Unit 2

International Monetary System

Sanjay Ghimire
TU-SoM

1
 Contents

– History of international monetary system;

– Contemporary currency regime;
– Fixed versus flexible exchange rates;
– Emerging markets and regime choices

2
 Money

● Money is any object that is generally accepted as payment for goods and
services and the repayment of debt.
● Money serves four primary purposes. It is:
– A medium of exchange: an object that is generally accepted as a form of payment.
– A unit of account: a means of keeping track of how much something is worth.
– A store of value: it can be held and exchanged later for goods and services at an
approximate value.
– A standard of deferred payments (this is not considered a defining purpose of money by all
economists).
● Types of Money
– Commodity Money: Precious metals, salt, beads, alcohol
– Representative money: Certificates, paper money, token coins.
– Fiat Money: Bank notes (paper money) and coins
– Fiduciary money: Checks, bank drafts etc.
– Commercial bank money: Funds in a checking account (ATM)

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 International Monetory System

● The international monetary system consists of laws,

rules, institutions, instruments, and procedures, all of
which are involved in the international transfers of
money
● The IMS refers to the institutional arrangements that
countries adopt to govern exchange rates
● The elements above affect foreign exchange rates,
international trade and capital flows, and
balance-of-payments adjustments.
● Thus IMS ensure Liquidity, Adjustment and Stablity of
4 the international trade
 Evolution of IMS

● 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
– 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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 Bimetalism

● A “double standard” in the sense that both gold and

silver were used as money.
● 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.
● International monetary system was less than fully
systematic up until the 1870s.
● Bimetallic standard often experienced the well-known
phenomenon referred to as Gresham’s law (bad
money kill good money).

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 The classical gold standards

● Established 1821 in Great Britain when notes from bank

of England were fully redeemable for gold.
● 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.
● In order to support unrestricted convertibility into gold,
banknotes need to be backed by a gold reserve of a
minimum stated ratio. In addition, the domestic money
stock should rise and fall as gold flows in and out of the
7 country.
 The classical gold standards

● 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)
● Highly stable exchange rates under the classical gold
standard provided an environment that was favorable to
international trade and investment.
● Misalignment of exchange rates and international imbalances
of payment were automatically corrected by the
price-specie-flow mechanism.
● Limited supply of gold and countries unwillingness poses
serious limitation.
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 Interwar Period

● Disturbed supply of gold.

● Exchange rates fluctuated as countries widely used
“predatory” depreciations of their currencies as a means of
gaining advantage in the world export market.
● The result for international trade and investment was
profoundly detrimental.
● Periods of serious chaos such as German hyperinflation and
the use of exchange rates as a way to gain trade advantage.
● Attempts were made to restore the gold standard, but
participants lacked the political will to “follow the rules of the
game”. Britain and US adopt a kind of gold standard.
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Bretton Woods System
● Named for a 1944 meeting of 44 allied powers 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 IMF and the World
Bank.
● 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.
Bretton Woods System
● Under the original provisions, all countries fixed the value of their
currencies in terms of gold but were not required to exchange their
currencies for gold.
● Only the dollar remained convertible into gold (at $35 per ounce).
● Each country was responsible for maintaining its exchange rate
within ±1% of the adopted par value by buying or selling foreign
reserves as necessary.
● The Bretton Woods system was a dollar-based gold exchange
standard.
● Collapse, 1971
a. U.S. high inflation rate
b. U.S.$ depreciated sharply (devalued the dollar to 1/38 of an
ounce of gold, and then to 1/42 of an ounce.)
Bretton Woods System
German
British mark French
pound franc
Pa
a r e
P alu
Par Va r
Value lue
V

U.S. dollar

Pegged at $35/oz.

Gold
 Bretton Woods System

● Advocates of the dollar based gold-exchange system

argue that :
– The system economizes on gold because countries can use not
only gold but also foreign exchanges as an international means
of payment. Foreign exchange reserves offset the deflationary
effects of limited addition to the world’s monetary gold stock.
– Individual countries can earn interest on their foreign exchange
holdings, whereas gold holdings yield no returns.
– countries can save transaction costs associated with
transporting gold across countries under the gold-exchange
system.

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 The Flexible Exchange Rate Regime

● 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 asset.

2-14
 Current Exchange rate regimes

● 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 (or horizontal band around) another currency
● No national currency (Dollarization)
– Some countries do not bother printing their own, they just use
the U.S. dollar. For example, Ecuador, Panama, and El
Salvador have dollarized.
● Monetary unification
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 Fixed vs. Flexible Exchange Rate

● Arguments in favor of flexible exchange rates:

– Easier external adjustments.
– National policy autonomy.
● Arguments against flexible exchange rates:
– Exchange rate uncertainty may hamper international trade.
– No safeguards to prevent crises.
● Currencies depreciate (or appreciate) to reflect the
equilibrium value in flexible exchange rates
● Governments must adjust monetary or fiscal policies
to return exchange rates to equilibrium value in fixed
exchange rate regimes
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 Fixed vs. Flexible Exchange Rate

● 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.
● 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 vs. Flexible Exchange Rate

Supply
Dollar price per (S)
£ (exchange
rate)

$1.60
Demand
$1.40 (D)

Trade deficit

18 S D Q of18
 Fixed vs. Flexible Exchange Rate

● 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 monetary and
fiscal policies intervention.

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 Fixed vs. Flexible Exchange Rate
Supply
Dollar price per £

Contractionary
(exchange rate)

policies (S)
(fixed
regime)

Demand
$1.40 (D)

Demand (D*)

20 Q of
D* =
 Some terms

● Depreciation: Decline in currency value in a

flexible exchange rate regime
● Devaluation: Decline in currency value in a
fixed exchange rate regime
● Appreciation: Increases in currency value in
a flexible exchange rate regime
● Revaluation: Increase in currency value in a
fixed exchange rate regime
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 European Monetary System (EMS)

● EMS was created in 1979 by EEC countries to

maintain exchange rates among their currencies
within narrow bands, and jointly float against outside
currencies.
● Objectives:
– Establish zone of monetary stability
– Coordinate exchange rates vis-à-vis non-EMS countries
– Develop plan for eventual European monetary union
● Exchange rate management instruments:
– European Currency Unit (ECU)
● Weighted average of participating currencies
● Accounting unit of the EMS
– Exchange Rate Mechanism (ERM)
22 ● Procedure by which countries collectively manage exchange
rates
 What Is the Euro (€)?

● The euro is the single currency of 1 Euro is Equal to:

the EMU which was adopted by 11 40.3399 BEF Belgian franc
Member States on 1 January 1999.
1.95583 DEM German mark
● These original member states
166.386 ESP Spanish
were: Belgium, Germany, Spain,
6.55957 FRF peseta
French franc
France, Ireland, Italy, Luxemburg,
Finland, Austria, Portugal and the .787564 IEP Irish punt
Netherlands. 1936.27 ITL Italian lira
● Prominent countries initially 40.3399 LUF Luxembourg
missing from Euro : 2.20371 NLG franc
Dutch guilder
– UK 13.7603 ATS Austrian
– Greece ????? 200.482 PTE schilling
Portuguese
5.94573 FIM escudo
Finnish
23
markka
 Benefits and Costs of the
Monetary Union

● Transaction costs reduced ⬥ Loss of national monetary

and FX risk eliminated and exchange rate policy
● Creates a Eurozone – independence
goods, people and capital ⬥ Country-specific
can move without asymmetric shocks can
restriction lead to extended
● Compete with the U.S. recessions
– Approximately equal in
terms of population and
GDP
● Price transparency and
competition
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 The Long-Term Impact of the Euro

● If the euro proves successful, it will advance

the political integration of Europe in a major
way, eventually making a “United States of
Europe” feasible.
● It is likely that the U.S. dollar will lose its
place as the dominant world currency.
● The euro and the U.S. dollar will be the two
major currencies.

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 Emerging markets and regime choices

Emerging Market
Country

High capital mobility is forcing emerging market nations to

choose between two extremes.

Free floating Regime Currency Board or Dollarization

• Currency board fixes the value of local
• Currency value is free to float up currency to another currency or basket;
and down with international market dollarization replaces the currency with
forces the US dollar.
• Independent monetary policy and • Independent monetary policy is lost;
free movements of capital allowed, political influences on he monetary policy
but at the loss of stability. is eliminated.
• Increased volatility may be more • Seignorage, the benefits accruing to a
than what a small country with a government from the ability to print its
26 small financial market can withstand own money is lost