UNIT 1.

INTERNATIONAL MONETARY SYSTEM

 Economic and financial transactions among different

countries require some sort of arrangement that could
facilitate settlement of payments. Institutional framework
within which international payments are made,
movements of capital are accommodated, and exchange
rates among currencies are determined. These
arrangements form the subject matter of the international
monetary system.

 The international monetary system we find today

is the result of a century-long evolution going back to the
days of the gold standard and even earlier when costly
metals were used for making payments

Evolution of the International Monetary System:

 Bimetallism: Before 1875

 Gold Standard System: 1875-1914
 Interwar Period: 1915-1944
 Bretton Woods System: 1945-1972
 The Flexible Exchange Rate Regime: 1973-
Present

BIMETALLISM: BEFORE 1875

  Bimetallism refers to the use of noble metals Gold and
Silver as currency. Prior to 1875 this was the
predominant monetary system in major countries.
 Some countries were on the gold standard, some on
the silver standard, and 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
of the currencies being exchanged. Gold and silver
had a universal price, and currencies were exchanged
at the value of the metal being exchanged.

Legal Gold price of silver

or how many grams of silver
you need to buy one gram of gold

16 :1

16 grams <= ONE DOLLAR IS DEFINED AS => 01 gram

of pure silver of pure gold

People could bring gold or silver bars at the Mint (the agency
responsible for coining money) and they would get gold or silver
dollar coins in exchange.

• Example:
Country Currency
Germany Silver
UK Gold
France Bimetal (silver & gold)
 Gresham’s Law implied that it would be the least
valuable metal that would tend to circulate.
GOLD STANDARD SYSTEM: 1875-1914:
“Gold constitutes treasure, and he who possesses it has all he needs
in this world”. Columbus

 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.

For example, if the dollar is pegged to gold at U.S. $30 = 1

ounce of gold (28.34 grams 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 = 1 ounce of gold = £6
$30 = £6
$5 = £1

 Highly stable exchange rates under the classical

gold standard provided an environment that was
conducive to international trade and investment.

 Shortcomings of Gold Standard System:

  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.

INTERWAR PERIOD: 1915-1944

 Exchange rates fluctuated as countries widely
used “predatory” depreciations of their currencies as a
means of gaining advantage in the world export
market.
 Attempts were made to restore the gold standard,
but participants lacked the political will to “follow the
rules of the game”.
 The result for international trade and investment
was profoundly detrimental.
 Economic nationalism (protectionism), economic and
political instabilities, bank failures, panicky flights of
capital across borders, 1929 Great Depression, all
reasons required a new system.

BRETTON WOODS SYSTEM: 1945-1972

  Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
 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 International
Monetary Fund (IMF) and the World Bank.
(International Bank for Reconstruction and
Development, IBRD)

• Under the Bretton System:

 Each country established a par rate in relation to the
US dollar.
 The US dollar was then pegged to gold at $35 per
ounce

Each country was responsible for maintaining their par

exchange rate with the dollar with in + - 1% of the adopted
par value by buying or selling foreign reserves as
necessary.
• Bretton Woods had provisions for reevaluating par if
deviations persist.
• The US dollar was the only currency directly
exchangeable for gold. Therefore, most international
transactions occurred in US dollars and gold.
• The Bretton Woods system was a dollar-based gold
exchange standard.
 German
British mark French
pound franc
r Par P
Pa lue Va ar
Value lue
Va
U.S. dollar

Pegged at $35/ounce.

Gold
Collapse of the Bretton Woods Agreement:
However, by the late 1960s, there was a dollar oversupply
in the world economy. This turnaround was due to the US
balance of payments deficit, which in turn was caused by
expansionary fiscal policy. The spending of the US
government increased for three reasons:
(i) The war in Vietnam;
(ii) Welfare expenditure; and
(iii) The space race with the USSR (send humans to
the moon by the end of the 1960s).
As the world economy grew, more international money
(dollar) was demanded. To supply that, the US had to run a
balance-of-payments deficit (how else can the rest of the
world get more dollars?) But if the US continued to run a
BOP deficit, it would loose credibility as a sound currency
country. That was the fundamental dilemma.
The amount of gold that the US had would soon be much
less than the amount of dollars held by other countries. This
meant that the US could not guarantee conversion of
international dollars into gold, if all foreign central banks
tried to cash in.
In the end, the US opted to run a BOP deficit, which led to
the loss of credibility and the collapse of the Bretton
Woods system.

THE FLEXIBLE EXCHANGE RATE REGIME: 1973-

PRESENT.
 January 1976 IMF members met in Jamaica and
came out Jamaica Agreement which is:
1. 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.
2. Gold was abandoned as an international reserve
asset.
3. Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.