EVOLUTION OF THE INTERNATIONAL MONETARY

INTERNATIONAL
UNIT 5 SECTION
BUSINESS
1
Unit 5, section
SYSTEMS 1: Evolution of the international monetary systems

You are welcome to the introductory Section of Unit 5. We are sure you did
not find any difficulty in the previous units. The International Monetary
System (IMS) exists to establish the rules by which countries value and
exchange their currencies. The International Monetary system provides a
mechanism for correcting imbalances between a country's international
payments and its receipts. Moreover, the cost of converting foreign money
into a firm's home currency depends on the efficiency of the international
monetary system. The operations of IMS also serve as a source of vital
information about the health of any economy and the likely changes to their
fiscal and monetary policies.

By the end of the lesson, you should be able to;

 review the evolution of the international monetary system

Read on

Evolution of International Monetary Systems

The International Monetary System consists of the institutional frameworks,
rules, and procedures that govern how national currencies are exchanged for
one another. By providing a framework for the monetary and foreign
exchange activities of firms and governments worldwide, the system
facilitates international trade and investment. The system traces its roots to
the ancient allure of gold and silver that served as media of exchange in the
early trade activities. Currently, many nations have established relevant
systems and mechanisms (through the collection of agreements and
institutions) to manage and control exchange rates. The evolution can be
traced from these three eras.

The Gold Standard Era: Early years (1880-1939)

Gold, in the early days, was the internationally accepted currency for
payment of goods and services. The ancient reliance on gold coins led to the
adoption of the system known as gold standard – an international monetary
system in which nations linked the value of their paper currencies to specific
values of gold. Countries agreed to buy and sell their paper currencies in
exchange for gold on the request of any individual or firm. This system
required a nation to fix the value (price) of its currency to an ounce of gold.

The value of a currency expressed in terms of gold is called its par value
(official price in terms of gold). The calculation of each currency's par value
was based on the concept of purchasing power parity – purchasing power of
gold the same everywhere across nations. Because the gold standard fixed
nations' currencies to the value of gold, it created a fixed exchange rate
system. Money issued by member countries had to be backed by reserves of
gold. Under the fixed exchange rate system, the price of a given currency
does not change relative to each other currency.

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In 1821, UK became the first country to adopt the gold standard - pegs
currencies to gold and guarantees convertibility to gold. This system
contained an automatic mechanism that contributed to the simultaneous
achievement of balance of payments equilibrium by all countries. An
exchange rate is the price of one currency in terms of a second currency.
The system made calculating exchange rates between any two currencies
simpler. For example, the US dollar was originally fixed at $20.67/oz of
gold and the British pound at £4.2474/oz. The exchange rate between the
dollar and the pound was $4.87/£ ($20.67÷£4.2474). The most important
currency became the British pound and as such, this era is sometimes called
the sterling-based gold standard as it reinforced the expansion of the British
Empire.

The advantages of the gold standard era included:

 reducing the risks in exchange rates as it maintained highly fixed
exchange rates between countries. The more stable the exchange rates
were, the less companies are affected by actual or potential adverse
changes in them.
 helping the system to correct a nation's trade imbalance.
 imposing strict monetary policies on all participating countries

Due to the increase in war expenses, nations involved in the war could no
longer rely on gold as the medium of exchange, hence resorting to printing
their own paper currencies. This new development led to the violation and
abolishment of the fundamental principle of the gold standard. This new
direction caused rapid inflation for these nations forcing some countries to
devalue their currencies. People quickly lost faith in the gold standard
because it was no longer an accurate indicator of a currency's true value. By
1939, the gold standard was effectively abolished.

Bretton Woods Agreement Era (1944-1973)

In 1944, representatives from 44 countries were determined not to repeat the
mistakes that caused the World War II, instead resolved to promote
worldwide peace and prosperity. They met at a resort in Bretton Woods, New
Hampshire to renew the gold standard on a greatly modified basis and agreed
to the creation of two new international organisations (International Bank for
Reconstruction and Development [IBRD] and the International Monetary
Fund [IMF]) to assist in rebuilding the international monetary system and the
world economy.

The principles of the Bretton Woods operated under a fixed exchange rate
system that led to the establishment of a fund of gold and currencies
available to members for stabilisation of their respective currencies (IMF),
and the establishment of a bank that would provide funding for long-term
development projects (the World Bank). The IMF is an international agency
that attempts to stabilise currencies by monitoring the foreign exchange

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systems of member countries and lending money to developing economies.

The World Bank is an international agency that provides loans and technical
assistance to low- and middle-income countries, with the goal of reducing
poverty. The new system was designed to balance the strict discipline of the
gold standard with the flexibility that countries needed to deal with
temporary domestic monetary difficulties. Bretton Woods established the
notion of fixing exchange rates within an international regime to minimise
currency risk.

The demise of the Bretton Woods agreement began in the late 1960s when
the U.S. government used deficit spending to finance both the Vietnam War
and expensive government programs. Rising government spending
stimulated the economy, and U.S. citizens began buying more imported
goods. This aggravated the U.S. balance of payments, and the United States
began to experience trade deficits with Japan, Germany, and other European
countries.

Over time, demand for U.S. dollars so exceeded supply that the U.S.
government could no longer maintain an adequate stock of gold. This
situation put pressure on governments in Europe, Japan, and the United
States to revalue their currencies. As a result, the link between the U.S.
dollar and gold was suspended in 1971, and the promise to exchange gold
for U.S. dollars was withdrawn. This action brought an end to the Bretton
Woods system.

Floating Exchange Rates Era (1973-Present)

The world's major currencies float in value versus each other without
government intervention. Currency speculators drive the demand for a
currency to some extent. Supply and demand for a currency determines its
price in the market to a greater extent i.e. demand for a currency (foreign
exchange) derives from demand by foreigners for goods, services and assets
that a nation offers for sales. When the price of a country's products is high,
the quantity of products demanded is low. As a result, the quantity of the
country's currency demanded is also low.

When the price of a country's currency is low, the quantity of the currency
supplied is also low and vice versa. Also, when the price of foreign products
is high, the quantity of foreign products a nation will demand is low and
vice versa. As a result, the amount of a country's currency its citizens are
willing to sell in order to buy the currency needed to purchase foreign goods
is also low and vice versa. The interaction between demand and supply of a
country's currency determines its price – the equilibrium price/foreign
exchange rate.

The flexible exchange rate system that resulted after the IMF’s decision of
1976 is referred to as “managed” float because there is more to the
determination of the rates than the daily market forces of supply and

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demand. There is still government intervention in the markets to adjust the

values of the major currencies. In addition, many small countries peg their
currencies to that of a major nation; and most of the major members of the
European Union, including France and Germany, have formed the European
monetary system (EMS), which fixes their currency values in relation to
each other, and floats them together against the rest of the world. Today the
principal unpegged currencies are the US dollar, the Canadian dollar, the
Swiss franc and the Japanese yen.

Fixed Exchange Rate System

The value of a currency is set to the value of another (or the value of a
basket of currencies), at some specified rate. The system is sometimes called
a "pegged" exchange rate system and is the opposite of the floating
exchange rate system. As the reference value rises and falls, so does the
currency pegged to it. Many developing economies and some emerging
markets use this system today. For example, China pegs its currency to the
value of a basket of currencies, and Belize pegs the value of its currency to
the U.S. dollar. To maintain the peg, the governments of these countries
intervene in currency markets to buy and sell dollars and other currencies, in
order to maintain the exchange rate at a fixed, present level.

We have explained the evolution of the international monetary system and

how businesses operated internationally. The eras identified included the
gold standard, Bretton Wood, and the floating exchange rates. We must
therefore appreciate that these eras led to the development of International
Monetary Fund and World Bank.

Now assess your understanding of this Section by answering the following

self-assessment questions. Good luck!

Activity 5.1
 What are the important differences between the Bretton Woods fixed
exchange rate system and the current IMF system? How do these
differences affect the MNE manager?
 How may the International Monetary Fund affect companies’ activities
in international business?

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