The International Monetary System

Prepared for class discussion

By
Prof.S.Suryanarayanan
 international monetary system
 The international monetary system refers to the institutional arrangements
that countries adopt to 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
 the U.S. dollar, the EU euro, the Japanese yen, and the British pound all
float freely against each other
 their values are determined by market forces and fluctuate day to day
 A pegged exchange rate system exists when a country fixes the value of its
currency relative to a reference currency
 Many Gulf states peg their currencies to the U.S. dollar
 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
 China pegs the yuan to a basket of other currencies
 A fixed exchange rate system exists when countries fix their currencies against each
other at some mutually agreed on exchange rate
 European Monetary System (EMS) prior to 1999
 The gold standard refers to a system in which countries peg currencies to
gold and guarantee their convertibility
 The gold standard dates back to ancient times when gold coins were a
medium of exchange, unit of account, and store of value
 payment for imports was made in gold or silver
 Later, payment was made in paper currency which was linked to gold at a
fixed rate
 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
 The great strength of the gold standard was that it contained a powerful
mechanism for achieving balance-of-trade equilibrium by all countries
 when the income a country’s residents earn from its exports is equal to the
money its residents pay for imports
 It is this feature that continues to prompt calls to return to a gold standard
 The gold standard worked well from the 1870s until 1914
 but, many governments financed their World War I expenditures by printing
money and so, created inflation
 People lost confidence in the system
 the demand on gold for their currency put pressure on countries' gold
reserves and forced them to suspend gold convertibility
 By 1939, the gold standard was dead
 Example: currency defined as $20.67/ ounce and £ 4.2474/ounce. Currency
exchange rate is 20.67/4.2474 ie $4.866 per £ After devaluation it was £
1=$8.24 ( dollar price increased from 20.67 to 35)
 Gold standard extended till world war I
Bretton woods agreement 1944-1971
 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
 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)
1. The International Monetary Fund (IMF)
1. fixed exchange rates stopped competitive devaluations and brought stability
to the world trade environment
2. fixed exchange rates imposed monetary discipline on countries, limiting
price inflation
3. in cases of fundamental disequilibrium, devaluations were permitted
4. the IMF lent foreign currencies to members during short periods of balance-
of-payments deficit, when a rapid tightening of monetary or fiscal policy
would hurt domestic employment
2. The World Bank
 Countries can borrow from the World Bank in two ways
1. Under the IBRD scheme, money is raised through bond sales in the
international capital market
 borrowers pay a market rate of interest - the bank's cost of funds
plus a margin for expenses.
2. Through the International Development Agency, an arm of the bank
created in 1960
 IDA loans go only to the poorest countries
 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
 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 $767 billion
 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 global financial crisis of 2008–2010; sovereign debt crisis of 2010–
2011
 Which Is Better – Fixed Rates Or Floating Rates?
 Floating exchange rates provide
1. Monetary policy autonomy
 removing the obligation to maintain exchange rate parity restores
monetary control to a government
2. Automatic trade balance adjustments
 under Bretton Woods, if a country developed a permanent deficit in its
balance of trade that could not be corrected by domestic policy, the IMF
would have to agree to a currency devaluation
3. Help countries recover from financial crises
 But, a fixed exchange rate system
1. Provides monetary discipline
 ensures that governments do not expand their money supplies at
inflationary rates
2. Minimizes speculation
3. Uncertainty
4. Lack of connection between trade balance and exchange rates
 Who is right?
 There is no real agreement as to which system is better
 We know that a Bretton Woods-style fixed exchange rate regime will not work
 But a different kind of fixed exchange rate system might be more enduring
 could encourage stability that would facilitate more rapid growth in
international trade and investment
 Various exchange rate regimes are followed today
 21% of IMF members follow a free float policy
 23% of IMF members follow a managed float system
 5% of IMF members have no legal tender of their own
 excludes Euro Zone countries
 the remaining countries use less flexible systems such as pegged
arrangements, or adjustable pegs
 A country following a pegged exchange rate system pegs the value of its
currency to that of another major currency
 popular among the world’s smaller nations
 imposes monetary discipline and leads to low inflation
 adopting a pegged exchange rate regime can moderate inflationary
pressures in a country
 What Is A Currency Board?

 Countries using a currency board commit to converting their domestic

currency on demand into another currency at a fixed exchange rate
 the currency board holds reserves of foreign currency equal at the
fixed exchange rate to at least 100% of the domestic currency
issued
 the currency board can issue additional domestic notes and coins
only when there are foreign exchange reserves to back them
 What Is The Role Of The IMF Today?
 Today, the IMF focuses on lending money to countries in financial crisis
 There are three main types of financial crises:
1. Currency crisis
2. Banking crisis
3. Foreign debt crisis
 A currency crisis
 occurs when a speculative attack on the exchange value of a currency
results in a sharp depreciation in the value of the currency, or forces
authorities to expend large volumes of international currency reserves and
sharply increase interest rates in order to defend prevailing exchange rates
 Brazil 2002
 A banking crisis refers to a situation in which a loss of confidence in
the banking system leads to a run on the banks, as individuals and
companies withdraw their deposits
 A foreign debt crisis is a situation in which a country cannot service its
foreign debt obligations, whether private sector or government debt
 Greece and Ireland 2010
 The Mexican currency crisis of 1995 was a result of
 high Mexican debts
 a pegged exchange rate that did not allow for a natural adjustment of prices
 To keep Mexico from defaulting on its debt, the IMF created a $50 billion
aid package
 required tight monetary policy and cuts in public spending
 Asian Currency Crisis
 The 1997 Southeast Asian financial crisis was caused by events that took place in
the previous decade including
1. An investment boom - fueled by huge increases in exports
2. Excess capacity - investments were based on projections of future demand
conditions
3. High debt - investments were supported by dollar-based debts
4. Expanding imports – caused current account deficits
 By mid-1997, several key Thai financial institutions were on the verge of default
 speculation against the baht
 Thailand abandoned the baht peg and allowed the currency to float
 The IMF provided a $17 billion bailout loan package
 required higher taxes, public spending cuts, privatization of state-owned
businesses, and higher interest rates
 Speculation caused other Asian currencies including the Malaysian Ringgit, the
Indonesian Rupaih and the Singapore Dollar to fall
 These devaluations were mainly driven by
 excess investment and high borrowings, much of it in dollar-denominated
debt
 a deteriorating balance of payments position
 The IMF provided a $37 billion aid package for Indonesia
 required public spending cuts, closure of troubled banks, a balanced budget,
and an end to crony capitalism
 The IMF provided a $55 billion aid package to South Korea
 required a more open banking system and economy, and restraint by
chaebol
 How IMF has done
 By 2012, the IMF was committing loans to 52 countries in economic and
currency crisis
 All IMF loan packages require tight macroeconomic and monetary policy
 However, critics worry
 the “one-size-fits-all” approach to macroeconomic policy is inappropriate for
many countries
 the IMF is exacerbating moral hazard - when people behave recklessly
because they know they will be saved if things go wrong
 the IMF has become too powerful for an institution without any real
mechanism for accountability
 But, as with many debates about international economics, it is not clear who is
right
 However, in recent years, the IMF has started to change its policies and be
more flexible
 urged countries to adopt fiscal stimulus and monetary easing policies in
response to the 2008-2010 global financial crisis
What Does The Monetary System Mean For Managers?
 Managers need to understand how the international monetary system affects
1. Currency management - the current system is a managed float -
government intervention can influence exchange rates
 speculation can also create volatile movements in exchange rates

2. Business strategy - exchange rate movements can have a major impact

on the competitive position of businesses
 need strategic flexibility

3. Corporate-government relations - businesses can influence

government policy towards the international monetary system
 companies should promote a system that facilitates international
growth and development