Chapter Two

The International
Monetary System INTERNATIONAL 2
FINANCIAL
MANAGEMENT
International Monetary System can be defined as the
institutional framework within which:
•International payments are made.
•The movement of capital is accommodated.
EUN / RESNICK
•Exchange rates are
Second Edition
determined.
 Chapter Two Outline

 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

2-1
What is International Monetary System
 International Monetary System can be defined as
the institutional framework within which:
 International payments are made.
 The movement of capital is accommodated.
 Exchange rates are determined.
 Includes agreements, rules, mechanisms, policies,
regarding exchange rates, international payments
and flow of capital.

2-2
 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
 Bimetallism is the standard in which the value of the monetary
unit is defined as equivalent to certain quantities of two
metals, typically gold and silver, creating a fixed rate of
exchange between them
 A “double standard” in the sense that both gold and silver were
used as money.
 A country’s capacity to print the money was decided on the
basis of gold and silver reserves held by the country
 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.
 Exchange ratio between two metals (gold and silver) was
fixed
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 Bimetallism: Before 1875
 Some countries were on the gold standard, some on the
silver standard, some on both.
 Britain was on bimetallism until 1816, USA until 1873
and France until 1878
 Some of the countries such as India, Holland, Germany
etc were on silver standard
 Exchange rate between currencies used to remain fixed

2-5
 Bimetallism: Before 1875
 Countries on bimetallism often experiences a well
known phenomenon called Gresham’s Law
 Gresham’s Law implied that it would be the least
valuable metal that would tend to circulate.
 Abundant metal is used as money driving more
scarce metal out of circulation
 According to Gresham’s Law bad money drives
out good money

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 Classical Gold Standard:
1875-1914
 The gold standard is a monetary system where a country's
currency or paper money has a value directly linked to certain
quantities of gold.
 A country’s capacity to print the money was decided on the
basis of gold reserves held by the country
 A country that uses the gold standard sets a fixed price for
gold and buys and sells gold at that price.
 That fixed price is used to determine the value of the
currency.
 For example, if the U.S. sets the price of gold at $100 an ounce,
the value of the dollar would be 1/100th ounce of gold.
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 Classical Gold Standard:
1875-1914
 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.
 Exchange rate between currencies used to remain fixed
 Lasted for about 40 years as an international monetary
system
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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

2-9
 Classical Gold Standard:
1875-1914
 Advantages of gold standard
 Misalignment of exchange rates is automatically
corrected by cross border flow of gold
 Balance of payment position is automatically
corrected through price specie flow mechanism
 Hedge against the inflation  Because gold has
natural scarcity and no one can increase its
supply at will

2-10
 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.
 Limited supply of gold results in deflationary
pressure
 Even if the world returned to a gold standard, any
national government could abandon the standard.

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 Interwar Period: 1915-1944

 World war I ended the classical gold standard in

august 1914 as major countries such as Great
Britain, France ,Germany and Russia suspended
redemption of bank notes in gold and imposed
restrictions on the gold export

2-12
 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”.
 Most countries followed the policy of
sterilization of gold
2-13
 Interwar Period: 1915-1944
 Reasons for the collapse of inter war system
 Hyper inflation

 Depression and financial crisis

 The result for international trade and investment was

profoundly detrimental.
 Following the huge outflow of gold Britain experienced
chronic BOP deficit lack of confidence in British pound
 It is during this period that US dollar emerged as the
dominant world currency replacing the dominance of
British Pound
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 Bretton Woods System:
1945-1972
 Named for a 1944 meeting of 44 nations (370 delegates)
at Bretton Woods, New Hampshire, Washington.
 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.
 Considered as most remarkable event in history of
world finance
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 Bretton Woods System:
1945-1972
 IMF was entrusted with the responsibility of formulation
and enforcement of rules and policies of international
monetary system
 IMF was also made responsible for monitoring and
managing exchange rates between currencies
 IMF also lend funds to countries
 International bank for Reconstruction and Development
(IBRD) better known as world bank was made
responsible for financing individual development project

2-16
 Bretton Woods System:
1945-1972
 Under the Bretton Woods system each country need to establish par
value in relation to the U.S. dollar, which was pegged to gold at $35
per ounce
British German French
Pound Mark Franc
Par Value
Par Value Par Value
US Dollar
Pegged @ $35/oz
Gold
• Each country was responsible for maintaining its exchange rate
within ±1% of the adopted par value by buying or selling foreign
reserves as necessary.
2-17
 Mount Washington Hotel

2-18
 Bretton Woods System:
1945-1972
 Under this system US dollar was the only
currency fully convertible to gold, other
currencies were not directly convertible to gold
 Countries hold US dollar as well as gold as an
international means of payment
 The Bretton Woods system was a dollar-based
gold exchange standard.

2-19
 Bretton Woods System:
1945-1972
 Advantages:
 Foreign exchange reserves offset the deflationary
effects created by limited supply of gold
 Individual countries can earn the interest on their
foreign exchange reserves
 Countries can save the transaction cost
associated with transportation of gold.
 Increased growth of international trade and
investment
2-20
 Bretton Woods System:
1945-1972
 Limitations:
 System like Breeton Woods can work as long as other
countries have confidence in reserve currency (USD) and
in US treasury to convert USD into gold
 Under Breeton Woods system reserve currency country
need to run balance of payment deficits
 But if such deficits is large and persistent they can lead to
crisis of confidence in reserve currency
 By 1971 foreign holdings of US dollars stood at $50
billion while US gold reserves were valued at only $15
billion.
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 Bretton Woods System:
1945-1972
 Measures taken to save Bretton Wood System
 Creation of SDR
 It is an artificial currency created by IMF
 The main objective was to alleviate the pressure
on US dollar
 It is basket currency comprising 16 individual
currencies
Was allotted to members of IMF
 SDR was used as a reserves currency as well as an
international means of payment
2-22
 Bretton Woods System:
1945-1972
 Measures taken to save Bretton Wood System
 Smithsonian Agreement

In an attempt to save Breeton woods system 10 major

countries known as a group of 10 met at Smithsonian
in 1971
According to this agreement
 The price of gold was raised to $38
 Each country revalued their currency against USD
by 10%
 The band for the movement in exchange rate was
expanded from 1% to 2.25%
2-23
 Bretton Woods System:
1945-1972
 Devaluation of US dollar was not sufficient to stabilize
the situation
 In Feb 1973 US dollar further came under heavy selling
pressure
 The price of gold was further raised from 38$ to 42$
 By March 1973 followed by Japanese and European
currencies, other currencies were allowed to float
 This resulted into collapse of Bretton Woods System

2-24
The Flexible Exchange Rate Regime:
1973-Present.
 In 1973 after the collapse of Bretton Wood
system IMF members met at Jamaica (Jamaican
agreement) to adopt the flexible exchange rate as
international monetary system

2-25
The Flexible Exchange Rate Regime:
1973-Present.
 Flexible exchange rates were declared acceptable
to the IMF members.
 Central banks were allowed to intervene in the
exchange rate markets to pacify unwarranted
volatilities.
 Gold was officially abandoned as an international
reserve asset.
 Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.
2-26
Current Exchange Rate Arrangements
 Exchange arrangements with no separate legal tender
 Currency of another country circulates as sole legal tender
 Same legal tender (Currency) is shared by the members of the
union
 Example ;
 Ecuador, El Salvador, Palau and Panama using US dollar
 19 members of European Union sharing Euro as currency

 Currency board arrangement

 An arrangement in which a country exchanges its domestic
currency for a specific foreign currency at a fixed exchange rate
 The peg is managed by the currency board
 Examples
 Hong Kong fixed to the US dollar and Estonia fixed to Euro
2-27
Current Exchange Rate Arrangements
 Other conventional fixed peg arrangements
 A country pegs its currency to a major currency or basket of
currencies at fixed exchange rate wherein the exchange rate is
allowed to fluctuate within the narrow margin of less than 1%
around the central rate
 Examples : Morocco, Saudi Arabia and Ukraine
 Pegged exchange rates within horizontal bands
 Value of currency is maintained within the margins of fluctuations
around a fixed peg that are wider than at least 1percent, plus or
minus around central rate.
 Examples: Denmark, Slovenia and Hungary

2-28
Current Exchange Rate Arrangements
 Crawling Peg
 The fixed exchange rate between two currencies is adjusted
periodically in a small amounts at a fixed rate or in response to
changes in selected quantitative indicators .
 Examples: Bolivia, Costa Rica and Tunisia
 Exchange rate within crawling bands
 The fixed exchange rate between two currencies is adjusted
periodically in a small amounts at a fixed rate or in response to
changes in selected quantitative indicators within a band of rates.
 Examples: Belarus and Romania

2-29
Current Exchange Rate Arrangements
 Managed float
 An Arrangement in which exchange rates fluctuate from day to
day, but central banks attempt to influence their
countries' exchange rates by buying and selling currencies to
maintain a certain range.
 Examples: China, India, Russsia, Singapore, Thailand etc.
 Free float/Independent Float
 The exchange rate is market determined, with any foreign
exchange intervention aimed at moderating the rate of change and
preventing undue fluctuations.
 Examples: Australia, USA, Brazil, Canada etc.

2-30
 European Monetary System
 According to Smithsonian agreement the band of
exchange rate movement was expanded from 1% to
2.25%
 However the members of European Economic
Community have adopted a narrower band of 1.125%
 These group of countries were known as Snake
arrangement
 European countries believed that stability in exchange rate
will help in promoting bilateral trade between them

2-3
 European Monetary System
 Later on the Snake arrangement was replaced by
European Monetary System (EMS)
 The main Objectives of EMS are :
 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.

2-32
 European Monetary System
 European Currency Unit (ECU)
 It is basket currency constructed as a weighted average
of the currencies of the members countries of the
European Union
 Exchange Rate Mechanism (ERM)
 EMS refers to the procedure used by thee European
member countries to collectively manage their
exchange rates

2-33
 The Euro and European Monetary
Union

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 The Euro
 The euro is the single currency of the European
Monetary Union which was adopted by 12
Member States on 1 January 1999.
 These member states are: Belgium, Germany,
Grease, Spain, France, Ireland, Italy, Luxemburg,
Finland, Austria, Portugal and the Netherlands.

2-35
 Countries using EURO as a currency
1 Andorra*

Austria 2 Cyprus
1
2 Belgium 3 Estonia

3 Finland 4 Kosovo*
4 France 5 Latvia
5 Germany 6 Lithuania
Adopted Adopted
6 Greece 7 Malta
Euro in Euro
1999 7 Ireland 8 Monaco*
Later
8 Italy Montenegro*
9
9 Luxembourg San Marino*
10
10 Netherlands
11 Slovakia
11 Portugal
12 Slovenia
12 Spain
13 Vatican City*
EURO CONVERSION RATES
1 Euro is Equal to:
40.3399 BEF Belgian franc
1.95583 DEM German mark
166.386 ESP Spanish peseta
6.55957 FRF French franc
.787564 IEP Irish punt
1936.27 ITL Italian lira
40.3399 LUF Luxembourg franc
2.20371 NLG Dutch gilder
13.7603 ATS Austrian schilling
200.482 PTE Portuguese escudo
5.94573 FIM Finnish markka

2-37
 What is the official sign of the euro?
 The sign for the new single currency looks like an
“E” with two clearly marked, horizontal parallel
lines across it.

It was inspired by the Greek letter epsilon, in reference to

the cradle of European civilization and to the first letter of
the word 'Europe'.

2-38
 What are the different denominations
of the euro notes and coins ?
 There will be 7 euro notes and 8 euro coins.
 The notes will be: 500, 200, 100, 50, 20, 10, and
5 euro.
 The coins will be: 2 euro, 1 euro, 50 euro cent, 20
euro cent, 10, euro cent, 5 euro cent, 2 euro cent,
and 1 euro cent.

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 European Central Bank
 Monetary policy for Euro 12 countries is now conducted
by European Central Bank headquartered in Frankfurt
Germany whose primary objective is to maintain price
stability in Europe
 The national central bank of 12 countries didn’t
disappeared
 Together with ECB they formed European System of
Central Banks (ESCB)
 ECB is similar to Federal Reserve in USA

2-40
 Benefits of Monetary Union
 Reduced transaction cost
 Elimination of exchange rate risk
 Companies can save hedging cost
 Consumers get the benefit of comparison shopping
 More price transparency
 Improved international competitive position of European
companies
 Increased political co-operation and peace in Europe

2-41
 Costs of Monetary Union

 Loss of national monetary policy independence

 Loss of national exchange rate policy

independence

2-42
 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 resulted in heavy selling pressure on Peso and
Mexican Stock
 By early Jan 1995 Peso fell against USD by almost 40%
 Individual investors and international MF have liquidated
their investment in Mexican Securities
 USA gave bail out package of $53 billion

2-43
 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.
 This created instability in Mexican Financial Market as
well as world financial market
 Lessons emerge:
 It is essential to have a multinational safety net in place to
safeguard the world financial system from such crises.
 No single country or institution can handle the global crisis
 Excessive dependence on foreign capital is not desirable

2-44
 The Asian Currency Crisis
 On July 2, 1997 the Thai Bhat was suddenly devaluated
 Local financial crisis quickly escalated into global
financial crisis
 Very soon the financial crisis trespassed into the Asian
countries like Indonesia, Korea, Malaysia, Brazil
Philippines etc.
 Korean Won fell by 50% and Indonesian Rupiah fell by
80% against the USD

2-45
 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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 The Asian Currency Crisis
 Factors responsible for Asian currency crisis
 Weak domestic financial system
 Free international capital flows
 Contagion effect of changing market sentiments
 Inconsistent economic policies

2-47
 Fixed versus Flexible
Exchange Rate Regimes
 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.

2-48
 End Chapter Two

McGraw-Hill/Irwin 2-49 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights