International Monetary System

 Evolution of the International Monetary System

 Current Exchange Rate Arrangements
 European Monetary System
 Euro and the European Monetary Union
 The Mexican Peso Crisis
 The Asian Currency Crisis
 Fixed versus Flexible Exchange Rate Regimes

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What is an international monetary system?

 Narrowly speaking, it refers to international

exchange rate system.
 There are three international exchange rate
systems in history:
the gold standard,
the Bretton Woods, and
the floating exchange rate system.

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 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 rate among currencies are
determined.
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Features of a good international monetary system

 Adjustment : a good system must be able to adjust

imbalances in balance of payments quickly and at a
relatively lower cost;
 Stability and Confidence: the system must be able to keep
exchange rates relatively fixed and people must have
confidence in the stability of the system;
 Liquidity: the system must be able to provide enough
reserve assets for a nation to correct its balance of
payments deficits without making the nation run into
deflation or inflation.

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 Evolution of the
International Monetary System
 Bimetallism: Before 1875
 Classical Gold Standard: 1875-1914
 Interwar Period: 1915-1944
 Bretton Woods System: 1945-1972
 The Flexible Exchange Rate Regime: 1973-
Present

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 Bimetallism: Before 1875
 A “double standard” in the sense that both gold
and silver were used as money.
 Some countries were on the gold standard, some
on the silver standard, some on both.
 Both gold and silver were used as international
means of payment and the exchange rates among
currencies were determined by either their gold or
silver contents.

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 Bimetallism: Before 1875
 Britain- until 1816 (Neapoleonic war)
 US – until 1873 (dropped silver dollar)
 France – until 1878
 China, India, Germany – Silver standard

 No systematic IMS until 1870

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 Classical Gold Standard:
1875-1914
The gold standard had its origin in the use of gold
coins as a medium of exchange, unit of account,
and store of value.
 During this period in most major countries:
 Gold alone was assured of unrestricted coinage
 There was two-way convertibility between gold and national
currencies at a stable ratio.
 Gold could be freely exported or imported.
 The exchange rate between two country’s currencies
would be determined by their relative gold contents.
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 Classical Gold Standard:
1875-1914
For example, if the dollar is pegged to gold at
U.S.$30 = 1 ounce of gold, and the British pound
is pegged to gold at £6 = 1 ounce of gold, it must
be the case that the exchange rate is determined
by the relative gold contents:

$30 = £6
$5 = £1

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 Classical Gold Standard:
1875-1914
 Highly stable exchange rates under the classical
gold standard provided an environment that was
conducive to international trade and investment.
 Misalignment of exchange rates and international
imbalances of payment were automatically
corrected by the price-specie-flow mechanism
which is attributed to David Hume, Scottish
philosopher

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 price-specie-flow mechanism
 If any country has
 Net Exports > Gold inflow > Increase in Money
supply > Increase in price level > Slower the exports
 Net Imports > Gold outflow > decrease in Money
supply > decrease in price level > encourage exports
 This mechanism was intended to restore
equilibrium automatically

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 Rules of the game
 Fix an official gold price or “mint parity” and allow free
convertibility between domestic money and gold at that
price.
 Impose no restrictions on the import or export of gold by
private citizens, or on the use of gold for international
transactions.
 Issue national currency and coins only with gold backing,
and link the growth in national bank deposits to the
availability of national gold reserves.
 If Rule I is ever temporarily suspended, restore
convertibility at the original mint parity as soon as
possible.

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 Classical Gold Standard:
1875-1914
 There are shortcomings:
 The supply of newly minted gold is so restricted that
the growth of world trade and investment can be
hampered for the lack of sufficient monetary reserves.
 Even if the world returned to a gold standard, any
national government could abandon the standard if
govt. finds it politically necessary to pursue national
objectives that are inconsistent with gold standards.

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 The Interwar
Interwar Years,1915-1944
Period: 1918-1939
 With the eruption of WW-I in 1914, the gold
standard was suspended.
 The interwar years were marked by severe economic
instability and hyperinflation in Europe.

 The German Hyperinflation

 Germany’s price index rose from a level of 262 in
January 1919 to a level of 126,160,000,000,000 in
December 1923 (a factor of 481.5 billion).

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 The Interwar
Interwar Years,1915-1944
Period: 1918-1939
 After war, Return to Gold Standard
 1919
 U.S. returned to gold
 1922
 A group of countries (Britain, France, Italy, and
Japan) agreed on a program calling for a general
return to the gold standard and cooperation among
central banks in attaining external and internal
objectives.
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 The
The Interwar
Interwar
Interwar Years,1915-1944
Years,
Period: 1918-1939

 1925
Britain returned to the gold standard
 1929
The Great Depression was followed by bank
failures throughout the world.
 1931
Britainwas forced off gold when foreign holders
of pounds lost confidence in Britain’s commitment
to maintain its currency’s value.
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 The
TheInterwar
Interwar Years,
Period:
Interwar 1918-1939v
1915-1944
Years, 1918-1939
 International Economic Disintegration
 Many countries suffered during the Great Depression.
 Major economic harm was done by restrictions on
international trade and payments.
 These beggar-thy-neighbor policies provoked foreign
retaliation and led to the disintegration of the world
economy.
 Exchange rates fluctuated as countries widely used
“predatory” depreciations of their currencies as a means
of gaining advantage in the world export market.
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 Interwar Period: 1915-1944

Attempts were made to restore the gold standard, but

participants lacked the political will to “follow the rules of
the game” and Great Depression in 1929 and the
accompanying financial crisis were the main reasons

 All countries’ situations could have been bettered

through international cooperation
 Bretton Woods agreement

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 Bretton Woods System:
1945-1972
 Named for meeting of 44 nations at Bretton
Woods, New Hampshire in July 1944.
 The purpose was to design a postwar international
monetary system.
 The goal was exchange rate stability without the
gold standard.
 The result was the creation of the IMF and the
World Bank.

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 Bretton Woods System:
1945-1972
 Under the Bretton Woods system, the U.S. dollar was
pegged to gold at $35 per ounce and other currencies were
pegged to the U.S. dollar.
 Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par value by
buying or selling foreign reserves as necessary.
 The Bretton Woods system was a dollar-based gold
exchange standard.

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 Bretton Woods System:
1945-1972

German
British mark French
pound franc
Par
Value

U.S. dollar

Pegged at $35/oz.
Gold
 Bretton Woods System:
1945-1972
 Triffin Paradox
 To satisfy the growing need for reserve, the US had to run balance
of payment deficit continuously which may eventually impair the
public confidence in the dollar
 1960 – US gold stock fell short of foreign dollar holdings
created concern about viability of system
 Creation of artificial reserve called SDR in 1970
 SDR is basket currency allotted to IMF members
 Weighted avg. of 16 currencies – more than 1 % share in
world export, 1981 only 5 currencies

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 Bretton Woods System:
1945-1972
 Smithsonian Agreement
 To save the bretton woods system G-10 met at
Smithsonian institution in Washington.
 the price of gold was raised to 38$
 Each country revalued its currency by 10%
 The band of 1% expanded to 2.25%
 February 1973, further devaluation by 42$
 By March 1973, Japan and European currecies
were allowed to float and end of Bretton woods
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Collapse of the Bretton Woods System: Process
of dollar devaluation
ounce of gold
Dollar value per

35

38
42.22

1944
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The Flexible Exchange Rate Regime:
1973-Present.
 Jamaica Agreement in January 1976
 Flexible exchange rates were declared acceptable
to the IMF members.
 Central banks were allowed to intervene in the
exchange rate markets to iron out unwarranted
volatilities.
 Gold was abandoned as an international reserve
 Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.
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Current Exchange Rate Arrangements
 Free Float
 The largest number of countries, about 48, allow market forces to
determine their currency’s value.
 Managed Float
 About 25 countries combine government intervention with market
forces to set exchange rates.
 Pegged to another currency
 Such as the U.S. dollar or euro (through franc or mark).
 No national currency
 Some countries do not bother printing their own, they just use the
U.S. dollar. For example, Ecuador has recently dollarized.

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 IMF Classification
The current exchange rate system is a hybrid of many different arrangements.
The International Monetary Fund classifies these exchange rate regimes into
eight specific categories. The eight categories span the spectrum of exchange
rate regimes from rigidly fixed to independently floating:

 Exchange Arrangements with No Separate Legal Tender: The currency of

another country circulates as the sole legal tender or the member belongs to a
monetary or currency union in which the same legal tender is shared by the
members of the union.
 Currency Board Arrangements: A monetary regime based on an implicit
legislative commitment to exchange domestic currency for a specified foreign
currency at a fixed exchange rate, combined with restrictions on the issuing
authority to ensure the fulfillment of its legal obligation.

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 IMF Classification
 Other Conventional Fixed Peg Arrangements: The country pegs its
currency at a fixed rate to a major currency or a basket of currencies , where
the exchange rate fluctuates within a narrow margin or at most ±1% around a
central rate.
 Pegged Exchange Rates within Horizontal Bands: The value of the
currency is maintained within margins of fluctuation around a formal fixed
peg that are wider than ±1% around a central rate.
 Crawling Pegs: The currency is adjusted periodically in small amounts at a
fixed, pre-announced rate or in response to changes in selective quantitative
indicators.
 Exchange Rates within Crawling Pegs: The currency is maintained within
certain fluctuation margins around a central rate that is adjusted periodically at
a fixed pre-announced rate or in response to change in selective quantitative
indicators.
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 IMF Classification
 Managed Floating with No Pre-Announced Path for the Exchange Rate:
The monetary authority influences the movements of the exchange rate
through active intervention in the foreign exchange market without specifying
or pre-committing to a pre-announced path for the exchange rate.
 Independent Floating: The exchange rate is market determined, with central
bank intervening only to moderate the speed of change and to prevent
excessive fluctuations, but not attempting to maintain it at or drive it to any
particular level.

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 Arguments favoring floating rates
1. Better adjustment
2. Better confidence
3. Better liquidity
4. Gains from freer trade
5. Increased independence of policy
 Easier external adjustments.
 National policy autonomy

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 Arguments against floating rates:

1. Cause uncertainty and inhibit international trade

and investment
2. Cause destabilizing and speculation
3. No safeguards to prevent crises
4. Are inflationary
5. Are unstable because of small trade elasticity
6. Cause structural unemployment

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 Fixed versus Flexible
Exchange Rate Regimes
 Suppose the exchange rate is $1.40/£ today.
 In the next slide, we see that demand for British
pounds far exceed supply at this exchange rate.
 The U.S. experiences trade deficits.

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 Fixed versus Flexible
Exchange Rate Regimes
Dollar price per £

Supply
(exchange rate)

(S)

Demand
$1.40 (D)

Trade deficit

S D Q of £
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 Flexible
Exchange Rate Regimes
 Under a flexible exchange rate regime, the dollar
will simply depreciate to $1.60/£, the price at
which supply equals demand and the trade deficit
disappears.

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 Fixed versus Flexible
Exchange Rate Regimes
Dollar price per £

Supply
(exchange rate)

(S)

$1.60
Dollar depreciates Demand
$1.40 (flexible regime) (D)

Demand (D*)

D=S Q of £
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 Fixed versus Flexible
Exchange Rate Regimes
 Instead, suppose the exchange rate is “fixed” at
$1.40/£, and thus the imbalance between supply
and demand cannot be eliminated by a price
change.
 The government would have to shift the demand
curve from D to D*
 In this example this corresponds to contractionary
monetary and fiscal policies.

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 Fixed versus Flexible
Exchange Rate Regimes
Dollar price per £

Contractionary
Supply
(exchange rate)

policies (S)
(fixed regime)

Demand
$1.40 (D)

Demand (D*)

D* = S Q of £
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 European Monetary System
 Eleven European countries maintain exchange
rates among their currencies within narrow bands,
and jointly float against outside currencies.
 Objectives:
 To establish a zone of monetary stability in Europe.
 To coordinate exchange rate policies vis-à-vis non-
European currencies.
 To pave the way for the European Monetary Union.

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 The Mexican Peso Crisis
 On 20 December, 1994, the Mexican government
announced a plan to devalue the peso against the
dollar by 14 percent.
 This decision changed currency trader’s
expectations about the future value of the peso.
 They stampeded for the exits.
 In their rush to get out the peso fell by as much as
40 percent.

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 The Mexican Peso Crisis
 The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of
portfolio capital.
 Two lessons emerge:
 It is essential to have a multinational safety net in place
to safeguard the world financial system from such
crises.
 An influx of foreign capital can lead to an overvaluation
in the first place.
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 The Asian Currency Crisis
 The Asian currency crisis turned out to be far
more serious than the Mexican peso crisis in
terms of the extent of the contagion and the
severity of the resultant economic and social
costs.
 Many firms with foreign currency bonds were
forced into bankruptcy.
 The region experienced a deep, widespread
recession.
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 Currency Crisis Explanations
 In theory, a currency’s value mirrors the fundamental
strength of its underlying economy, relative to other
economies in the long run.
 In the short run, currency trader’s expectations play a
much more important role.
 In today’s environment, traders and lenders, using the
most modern communications, act by fight-or-flight
instincts. For example, if they expect others are about to
sell Brazilian reals for U.S. dollars, they want to “get to
the exits first”.
 Thus, fears of depreciation become self-fulfilling
prophecies.
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 Quiz Time
1. Explain the mechanism which restores the balance of
payments equilibrium when it is disturbed under the gold
standard.
2. Discuss the advantages and disadvantages of the gold standard.
3. What were the main objectives of the Bretton Woods system?
4. Explain how the special drawing rights (SDR) is constructed.
Also, discuss the circumstances under which the SDR was
created.
5. List the advantages of the flexible exchange rate regime.
6. Criticize the flexible exchange rate regime from the viewpoint
of the proponents of the fixed exchange rate regime.
7. Discuss the criteria for a ‘good’ international monetary system.
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