CHAPTER TWO

The International Monetary System:

History and Where we are Today
What is International monetary system?

Formal Definition - Structure in which foreign exchange

rates are determined, international trade and capital
flows accommodated and balance of payments
adjustments made.
In our context, International monetary system refers to
the system and rules that govern the use and exchange
of money around the world and between countries.
Each country has its own currency as money and the
international monetary system governs the rules for
valuing and exchanging these currencies.
 History of Exchange Rate Regimes

Defined: The way in which a country manages its

currency and thus the arrangement by the price of
that countrys currency is determined on foreign
exchange markets.
Arrangements ranging from:
Floating Rate
Managed Rate (AKA Dirty Float)
Pegged Rate
Arrangement is determining by governments.
History of Exchange Rate Regimes
Over the past 200+ years, the world has gone
though major changes its global exchange rate
environment.
Starting with the gold standard regime of the latter
part of the 19th century to todays somewhat
mixed/flexible system we can identify there 3
distinct periods:
(1) Gold Standard: 1816 - 1914
(2) Bretton Woods: 1945 1973
(3) Mixed/flexible System: 1973 the present
Gold Standard: 1816 - 1914
During the 1800s the industrial revolution
brought about a vast increase in the production
of goods and widened the basis of world
trade.
At that time, trading countries believed that a
necessary condition to facilitate world trade
was a stable exchange rate system.
Gold Standard: 1816 - 1914
Stable exchange rates were seen as
necessary for encouraging and settling
commercial transactions across borders (both
by companies and by governments).
So by the second half of the 19th century,
most countries had adopted the gold
standard exchange rate regime.
Basics of the Gold Standard
The gold standard regime required that domestic
currencies (national money) be defined in terms of
a specific weight of gold.
For example:
The British pound was fixed at .23546% of an
ounce of pure gold (in 1816).
The U.S. dollar was fixed at 0.048379% of an
ounce of pure gold (in 1879).
Thus, the dollar pound parity (i.e., the exchange
rate) was set at $4.867
.23546/.048379 = 4.867
Basics of the Gold Standard
How it worked:
Assume the United Kingdom ran a trade deficit with the
United States.
As a result, gold would flow from the UK to the US (gold
financed trade imbalances).
Each countrys domestic money supply was tied into the
amount of gold it held, thus the U.S. money supply would
rise.
The increase money supply would increase prices in the
United States, which in turn would make U.S. goods less
attractive to the UK.
The net result was that the trade surplus of the US would
decrease and the trade deficit of the UK would decrease.
Basics of the Gold Standard
The Gold Standard also required that each country
adjust its domestic money supply in direct relation to
the amount of gold it held.
Increase in gold would increase the domestic money and
a reduction in its gold supply would reduce the money
supply.
The Advantages of the Gold
Standard
(1) Reduce risk of Exchange rate
The gold standard dramatically reduced the
risk in exchange rates because it is established
fixed exchange rates between currencies.
Any fluctuations were relatively small.
The Advantages of the Gold Standard
This made it easier for global companies to
manage costs and pricing.
International trade grew throughout the world,
although economists are not always in
agreement as to whether the gold standard was
an essential part of that trend.
The Advantages of the Gold Standard
(2) Forced countries to use strict monitory policies
The second advantage is that countries were
forced to observe strict monetary policies.
They could not just print money to combat
economic downturns.
The Advantages of the Gold Standard
One of the key features of the gold standard
was that a currency had to actually have in
reserve enough gold to convert all of its
currency being held by anyone into gold.
Thus, the volume of paper currency could not
exceed the gold reserves.
The Advantages of the Gold Standard
(3) To correct trade imbalance
For example, if a country was importing more
than it is exporting, (called a trade deficit), then
under the gold standard the country had to
pay for the imports with gold.
The Advantages of the Gold
Standard
The government of a country would have to reduce
the amount of paper currency, because there could
not be more currency in circulation than its gold
reserves.
With less money floating around, people would have
less money to spend (thus causing a decrease in
demand) and prices would also eventually
decrease.
The Advantages of the Gold
Standard
As a result, with cheaper goods and services to
offer, companies from the country could export
more, changing the international trade balance
gradually back to being in balance.
The Advantages of the Gold Standard
Note:
For these three primary reasons, and as a result
of the 2008 global financial crises, some
modern economists are calling for the return of
the gold standard or a similar system.
Why Gold standard collapse ?
World War I (1914) Through World War II
(1944)
World War I marks the beginning of the end of the
Gold Standard .
During the war, countries suspended the convertibility
of their currencies into gold.
After WW I, various attempts were made to restore
the classical gold standard.
1919: United States returned to a gold standard.
1925: Great Britain joined, followed by France and
Switzerland.
World War I (1914) Through World War II (1944)
These attempts proved unsuccessful.
Why: During this time, most countries were
more concerned with their national economies
than exchange rate stability.
Especially during the Great Depression (1929
1930s)
Asa result, countries abandoned their
attempts to return to an interwar gold
standard.
Britain and Japan dropped it in 1931, the U.S. in
1933.
Bretton Woods: A Pegged Regime

As World War II is coming to an end, all 44 allied countries

meet in Bretton Woods, New Hampshire for the purpose of
establishing a new international monetary system.
It was developed at the United Nations Monetary and
Financial Conference held from July 1 to July 22, 1944 .
At Bretton Woods, countries agree that fixed exchange rates
were necessary for restarting world trade and global
investment (both of which had fallen dramatically).
Bretton Woods: A Pegged Regime

The Bretton Woods Agreement was the landmark

system for monetary and Exchange rate
management established.
Under the agreement, currencies were pegged to
the price of gold, and the U.S. dollar was seen as
a reserve currency linked to the price of gold.
It was also obvious that the US dollar would
become the cornerstone of any new international
monetary system.
Bretton Woods: A Pegged Regime
Key points of the Bretton Woods were:
Pegging the U.S. dollar to gold at $35 per ounce
(with the USD the only currency convertible into
gold).
All other countries peg their currencies to the U.S.
dollar.
Their par values are set in relation to the
U.S. dollar
GBP = $2.80; JPY = 360 (1 in 1949)
Bretton Woods: A Pegged Regime
Countriesagreed to support their
exchange rates within + or 1% of these
par values.
This is done through the buying or selling of
foreign exchange when market forces
needed to be offset.
The Seeds of Bretton Woods Demise
In the 1960s, Bretton Woods begins to unravel.
President Lyndon Johnson tries to finance both his Great
Society programs at home and the American war in
Vietnam.
This produces a large US Federal budget deficit, which,
coupled with easy monetary policy, results in:
o High inflation in the United States and
o An increase in U.S. spending for cheaper imports
The Seeds of Bretton Woods Demise
As a result, the United States balance of payments
moves from a surplus into a deficit.
Dollar is seen by the market as overvalued.
Foreigners become concerned about holding
overvalued U.S. dollars at a rate of $35 an ounce.
o Markets are suggesting it should take more than
$35 to buy 1 ounce of gold.
By the mid-1960, the U.S. balance of payment (e.g.,
trade balance) started to deteriorate (a declining
surplus).
By 1971, the U.S. merchandise trade balance moved
into deficit.
The Last Years of Bretton Woods: 1970 -1973

By 1970, financial markets are reluctant to

hold the overvalued U.S. dollar.
Markets sell USD on foreign exchange markets.
o This puts downward pressure on the exchange
rate for dollars.
o And upward pressure on the exchange rate for
foreign currencies.
Central banks engage in massive intervention
in an attempt to hold their Bretton Woods par
values.
o Central banks buy U.S. dollars as they are
sold in markets.
The Last Years of Bretton Woods: 1970 -1973
As a result, foreign holdings of dollars increase
dramatically and eventually exceed U.S. gold
holdings.
By 1971, gold coverage for U.S. dollars had
dropped to 22%.
In August 1971, President Nixon suspends dollar
convertibility into gold.
o In response, more dollars are sold on foreign
exchange markets pushing the dollar lower (and
foreign currencies higher).
Smithsonian Agreements, December 1971
In December 1971, ten major counties meet in
Washington, D.C. with the aim of restoring
stability to the international monetary system.
Meeting concludes with the Smithsonian
Agreements, whereby:
Key countries agree to revalue their currencies
and in essence set new par values against the US
dollar (e.g., yen +17%, mark +13.5%, pound and
franc +9%)
Smithsonian Agreements, December
1971
The U.S. also agrees to raise the dollar price of
gold from $35 to $38 ounce (represents a further
devaluation of the dollar).
It was also agreed that currencies could now
fluctuate + or 2.25% around their new par
values.
 The Final Collapse of the Dollar, February 1973
13 months after the Smithsonian Agreements, the dollar comes
under renewed attack for being overvalued.
In February 1973, markets sell off dollars again.
As before, central banks intervene and buy dollars.
On February, 12th, 1973 the dollar is devalued further to $42
per ounce.
But the price of gold on the London gold markets trades at $70 per
ounce.
Japan and Italy finally let their currencies float on February 13th.
France and Germany continue to manage their currencies in relation
to the dollar.
In response to mounting speculative currency flows, foreign exchange
markets are closed on March 1, 1973, and reopen on March 19,
1973.
The End of Bretton Woods
On March, 19, 1973, when foreign exchange markets
reopen, major countries announce that they are
floating their currencies:
On March 19, 1973, the list of countries floating
their currencies includes Japan, Canada, and those in
Western Europe.
The Bretton Woods fixed exchange rate system
effectively ends on this date.
Approximately 3 months later, by June 1973, the dollar
has floated down an average of 10% against the
major currencies of the world.
Exchange Rate Regimes Today
Currently, current exchange rate regimes fall along a
spectrum as represented by national government
involvement in affecting (managing) their currencys
exchange rate.

Very Little (if any) Active

Involvement Involvement

Forex Market is Government is

Determining Managing or
Exchange rate Pegging
Exchange rate
Peggers
Peggers tie their currency to one or more
currencies
A number of smaller countries tie themselves to
their leading trading partner because they
would not want to see major economic changes
caused by exchange rate changes
Peggers
Countries can tie their currencies to more than one
currency such as the SDR or a basket determined by
their trading or investment partners
Baskets are usually less risky (less variation) and
hence purchasing power would be more stable
Other Conventional Fixed Peg
Arrangements
In this category exchange rates dont fluctuate much
around a central rate (at most +/- 1% around a
central rate)
Pegged Exchange Rates within
Horizontal Bands
A similar to the previous arrangement except that
the bands are wider than +/- 1%
Crawling Pegs
The exchange rate adjusts in small increments or to
changes in various indicators (for example, inflation)
Exchange Rates Within Crawling Pegs

Similar to the previous group except that the

exchange rate fluctuates within a band of a central
rate
Managed Floating with no Preannounced
Path for the Exchange Rate
Often the central banks intervene to support this
rate
Independently Floating
Countries let the value of their currencies be
determined by the market
Most of the major currencies of the world are
in this category with the exception of those
currencies in the European Monetary Union
The central banks of these countries may
intervene occasionally (sometimes to limit
variation)
Remark:
The currencies of most countries are not floating.

Only 80/186 countries are in Managed floating

and independent floating category.
Summery of current Exchange Rate Regimes in
general?
Mixed/Flexible International Monetary System
consisting of:
Floating exchange rate regimes:
Market forces determine the relative value of a currency.
Managed (dirty float) rate regimes:
Governments managing their currencys value with regard to a
reference currency.
Market moves these currencies, but governments are managing the
process and intervening when necessary.
Pegged exchange rate regimes:
Government fixes (links) the value of its currency relative to a
reference currency.
Fewer of these regimes than in the past.
Post Bretton Woods Summary

Since March 1973, the major currencies of the

world have operated under a floating exchange
rate system.
While central banks of these major countries have
occasionally interviewed in support of their
currencies, this intervention has become less over the
years.
The US last intervened in 1998.
Post Bretton Woods Summary
In addition to the major currencies of the world,
a growing number of other developing country
currencies have also moved to a floating rate
system.
Thus: more and more, market forces are driving currency
values.
The post Bretton Woods period has resulted exchange rates
become much more volatile and , perhaps, less predictable
then they were during previous fixed exchange rate eras.
This currency volatility complicates the management of
global companies.
Note:
The currencies of most countries are not floating.

Only 80/186 countries are in the last two

categories.
 European Monetary System

The European Monetary System originated in an

attempt to stabilize inflation and stop
large exchange rate fluctuations between European
countries.
The European Monetary System (EMS) is a 1979
arrangement between several European countries
which links their currencies in an attempt to stabilize
the exchange rate.
European Monetary System
This system was succeeded by the
European Economic and Monetary Union (EMU), an
institution of the European Union (EU), which
established a common currency called the euro.
Then, in June 1998, the European Central Bank was
established and, in January 1999, a unified
currency, the euro, was born and came to be used
by most EU member countries.
Criteria for Full Membership in the
European Monetary Union
Nominal inflation rates should be no more than
1.5% above the average for the three members of
the European Union with the lowest inflation rates
Long-term interest rates should be no more than 2%
above the average for the three members with the
lowest interest rates
Criteria for Full Membership in the
European Monetary Union
The fiscal deficit should be no more than 3% of the
gross domestic product
Government debt should be no more than 60% of
gross domestic debt
Euro
Is a currency issued by the European Central Bank
Its value does not depend on any other constituent
currency. This is not true for the ECU or the SDR
Initial value set at $1.16675/.

Value of Euro Oct 2000 - $.82/

Value July, 2008 - $1.60/

Value as of August, 2011- $1.44/

In Euro Zone
Cheaper transaction costs
Currency risks are reduced
More price transparency and more competition
among companies within the Euro zone.
 End of Chapter Two