1.

3 The International Monetary System

The international monetary system refers primarily to the set of policies, institutions,
practices, regulations, and mechanisms that determine the rate at which one currency is
exchanged for another.

1.3.1 History of the International Monetary system

Figure 1: The Evolution and Eras of the Global Monetary System

The Gold Standard (1876–1913)

Gold has been used as a medium of exchange and store of value since ancient times.
The late 19th century saw the formalization of the gold standard, where countries set
a par value for their currencies in gold. The U.S. adopted this in 1879, setting the
dollar to $20.67 per ounce of gold, while the British pound was pegged at £4.2474 per
ounce. Exchange rates were fixed, and countries maintained gold reserves to back their
currency’s value. The system limited money supply growth to the rate at which gold
could be acquired. The gold standard was suspended with the outbreak of World War I.

The Interwar Years and World War II (1914–1944)

During this period, currencies fluctuated widely, leading to economic instability. Specu-
lators exacerbated currency weaknesses, and world trade declined. The U.S. adopted a

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modified gold standard in 1934, devaluing the dollar to $35 per ounce of gold, trading
only with foreign central banks. Exchange rates were based on gold, but many currencies
lost convertibility during World War II.

Bretton Woods and the International Monetary Fund (1944)

The Bretton Woods Agreement established a U.S. dollar-based international monetary

system and created the International Monetary Fund (IMF) and the World Bank. The
IMF aids countries with balance of payments and exchange rate problems, while the World
Bank supports economic development. Countries fixed their currencies’ value in gold but
did not need to exchange currencies for gold. The U.S. dollar remained convertible to
gold. Exchange rates were maintained within 1-2.25% of par value, and devaluation was
restricted.

Fixed Exchange Rates (1945–1973)

The Bretton Woods system worked well post-World War II but faced challenges due to
differing national policies, inflation rates, and external shocks. The U.S. dollar, as the
main reserve currency, suffered from persistent deficits, leading to a loss of confidence
and significant gold reserve depletion in 1971. By 1973, the fixed-rate system collapsed,
and currencies began to float.

The Floating Exchange Rates (1973–1997)

Since 1973, exchange rates have become more volatile and less predictable. Notable events
include the creation of the European Monetary System (EMS) in 1979, the dollar peak
in 1985, the EMS crisis in 1992, the Asian crisis in 1997, the launch of the euro in 1999,
the Brexit vote in 2016, and the rise of the dollar from 2014-2017.

The Emerging Era (1997–Present)

Post-1997, emerging market economies and currencies have grown in importance. The
global monetary system is increasingly embracing major emerging market currencies,
starting with the Chinese renminbi.

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1.3.2 IMF Exchange Rate Classification

Hard Pegs:

• Arrangement with no separate legal tender The currency of another country

circulates as the sole legal tender (formal dollarization), as well as members of
a monetary or currency union in which the same legal tender is shared by the
members.

• Currency board arrangement: A monetary arrangement based on an explicit

legislative commitment to exchange domestic currency for a specific foreign cur-
rency at a fixed exchange rate, combined with restrictions on the issuing authority.
Restrictions might imply that domestic currency will be issued only against foreign
exchange and that it remains fully backed by foreign assets.

Soft Pegs:

• Conventional pegged arrangement A country formally pegs its currency at

a fixed rate to another currency or a basket of currencies of major financial or
trading partners. Country authorities stand ready to maintain the fixed parity
through direct or indirect intervention. The exchange rate may vary ±1% around
a central rate, or may vary no more than 2% for a six-month period.

• Stabilized arrangement A spot market rate that remains within a margin of

2% for six months or more and is not floating. Margin stability can be met by
either a single currency or basket of currencies (assuming statistical measurement).
Exchange rate remains stable as a result of official action.

• Intermediate pegs: Crawling peg Currency is adjusted in small amounts at

a fixed rate or in response to changes in quantitative indicators (e.g., inflation
differentials).

• Crawl-like arrangement Exchange rate must remain within a narrow margin of

2% relative to a statistically defined trend for six months or more. Exchange rate
cannot be considered floating. Minimum rate of change is greater than allowed
under a stabilized arrangement.

• Pegged exchange rate within horizontal bands The value of the currency is
maintained within 1% of a fixed central rate, or the margin between the maximum
and minimum value of the exchange rate exceeds 2%. This includes countries that
are today members of the Exchange Rate Mechanism II (ERM II) system.

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Floating Arrangements:

• Floating Exchange rate is largely market determined without an ascertainable or

predictable path. Market intervention may be direct or indirect, and serves to
moderate the rate of change (but not targeting). Rate may exhibit more or less
volatility.

• Free floating A floating rate is freely floating if intervention occurs only excep-
tionally, and confirmation of intervention is limited to at most three instances in a
six-month period, each lasting no more than three business days.

Residual

• Other managed arrangements This category is residual, and is used when the
exchange rate does not meet the criteria for any other category. Arrangements
characterized by frequent shifts in policies fall into this category.

Figure 2: Taxonomy of Exchange Rate Regimes

1.3.3 Fixed Versus Flexible Exchange Rates

A nation’s choice as to which currency regime to follow reflects national priorities about
all facets of the economy, including inflation, unemployment, interest rate levels, trade

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balances, and economic growth. The choice between fixed and flexible rates may change
over time as priorities change. At the risk of overgeneralizing, the following points partly
explain why countries pursue certain exchange rate regimes. Fixed exchange rates have
a number of disadvantages—as we will show in the following section—and maintaining
them can be difficult and costly. But they also offer some advantages as follows:

• Fixed rates provide stability in international prices for the conduct of trade. Stable
prices aid in the growth of international trade and lessen risks for all businesses.

• Fixed exchange rates are inherently anti-inflationary, requiring the country to follow
restrictive monetary and fiscal policies. This restrictiveness, however, can be a bur-
den to a country wishing to pursue policies to alleviate internal economic problems
such as high unemployment or slow economic growth.

• Fixed exchange rate regimes necessitate that central banks maintain large quantities
of international reserves (hard currencies and gold) for use in the occasional defense
of the fixed rate. As international currency markets have grown in size, increasing
reserve holdings has become a growing burden.

• Fixed rates, once in place, may be maintained at levels that are inconsistent with
economic fundamentals. As the structure of a nation’s economy changes, and as
its trade relationships and balances evolve, the exchange rate itself should change.
Flexible exchange rates allow this to happen gradually and efficiently, but fixed
rates must be changed administratively—usually too late, with too much publicity,
and at too large a one-time cost to the nation’s economic health.

The terminology associated with changes in currency values is also technically

specific. When a government officially declares its own currency to be worth less or
more relative to other currencies, it is termed a devaluation or revaluation, respectively.
This obviously applies to currencies whose value is controlled by government. When a
currency’s value is changed in the open currency market—not directly by government—it
is called a depreciation (with a fall in value) or appreciation (with an increase in value).

1.3.4 The Trilemma and Exchange Rate Regime Choice

The shape of any international monetary system is constrained by what is often called
the trilemma. This “impossible trinity” of international finance stems from the fact that,
in general, economic policy makers would like to achieve each of the following three goals:

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 1. Exchange rate stability. The value of the currency is fixed in relation to other
major currencies, so traders and investors could be relatively certain of the foreign
exchange value of each currency in the present and into the near future.

2. Full financial integration. Complete freedom of monetary flows would be al-

lowed, so traders and investors could easily move funds from one country and cur-
rency to another in response to perceived economic opportunities or risks.

3. Monetary independence. Domestic monetary and interest rate policies would

be set by each individual country to pursue desired national economic policies, espe-
cially as they might relate to limiting inflation, combating recessions, and fostering
prosperity and full employment.

Together, these qualities are termed the impossible trinity because the forces
of economics do not allow a country to simultaneously achieve all three goals: monetary
independence, exchange rate stability, and full financial integration. The impossible
trinity makes it clear that each economy must choose its own medicine. Here is what
many argue are the choices of three of the major global economic players:

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1.3.5 Typical Currency Control Measures

• Restriction or prohibition of certain remittance categories such as dividends or

royalties

• Ceilings on direct foreign investment outflows (e.g., the elaborate U.S. Office of
Foreign Direct Investment controls in effect 1968–1975)

• Controls on overseas portfolio investments

• Import restrictions

• Required surrender of hard-currency export receipts to central bank

• Limitations on prepayments for imports

• Requirements to deposit in interest-free accounts with central bank, for a specified

time, some percentage of the value of imports and/or remittances

• Foreign borrowings restricted to a minimum or maximum maturity

• Ceilings on granting of credit to foreign firms

• Imposition of taxes and limitations on foreign-owned bank deposits

• Multiple exchange rates for buying and selling foreign currencies, depending on
category of goods or services each transaction falls into

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