gold shipments.

 The

tendency of a currency to depreciate past the gold

export point was halted by outflows from the nation.
Deficit
The tendency of a currency to appreciate past the gold
import point was halted by gold inflows. Surplus

gold export point=mint parity

+shipping cost
Gold point

gold import point= mint parity

- shipping cost

Flexible exchange rate system

Under

truly flexible exchange rate system, a

deficit or surplus in the nations balance of
payments is automatically corrected by a
depreciation or an appreciation of the
nations currency,without any government
intervention and loss or accumulation of
international reserves.

Adjustable peg system

It

requires defining the par value and the allowed

band of fluctuation,with the stipulation that the
par value will be changed periodically and the
currency devalued to correct a balance-ofpayments deficit or revalued to correct a
surplus.It often invites speculative attack at the
time of financial markets. Because some
objective rule would have to be agreed upon and
enforced to determined when the nation must
change its par value.

Crawling pegs
To avoid

the disadvantage of relatively large changes

in par values and possibly destabilizing speculation.
Under this system ,par values are changed by small
preannounced amounts or percentages at frequent
and clearly specified intervals ,say ,every month,
until the equilibrium exchange rate is reached.
Preventing destabilizing speculation by manipulating
its short-term interest rate to neutralize any profit
resulting from the scheduled change in the exchange
rate.

Managed floating
Under

this system ,the nations monetary

authorities are entrusted with the
responsibility to intervene in foreign
exchange markets to smooth out these
short-run fluctuations without attempting to
affect the long-run trend in exchange rate.
Dirty floating
Pure floating

Managed floating
Benefits:

not only from fixed exchange rate

but also flexible.
Difficulties:
Monetary authorities may be in no better
position than professional speculators,
investors and traders to know the long-run
trend in exchange rate is.
There is still a need for international reserves.

Managed floating
What

proportion of the short-run fluctuation in

exchange rates monetary authorities succeed in
depends on what proportion of short-run excess
demand for or supply of foreign exchange they
absorb. Depending on their willingness to
intervene in foreign exchange markets for
stabilization purpose and the size of the nations
international reserves.
The rules of leaning against the wind are not
spelled out precisely.

(3)Fixed versus flexible exchange

rate system
The

key arguments for flexible rates rest on:

1)easier external adjustments
2)national policy autonomy
External balance will be achieved
automatically.The government does not
have to take policy actions to correct the
balance-of-payments disequilibrium.

(3)Fixed versus flexible exchange

rate system
Drawback

:
exchange rate uncertainty
However the firms can hedge exchange rate risk by
means of currency forward or options
contracts,uncertain exchange rate do not necessarily
hamper international trade.
Proponents of the fixed exchange rate regime argue
that:
Eliminating the uncertainty of exchange rate and
promote international trade

(3)Fixed versus flexible exchange

rate system
The

choice between the alternative exchange rate

systems is likely involve a trade-off between
national policy independence and international
economic integration.
If to pursue respective domestic economic goals,
flexible exchange rate
If to promote international economic
integration(like EU members Germany and
France),fixed exchange rate.

Gold standard
International monetary
system
Bretton Woods System
Managed-float system
Par value
Price-specie-flow
mechanism
SDR

Key words

Discuss the advantage and

disadvantage of the gold
standard.
What kind of measures
would you propose to
prevent the recurrence of
an Asia-type crisis?
Once capital markets are
integrated, it is difficult for
a country to maintain a
fixed exchange rate.
Explain why.

Questions and
Discussions

European Monetary
System and EU

10

Chapter objective:
Know something about EMS and
monetary union including EU, and integration.

Outline
1.European

Monetary System
2.the Euro and the European Monetary Union
(1)a Brief History of the Euro
(2) Benefits of Monetary Union
(3)Costs of Monetary Union
(4)Prospects of the Euro
3.Will it emerge Asian-Yuan?
4.Optimum currency area

1.European monetary system

Smithsonian Agreement,

signed in Dec.1971,the
band of exchange rate was 2.25%,EEC a
narrower band of 1.125%
This scale-down,European version of fixed
exchange rate system that arose concurrently with
the decline of the Bretton Woods system was called
the snake.
Stable exchange rates is essential for EEC to adopt
the snake for promoting intra-EEC trade and
deepen economic integration.

1.European monetary system

European Monetary System (EMS) replaced the snake in1979.
Its chief objectives:
1)To establish a zone of monetary stability in Europe.
2)To coordinate exchange rate policies vis--vis the non-EMS
currencies.
3)To pave the way for the eventual European monetary union.
The two main instruments of the EMS :
(1)European Currency Unit(ECU)
(2)Exchange Rate Mechanism(ERM)

(1)European Currency
Unit(ECU)
ECU,

a basket currency constructed as a

weighted average of the currencies of
member countries of the EU.
Weights,based on each currencys relative
GNP and share in intra-EU trade.
ECU, serves as the accounting unit of the
EMS.

(2)Exchange Rate
Mechanism(ERM)
ERM,

a procedure by which EMS member

countries collectively manage their exchange
rates.
ERM, based on parity grid system, a
system of par values among EMS currencies.
The par value of EMS currencies in terms of
the ECU which called the ECU central rates.

(2)Exchange Rate Mechanism(ERM)

,1 ECU=1.94964DM 1
ECU=6.53883Fr implies the parity between the
two currencies : Fr6.53883 /
DM1.94964=Fr3.3539/DM.
A band for a currency to fluctuate allowed to
deviate from the parities was 2.25%.
In Sept.1993 the band 15% the reason p.665
case study The members were not fully
committed to coordinating their economic policies,
a series of realignment.
Currently

(3)Maastricht Treaty
EU

members met at Masstricht in Dec.1991.

1)fixed exchange rate among the member
currencies by Jan.1999,a common currency
2)the European Central Bank(ECB), solely
responsible for the issuance of common
currency and conduct monetary policy in the
EU.

Chronology of the European Union

1951
1957
1968
1973
1979
1980

the European Coal and Steel

Community
the European Community was
signed in Rome
the Custom Union operating
The U.K,Ireland,Demark became
EC members.
EMS was established.
Greece became an EC member.

Chronology of the European Union

1986

1987
1991

1994
1995

1999

2002

Portugal and Spain became EC

members.
the Single European Act
the Maastricht Treaty
a timetable for fulfilling the
European Monetary Union(EMU).
EC was renamed the EU.
Austria,Finland,Sweden became
EU members.
a common European currency,the
euro was adopted by 11 EU member
countries.
euro became legal tender

Chronology of the European Union

2004

Poland and so on became EMU

members
2005 European Constitution
2007 27 EU members
2008 euro was adopted by 15 EU member
countries.

(3)Maastricht Treaty
The

member countries of EU agreed to closely

coordinate their fiscal, monetary,exchange rate policies
and achieve a convergence of their economies.
Each member shall strive to:
1)keep the ratio of government budget deficits to GDP
below 3%
2)keep gross public debts below 60%
3)achieve a high degree of price stability
4)maintain its currency within the prescribed exchange
rate ranges of the ERM.

2.the Euro and the European

Monetary Union
The

advent of a European single

currency, which may potentially rival
the U.S dollar as a global currency, has
profound implications for various
aspects of international finance.

(1)A brief history of the euro

The

EMU is a logical extension of the

EMS,and the ECU precursor of the euro.
The euro-11 countries was irrevocably fixed
to the euro at a conversion rate as of
Jan.1,1999.
To find a conversion rates between a pair of
national currencies, one needs to use the
euro conversion rates of the two currencies.

1 Euro Is Equal to
Austrian

schilling
Belgian franc
Dutch guilder
Finnish markka
French franc
German mark
Irish punt
Italian lira
Luxembourg franc
Portuguese escudo
Spanish peseta

13.7603
40 . 3399
2 . 20371
5 . 94573
6 . 55957
1 . 95583
0 . 78756
1936 . 27
40 . 3399
200 . 482
166 . 386

(1)A brief history of the euro

European

Central Bank conducts monetary policy

whose primary objective is to maintain price
stability. It is independent.
The task of ESCB: define and implicate the
common monetary policy of the Union, conduct
foreign exchange operations, hold and manage the
official foreign reserves of the euro member states.
The national central banks will have to follow the
policies of ECB and continue to perform
important functions of credit, payments.

(2) Benefits of monetary union

1)to

reduce transaction costs and the elimination

of exchange rate uncertainty
to promote restructuring via mergers and
acquisitions
optimal business location decisions
2)to strengthen the international competitive
position of European companies
3)to enhance efficiency and competitiveness of
the European economy

(2) Benefits of monetary union

4)to

pave the way for European capital

market in which both European and nonEuropean companies can raise money at
favorable rates.
5)to promote political cooperation and
peace in Europe
EMU was a matter of war and peace

(3)Costs of Monetary Union

1)the

loss of national monetary and

exchange rate policy independence
asymmetric shock
2)economic costs

(4)Prospects of the Euro

1)Will

the euro succeed?

Intra-euro zone trade accounts for about
60% of the euro-11 countries,benefits from
EMU are likely exceed substantially the
associate costs. Investing political capital
2)will the euro became a global currency
rivaling the U.S dollar?

(4)Prospects of the Euro

Dominance

of dollar :the U.S economy and

the relatively sound monetary policy of the
Federal Reserve
The euro is likely to emerge as the second
global currency.
The sovereign debit crisis challenges the
Euro Zone.

Economic comparison
Euro-11, U.S, Japan
1997 Euro-11 U.S Japan
GDP $billion
6309
7819 4223
Population million 290
268 126
International
18.6% 19.6% 7.9%
trade share
Budget deficit
2.5
0.3
3.4
%of GDP
Inflation rate
1.8%
2.4% 1.7%
Indicators

Source:OECD

4.Theory of optimum currency area

Originally

1961

conceived by Robert Mundell in

(1)Major points:
1)A currency

area is an area where exchange rates

are fixed within the area and floating exchange
rates exist against currencies outside the area.
2)It is the best grouping of countries to achieve
some objective, such as ease of adjustment to
shocks.
3)How should currency areas be chosen so that
exchange rate practices best allow pursuit of
economic goals, such as full employment.

(1)Major points:
The

theory suggests that the optimum area

is the region characterized by relatively
costless mobility of factors of production
(labor and capital).
It is a degree of factor mobility within the
zone,a high degree of factor mobility would
provide an adjustment mechanism.
The factor mobility will restore equilibrium.

(1)Major points:
If

factors are immobile,the equilibrium is

restored solely through relative price
change,an advantage to flexible exchange
rates. If the monetary authorities tend to
resist any price changes, the easiest way to
adjust is with flexible exchange rates
because of the adjustment through the
exchange rate rather than through prices.

(2)Benefits
Greater

price stability
Save the cost of
intervention, hedging
Save costs of
exchanging currencies
of imports
Save travel costs

costs
Give

up own
independent
stabilization and
growth policies

 ECU
EMS
ERM
Maastricht

Treaty
Optimum currency
area
EU

Key words

1)Potential benefits and costs

2)Economic and political
constraints
3)the potential impact of
China, Japan and Korea
on the international
financial system and
economy including their
relationship to the US

Questions and
Discussions :Will the
East Asia set up
community?