Chapter 5

Understanding
International Monetary
System
 Convertible currencies (hard
currencies)

They are exchangeable for any other

currency at uniform rates at financial
centers, worldwide.
Some examples are; US dollar, euro, British
pound sterlin, Turkish lira
 Gold Standard
Since ancient times, gold was used to store value,
exchange value, and measure value.
As trade increased, it became difficult to carry gold from
one place to the other, both because it was heavy and
also it was attracting thieves.
The first paper money was used by Egyptians, and later by
Kubilay Khan (grandson of Chenghiz Khan).
In the West, Sir Isaac Newton established the price of one
ounce of gold as 3 pounds, 17 shillings, 10.5 pence. So
gold standar in England has started. Until WW I, (except
during Napoleonic Wars), England converted pounds
into gold. London was the major center of finance in the
world, keeping 90% of world trade and finance.
 Gold Standard
In this system, each country sets a number
of units of its currency per ounce of gold,
and ratios of their gold equivalence
established the exchange rate between
any two currencies on the gold standard.
Since each currency is backed by gold, the
treasuries of the countries were committed
to exchange their currencies with gold or
visa versa.
 Gold Standard
It was simple.
It corrected the BOP unbalances. If there would be
too much gold in one country, the prices would
go up, imports increase, exports decrease, the
unbalance would be corrected. This automatic
adjustment was called price-specie-flow
mechanism (developed by David Hume, 1758).
Gold standard ended when Britain and other
countries sold most of their gold in the First WW,
Great Depression, and the Second WW. They
were left with no gold to back their currencies.
 Gold Standard
There are some advocates of the gold standard
even for today, like Steve Forbes (publisher),
Robert Bartley (The Wall Street Journal editor),
Jaques Rueff (French economist).
Major advantage of the gold standard is the
discipline it brings. Under the gold standard, the
governments can not print as much money as it
wants. Money printing is limited, because money
creation had to be backed by gold.
 Bretton Woods
After the WW II, in 1944, representatives of
the allied states met at Bretton Woods in
New Hampshire to plan the new
international political and monetary
system.
Among the others, there were two major
institutions to guard and control this
international monetary system: IMF and
the World Bank (IBRD).
 Bretton Woods
IMF was established to monitor the fixed exchange rate
system. In this system, the value of the member-
nations’currencies were fixed, with the par value (stated
value) based on gold, and the US dollar, which was
valued at $35 per ounce of gold. For example;
1 British pound = $2.40
1 French franc = $0.18
1 German marc = $0.2732
US government would exchange US dollars for gold, and
US dollar was the only currency to be exchanged by
gold. The system was also called dollar-based gold
exchange standard, and US dollar became the
international payment and reserve currency.
 Bretton Woods
Because US dollar was the international and reserve
currency, other countries needed them.
US had a cumulative deficit of $56 billion between 1958-
1971. US was printing dollars and importing goods, and
it was financing the Vietnam War.
France’s De Gaulle, realizing that the value of US dollar
would go down, started purchasing gold from the US
Treasury. The US gold reserves shrank from $24.8
billion to $12.2 billion.
In 1971, August, President Nixon suspended dollar’s
convertibility into gold for the stated price.
 Triffin Paradox

It is the concept that a national currency that

is also a reserve currency will eventually
run a deficit, which eventually inspires a
lack of confidence in the reserve currency
and leads to a financial crisis.
 Bretton Woods
IMF tried to make adjustments to protect the fixed
currencies, and created SDRs.
The Smithsonian Agreement was a further attempt
to restructure the international monetary system,
but it was not successful. US dollar’s value was
depreciating, continuously.
In 1973, Japan and Europe had allowed their
currencies to float.
Fixed exchange rate system established at the
Bretton Woods had ended.
 IMF
• IMF has 184 members contributing funds (in 2006, $308
billion), known as its quota, which is determined based
on the country’s share in the world economy.
• For example, the US has 17.08% of the total votes, and
is quota is 17.1, UK has 4.95 of the total, China 2.94,
and Japan 6.13.
• IMF is addressing economic and exchange rate policies
of countries with the largest trade imbalances. Causes of
these imbalances include low levels of savings in the US,
high levels of savings in China, inflexibility of Chinese
currency, continued BOP surpluses in Japan, Germany,
and oil-producing countries.
 Major challenges to IMFand the
international monetary system
Jeffrey Sachs lists the following challenges:
• Rise of Asian economies will make the US-centric IMF
approach obsolete. “The US no longer be the conductor
of the global monetary orchestra”.
• As Asia rises, so will the temptation toward protectionism
in US and Europe. The financial crisis will be more global
and more intricate.
• There will be regional currencies. The currencies of
many small countries will be cancelled.
• Ecological shocks, earthquakes, global warming, new
viruses like AIDS, will require new insurances, globally.
 Floating exchange rate system
After US “closed the gold window”, that is it is no
longer exchange gold for the paper dollars held
by the foreign banks, there was a shock in the
currency exchange markets.
There were two attempts to have new sets of fixed
currency exchange rates; one in December
1971, and the other in February 1973.
In both cases, speculators, banks, businesses,
and individuals believed that the central banks
had pegged the rates incorrectly, and they were
right.
 Floating exchange rates since 1973
• Oil crisis in 1973
• Oil crisis in 1979
• Rapid fall of US dollars against German marks
(1985-1987) and against Japanese yen (1993-
1995)
• Financial crisis in Europe in 1980’s
• South Eas Asian financial crisis in 1996-1998
• Russian crisis in 1998
• Financial crisis in US and Turkey 2001
• Global financial crisis that started in 2008
 Fixed currency exchange rates
They are rates that governments agree on and
undertake to maintain.
Floating currency exchange rates are rates that
are allowed to float against other currencies and
are determined by market forces.
Jamaica Agreement established the rules for the
floating system in 1976. It allows for flexible ERs
among the IMF members, while allowing CB
operations in the money markets to smooth out
volatile periods. Gold was demonetized.
 Current currency arrangements
IMF recognized three types of currency exchange
arrangements, later they were extended to eight. The
first three were;
1. Free (clean) float – It is closest to perfect competition,
because there is no government intervention and large
amounts of various monies are being traded by
thousands of buyers and sellers.
2. Managed (dirty) float – Governments intervene in the
currency markets as they perceive that national
interests to be served.
3. Fixed peg – A country pegs the value of its currency at
a fixed rate to another currency.
 Eight categories of exchange rate
arrangements by IMF
• ER arrangements with no separate legal tender
– is where a country adopts the currency of
another country or a group of countries. Eg. US
dollar in Panama, El Salvadore, and Ecuador.
• Currency board arrangements – describe a
legislated committment to exchange domestic
currency for a specific foreign currency at a fixed
rate. The currency board arrangement committs
the government to hold foreign currency
reserves equal to its domestic currency supply.
Eg. Estonia tied its kroon to euro, in Hong Kong
the Hong Kong dollar is tied to the US dollar.
 Continued...
• Other conventional fixed peg arrangements –
describe a peg in which there is a fixed rate
relationship and ER fluctuations are allowed
within a narrow band of less than one percent.
Eg. The Saudi Riyal is pegged to the US dollar
in this way.
• Pegged ERs within horizontal bands - describe
pegged arrangements in which the ER
fluctuations are allowed to be more than 1
percent around a central rate. Eg. Denmark’s
krone is pegged this way to euro.
 Continued...
• Crawling pegs – describe arrangement in which
currency is readjusted periodically at a fixed,
preannounced rate or in response to changes in
the indicators. Eg. Bolivia, Costa Rica, and
Tunisia operate this way.
• ERs within crawling pegs – describe fluctuating
margins around a central rate within which the
currency is maintained and adjusted periodically.
Eg. Romania.
 Continued...
• Managed floating with no preannounced path for
the ER – describes a monetaru authority that
actively intervenes on the ER market without
specifying or making public its goals and targets.
Eg. Algeria, India, Malaysia, and Singapore.
• Independently floating ERs – is an approach that
relies on the market. There may be
interventions, yet they are conducted to
moderate the rate of change rather than to
establish the currency’s level. Eg. US, Mexico,
Canada, and the UK.
 Number of countries in each
approach

Exchange arrangements with no separate tender 41 countries

Currency board arrangements 7 “
Other conventional fixed programs 40 “
Pegged exchange within horizontal bands 5 “
Crawling pegs 6 “
ERs within crawling pegs 2 “
Managed floating with no pronounced path 50 “
Independently floating 36 “
 Floating currencies
Floating currencies can move against one
another quickly and in large swings.
Such changes have many causes such as;
• Political events
• Expectations
• Government policies
• Trade imbalances and deficits
• Inflation rate
 The euro (€)
The euro (€) is the currency of the European Monetary
Union (EMU).
The agreement to move to a common currency, the
Maastricht Treaty, was signed by the EU members in
1991 with the target date of 1999. They tried to
harmonize their economies through disciplining budget
deficits, public debt, and ERs.
The monetary control was handed to an EU institution;
European Central Bank (ECB). The euro started
circulating (2002) in Austria, Belgium, Finland, France,
Germany, Ireland, Italy, Luxembourg, the Netherlands,
Portugal, and Spain. Greece joined later. UK, Sweden,
and Denmark did not join the euro zone.
 Benefits of euro
• It reduces transaction costs for conducting
business within the zone

• Eliminates ER fluctuation risks

• Businesses focus on Europe rather than

domestic national markets.
 Balance of Payments (BOP)
BOP is a record of country’s transactions with the
rest of the world. It is important for the
businesspeople for the following reasons:
• It shows the demand for the nation’s currency. If
X > I, it is expected that the value of the
currency will strengthen.
• It shows what kind of economic environment
prevails in the country. If BOP is in deficit, then it
is riskier to do business in that country.
Importing becomes more difficult.
 BOP Accounts
• It is double-entry accounting
• Payments to other countries are, funds
flowing out, are tracked as debits (-), and
payments from other countries, funds
flowing in, are tracked as credits (+).
• It has, generally, four major accounts and
many subaccounts:
 (1) Current Account
a. The goods or merchandise account deals with the
import and export of tangibles such as autos, t-shirts,
apples, etc.
b. The services account deals with the import and export
of intangibles, such as insurance, banking, tourism,
etc.
c. Unilateral transfers are transactions with no reciprocity,
such as, workers’ remittances, gifts, payments for
charities, grants, pensions and other transfers.

Net Current Account Balance

 (2) Capital Account
a. Direct investment – They are investments in enterprises or
properties located in one country, but they are controlled by the
residents of another country.
b. Portfolio investment – Long-term investments (more than one
year) that do not give the investors control, or management power
over the object of the investment.
c. Short-term capital flows – Changes in international assets and
liabilities with an original maturity of one year or less, like
currency exchange rate and interest rate hedging in the forward,
futures, options and swap markets; payments and receipts for
international finance and trade, short-term borrowings from
foreign banks, exchanges of foreign notes and coins, purchases
of foreign commercial paper or foreign government bill or notes.
(very difficult to calculate)

Net Capital Account Balance

 (3) Official Reserves Account
a. Gold export or import (net)
b. Increase of decrease in foreign
exchange (foreign currencies) held by
the government (net)
c. Increase or decrease in liabilities in
foreign central banks (net)

Net official reserves

 (4) Net statistical discrepancy

shows the difference between debit and

credit accounts of the BOP.

So, after the debit and credit accounts are

equalized, BOP is zero on both accounts.
 Special drawing rights (SDRs)
IMF created the SDRs in 1969 as a reserve asset as US
dollar was losing value, and other countries did not want
to keep US dollars in their treasury.
SDRs was not a currency but an accounting unit.
The SDRs’ value is based on a basket of currencies: US
dollar (44%), euro (34%), Japanese yen (11%), and
British pound sterlin (11%). The weights broadly reflect
the relative importance of the currencies in trade and
payments. The value of the SDRs is more stable than
any of the single currencies.
Yet, today, SDRs have limited use as a reserve asset.