International Monetary Systems

Dr.P.K. Gupta
The International Monetary System

The increased volatility of exchange rates is one of the main

economic developments of the past 40 years.

Policies for forecasting and reacting to exchange rate

fluctuations are still evolving.

Although volatile exchange rates increase risk, they also

create profit opportunities for firms and investors.

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The International Monetary System(IMS)
The international monetary system is the structure within
which foreign exchange rates are determined, international
trade and capital flows are accommodated, and the balance-
of-payments adjustments made.
All of the instruments, institutions, and agreements that link
together the world’s currency, money markets, securities, real
estate, and commodity markets are also encompassed within
that term.

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Currency Terminology
Hard or Strong – describes a currency that is expected to
revalue or appreciate relative to major trading currencies.
Eurocurrencies – are domestic currencies of one country on
deposit in a bank in a second country.

Hard currency or strong currency, in economics, refers to a

globally traded currency that can serve as a reliable and

stable store of value.

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Currency Terminology
Soft or Weak – describes a currency that is expected to
devalue or depreciate relative to major currencies.
Also refers to currencies being artificially sustained by their
governments

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Examples of Hard Currency

As of 2008, hard currencies could be argued to include the

United States dollar, euro, Swiss franc, British pound sterling,

Norwegian krone, Swedish krona, Canadian dollar, Japanese

yen, and Australian dollar. However, varying theories of

monetary policy preclude any such list from being called

definitive.

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History of the IMS

Pre 1875 Bimetalism

1875-1914: Classical Gold Standard

1915-1944: Interwar Period

1945-1972: Bretton Woods System

1973-Present: Flexible (Hybrid) System

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History of the IMS
The Gold Standard (1876 – 1913)
Gold has been a medium of exchange since 3000 BC
“Rules of the game” were simple, each country set the rate at which its
currency unit could be converted to a weight of gold
Currency exchange rates were in effect “fixed”
Expansionary monetary policy was limited to a government’s supply of gold
Was in effect until the outbreak of WWI as the free movement of gold was
interrupted
Essentially a fixed rate system (Suppose the US announces a willingness to
buy gold for $200/oz and Great Britain announces a willingness to buy gold
for £100. Then £1=$2)

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Advantage of Gold System

Disturbances in Price Levels Would be offset by the price-

specie-flow mechanism. When a balance of payments surplus

led to a gold inflow Gold inflow (country with surplus) led to

higher prices which reduced surplus Gold outflow led to lower

prices and increased surplus.

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History of the IMS
The Inter-War Years & WWII (1914-1944)
During this period, currencies were allowed to fluctuate over a fairly wide
range in terms of gold and each other
Increasing fluctuations in currency values became realized as speculators
sold short weak currencies
The US adopted a modified gold standard in 1934
Periods of serious chaos such as German hyperinflation and the use of
exchange rates as a way to gain trade advantage.
Britain and US adopt a kind of gold standard (but tried to prevent the species
adjustment mechanism from working).
During WWII and its chaotic aftermath the US dollar was the only major
trading currency that continued to be convertible

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Bretton Woods and IMF(1944)

As WWII drew to a close, the Allied Powers met at Bretton Woods, New
Hampshire to create a post-war international monetary system

The Bretton Woods Agreement established a US dollar based international

monetary system and created two new institutions the International
Monetary Fund (IMF) and the World Bank

U.S.$ was key currency valued at $1 = 1/35 oz. of gold All currencies linked
to that price in a fixed rate system. In effect, rather than hold gold as a
reserve asset, other countries hold US dollars (which are backed by gold)

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The Bretton Woods System (1946-1971)

U.S.$ was key currency valued at $1 = 1/35 oz. of gold

All currencies linked to that price in a fixed rate system.

In effect, rather than hold gold as a reserve asset, other

countries hold US dollars (which are backed by gold)

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 German
British mark French
pound franc
r Par P
Pa lue V a ar
Value lue
Va
U.S. dollar

Pegged at $35/oz.
Gold

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Collapse of Bretton Woods System
U.S. high inflation rate
U.S.$ depreciated sharply.
Smithsonian Agreement (1971) US$ devalued to 1/38 oz. of
gold.
1973 The US dollar is under heavy pressure, European and
Japanese currencies are allowed to float
1976 Jamaica Agreement
Flexible exchange rates declared acceptable
Gold abandoned as an international reserve

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IMF
The International Monetary Fund is a key institution in the new
international monetary system and was created to:
• Help countries defend their currencies against cyclical, seasonal, or
random occurrences
• Assist countries having structural trade problems if they promise to take
adequate steps to correct these problems

The International Bank for Reconstruction and Development (World

Bank) helped fund post-war reconstruction and has since then
supported general economic development

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History of the IMS
Fixed Exchange Rates (1945-1973)

The currency arrangement negotiated at Bretton Woods and monitored by the IMF
worked fairly well during the post-WWII era of reconstruction and growth in world
trade

However, widely diverging monetary and fiscal policies, differential rates of inflation
and various currency shocks resulted in the system’s demise

The US dollar became the main reserve currency held by central banks, resulting in
a consistent and growing balance of payments deficit which required a heavy capital
outflow of dollars to finance these deficits and meet the growing demand for dollars
from investors and businesses

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History of the IMS
Eventually, the heavy overhang of dollars held by foreigners resulted in
a lack of confidence in the ability of the US to met its commitment to
convert dollars to gold

The lack of confidence forced President Richard Nixon to suspend

official purchases or sales of gold by the US Treasury on August 15,
1971

This resulted in subsequent devaluations of the dollar

Most currencies were allowed to float to levels determined by market

forces as of March, 1973

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History of the IMS

An Eclectic Currency Arrangement (1973 – Present)

Since March 1973, exchange rates have become much more volatile

and less predictable than they were during the “fixed” period

There have been numerous, significant world currency events over

the past 30 years

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Emerging Markets and Regime Choices
A currency board exists when a country’s central bank commits to back its monetary base
– its money supply – entirely with foreign reserves at all times.

This means that a unit of domestic currency cannot be introduced into the economy
without an additional unit of foreign exchange reserves being obtained first.

Argentina moved from a managed exchange rate to a currency

board in 1991

In 2002, the country ended the currency board as a result of

substantial economic and political turmoil
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Emerging Markets and Regime Choices
Dollarization is the use of the US dollar as the official currency of
the country.
One attraction of dollarization is that sound monetary and
exchange-rate policies no longer depend on the intelligence and
discipline of domestic policymakers.
Panama has used the dollar as its official currency since 1907
Ecuador replaced its domestic currency with the US dollar in
September, 2000

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The Euro: Birth of a European Currency
In December 1991, the members of the European Union met at
Maastricht, the Netherlands to finalize a treaty that changed
Europe’s currency future.
This treaty set out a timetable and a plan to replace all individual
ECU currencies with a single currency called the euro.

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The Euro: Birth of a European Currency
To prepare for the EMU, a convergence criteria was laid out
whereby each member country was responsible for managing the
following to a specific level:
Nominal inflation rates
Long-term interest rates
Fiscal deficits
Government debt

In addition, a strong central bank, called the European Central

Bank (ECB), was established in Frankfurt, Germany.

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Effects of the Euro
The euro affects markets in three ways:
Cheaper transactions costs in the Euro Zone
Currency risks and costs related to uncertainty are reduced
All consumers and businesses both inside and outside the Euro Zone
enjoy price transparency and increased price-based competition

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Exchange Rate Systems

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The Fixed Rate System has governments buying and selling

currency reserves when exchange rates differ from stated par

values. Pure fixed systems are rare. Current examples: Cuba,

North Korea, Malaysia.

The Crawling Peg System has governments managing exchange

rates within a percentage range from par. A peg can be made to

other currencies (like a dollar) or to market baskets of currencies.

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The Target Zone Arrangement, is a managed multilateral float system
arranged by nations (like the G7) who have common interests and goals.
The European Monetary System is an example of this. This is managed by
the European Central Bank.
The Managed Float System, known as the dirty float, is managed by
governments to preserve orderly exchange and eliminate excess volatility.
Central banks manage currency valuations by buying and selling currencies,
and altering balances of payments, exchange reserves, and black market
rates.
Independent Float Systems, allow clean floating and full flexibility

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Examples of Ex Rate Systems
The United States uses independent floating
Canada uses managed floats
the EU uses target zones
Panama uses the crawling peg
Cuba uses the fixed system.

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Sample countries using different exchange rate systems

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Important Note:
Even though we may call it “free float” in fact the government can
still control the exchange rate by manipulating the factors that
affect the exchange rate (i.e., monetary policy)

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Under a floating rate system, exchange rates are set by demand
and supply.
price levels
interest rates
economic growth

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Managed Float (“Dirty Float”)
Market forces set rates unless excess volatility occurs,
then, central bank determines rate by buying or selling
currency. Managed float isn’t really a single system, but
describes a continuum of systems
Smoothing daily fluctuations
“Leaning against the wind” slowing the change to a different
rate
Unofficial pegging: actually fixing the rate
without saying so.
Target-Zone Arrangement: countries agree to maintain
exchange rates within a certain bound What makes target
zone arrangements special is the understanding that
countries will adjust real economic policies to maintain the
zone.
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Fixed Rate System: Government maintains
target rates and if rates threatened, central
banks buy/sell currency. A fixed rate system is
the ultimate good news bad news joke. The
good is very good and the bad is very bad.

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Advantage: stability and predictability
Disadvantage: the country loses control of monetary policy
(note that monetary policy can always be used to control an
exchange rate).
Disadvantage: At some point a fixed rate may become
unsupportable and one country may devalue. (Argentina is
the most dramatic recent example.) As an alternative to
devaluation, the country may impose currency controls.

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Fixed Versus Flexible Exchange Rates
Countries would prefer a fixed rate regime for the following
reasons:
stability in international prices
inherent anti-inflationary nature of fixed prices
However, a fixed rate regime has the following problems:
Need for central banks to maintain large quantities of hard currencies
and gold to defend the fixed rate
Fixed rates can be maintained at rates that are inconsistent with
economic fundamentals

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Attributes of the “Ideal” Currency
Possesses three attributes, often referred to as the Impossible
Trinity:
Exchange rate stability
Full financial integration
Monetary independence
The forces of economics to not allow the simultaneous
achievement of all three

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