The International Monetary

System

What Is The International

Monetary System?
International monetary system - the institutional
arrangements that govern exchange rates
A floating exchange rate system exists when a
country allows the foreign exchange market to
determine the relative value of a currency
A pegged exchange rate system exists when a
country fixes the value of its currency relative to a
reference currency
A dirty float exists when a country tries to hold the
value of its currency within some range of a reference
currency such as the U.S. dollar
A fixed exchange rate system exists when countries
fix their currencies against each other at some
mutually agreed on exchange rate
11-2

What Is The International

Monetary System?
From 1880s until today
v 1880s 1914
v 1918 1939
v 1944-1971
v 1976 Today

: Gold Standard
: Interwar years
: Bretton Woods System
: New exchange rate System

11-3

What Was The Gold Standard?

The Gold Standard refers to a system in
which countries peg currencies to gold and
guarantee their convertibility
in the 1880s, most nations followed the gold
standard
$1 = 23.22 grains of fine (pure) gold

the gold par value refers to the amount of a

currency needed to purchase one ounce of
gold
11-4

For example, suppose

1 unit of currency A = 10 ounce of gold
1 unit of currency B = 20 ounce of gold
Then
EA/B = 20 10 = 2 = price of currency B in terms of
currency A

11-5

The great strength of the gold standard was that

it contained a powerful mechanism for achieving
balance-of-payment equilibrium by all countries
(i.e. BOP = 0).
BOP < 0 outflow of gold the central bank
reacts by reducing its domestic credit holding
MS
P EP*/P CA BOP>0 inflow of gold
MS P EP*/P CA BOP = 0
i capital inflow BOP = 0
11-6

Why Did The

Gold Standard Make Sense?
The gold standard worked well from the 1880s
until 1914
but, many governments financed their World War I
expenditures by printing money and so, created
inflation

People lost confidence in the system

11-7

Interwar years: 1918 - 39

During WWI, the gold standard was
abandoned by many countries.
1919: US returned to the gold standard
little inflation during the war
1925: Britain returned to the gold standard
at the parity prevailing before the war

11-8

Britain s case
MS during and after the war P
So, Britain had to have contractionary monetary
policies unemployment
economic stagnation in 1920s
London s decline as int l financial center
Pound holders lost confidence in pounds and
began converting their pound to gold a run on
British gold reserves
1931 Britain was forced to abandon the gold
standard
11-9

US s case
1931: A run on US gold 15% drop in US
gold holdings
1933: US left the gold standard.
1934: US returned to the gold standard at
$35 per ounce (devaluation from $20.67).

11-10

1930s
Great depression Int l economic
disintegration
A period of competitive devaluations: In trying to
stimulate domestic economies by increasing
exports, country after country devalued.
FX controls
Trade barriers
int l monetary warfare

11-11

What Was The

Bretton Woods System?
In 1944, representatives from 44 countries met
at Bretton Woods, New Hampshire, to design a
new international monetary system that would
facilitate postwar economic growth
Under the new agreement
a fixed exchange rate system was established
all currencies were fixed to gold, but only the U.S.
dollar was directly convertible to gold
devaluations could not to be used for competitive
purposes
a country could not devalue its currency by more than
10% without IMF approval

11-12

What Was The

Bretton Woods System?
British
pound

German
mark

French
franc

Par
Value

U.S. dollar
Pegged at $35/oz.

Gold

11-13

What Institutions Were

Established At Bretton Woods?
The Bretton Woods agreement also
established two multinational institutions
1. The International Monetary Fund (IMF) to
maintain order in the international monetary
system through a combination of discipline and
flexibility
2. The World Bank to promote general economic
development
also called the International Bank for Reconstruction
and Development (IBRD)

11-14

Why Did Bretton Woods

System Collapse?
Bretton Woods worked well until the late 1960s
It collapsed when huge increases in welfare programs
and the Vietnam War were financed by increasing the
money supply and causing significant inflation
other countries increased the value of their currencies
relative to the U.S. dollar in response to speculation
the dollar would be devalued
However, because the system relied on an economically
well managed U.S., when the U.S. began to print money,
run high trade deficits, and experience high inflation, the
system was strained to the breaking point
the U.S. dollar came under speculative attack

11-15

Why Did Bretton Woods System

Collapse?
1958-65: Private capital outflows from US
1965-68: Johnson Administration
The bad US macroeconomic policy package
caused considerable damage to the US
economy and the int l monetary system.
Involvement in the Vietnam conflict
Great Society program
G Deficit MS P & CA (stagflation)

11-16

Why Did Bretton Woods System

Collapse?
1971: US CA deficit massive private purchase
of DM Bundesbank intervened in FX market by
buying huge amount of dollars, then it gave up and
allowed the DM to float.

August 1, 1971: Nixon s announcement

Stop to sell gold for dollars to foreign central banks
10% tax on all imports until revaluation of each
country s currency against the dollars
Freeze on prices and wages.

11-17

Floating Exchange Rates: 1973 Speculative attacks on the pound and the lira
1972: Britain allowed the pound to float.
1972-73: speculators began selling dollars
massively.
1973: US devalued the dollar again ($42.22 per
ounce of gold).
By March 1973 major currencies were all
floating.

11-18

What Was The

Jamaica Agreement?
A new exchange rate system was established in
1976 at a meeting in Jamaica
The rules that were agreed on then are still in
place today
Under the Jamaican agreement
floating rates were declared acceptable
gold was abandoned as a reserve asset
total annual IMF quotas - the amount member
countries contribute to the IMF - were increased to
$41 billion today they are about $300 billion
11-19

What Has Happened To

Exchange Rates Since 1973?
Since 1973, exchange rates have been
more volatile and less predictable than
they were between 1945 and 1973
because of
the 1971 and 1979 oil crises
the loss of confidence in the dollar after U.S.
inflation in 1977-78
the rise in the dollar between 1980 and 1985
the partial collapse of the EMS in 1992
the 1997 Asian currency crisis
the decline in the dollar from 2001 to 2009
11-20

What Has Happened To

Exchange Rates Since 1973?
Major Currencies Dollar Index, 1973-2010

11-21

A variety of ex rate system

Managed Floating: MA influences ex rates through
active FX market intervention

(Independently) Floating: the ex rate is market

determined. No FX intervention.

Currency Board: A legislative commitment to

exchange domestic currency for a specified foreign
currency at a fixed ex rate.

11-22

A variety of ex rate system

Fixed Peg: The ex rate is fixed against a major
currency. Active intervention needed.

Crawling Peg: The ex rate is adjusted periodically in

small amounts at a fixed, preannounced rate.

Dollarization: The dollar circulates as the legal tender.

11-23

Which Is Better Fixed Rates

Or Floating Rates?
Floating exchange rates provide
1. Independent macroeconomic policies.
2. Countries can choose different inflation rates.
3. Automatic trade balance adjustments

But, a fixed exchange rate system

1. Provides monetary discipline
2. Minimizes speculation
3. Reduces uncertainty

11-24

What Type of Exchange Rate

System Is In Practice Today?
Various exchange rate regimes are followed today
14% of IMF members follow a free float policy
26% of IMF members follow a managed float system
22% of IMF members have no legal tender of their own
the remaining countries use less flexible systems such as
pegged arrangements, or adjustable pegs

Countries with a pegged exchange rate system peg the

value of its currency to that of another major currency
Countries using a currency board commit to converting
their domestic currency on demand into another currency
at a fixed exchange rate

11-25

What Type of Exchange Rate

System Is In Practice Today?
Exchange Rate Policies of IMF Members

11-26

Choice of Peg or Float

Peg
Small size (GDP)
Open economy
Harmonious inflation rate
Concentrated trade

Float
Large size
Closed economy
Divergent inflation rate
Diversified trade

11-27