THE INTERNATIONAL

MONETARY SYSTEM
Mishu Agarwal
Lecturer- AKGIM
 Objectives
► Alternative exchange rate systems
► A brief history of the international monetary
system
► The European monetary system
► Costs and benefits of a single currency
 Evolution of the IMF
 Pre 1875 Bimetallism
 1875-1914: Classical Gold Standard
 1915-1944: Interwar Period
 1945-1972: Bretton Woods System
 1973-Present: Flexible (Hybrid) System
 Pre 1875 Bimetallism
►A double standard in the sense that both gold
and silver were used as money
► Some countries were on the Gold Standard some
on the silver standard, some on both
► Both silver and gold were used as international
means of payment and the exchange rates among
currencies were determined by either their gold
or silver contents
► Gresham’s Law implied that it would be the
least valuable metal that would tend to circulate
 The Classical Gold Standard (1875-
1914)
► The Classical Gold Standard had two essential
features
 Nations fixed the value of the currency in terms of Gold
and
 Gold is freely transferable between countries
► Essentiallya fixed rate system (Suppose the US
announces a willingness to buy gold for $200/oz and
Great Britain announces a willingness to buy gold
for £100. Then £1=$2)
 Interwar Period: 1915-1944
► Periods of serious chaos such as German
hyperinflation and the use of exchange rates as a
way to gain trade advantage.
► Britain and US adopt a kind of gold standard
(but tried to prevent the species adjustment
mechanism from working).
Bretton Woods System:1945-1972

German
British mark French
pound franc
r Par P
Pa lue Va ar
Value lue
Va
U.S. dollar

Pegged at $35/oz.
Gold
 Bretton Woods System:1945-1972
► U.S.$ was key currency valued at $1 = 1/35
oz. of gold
► All currencies linked to that price in a fixed
rate system.
► In effect, rather than hold gold as a reserve
asset, other countries hold US dollars (which
are backed by gold)
 Collapse of Bretton Woods (1971)
► U.S. high inflation rate
► U.S.$ depreciated sharply
► Smithsonian Agreement (1971) US$ devalued to 1/38
oz. of gold
► 1973 The US dollar is under heavy pressure,
European and Japanese currencies are allowed to
float
► 1976 Jamaica Agreement
 Flexible exchange rates declared acceptable
 Gold abandoned as an international reserve
Under a floating rate system, exchange rates
are set by demand and supply
► The model of demand and supply is extremely
useful in explaining exchange rates under a
floating system (just make sure you keep
track of what currency is purchased and what
is sold).
► Any number of factors might influence
exchange rates, including
 price levels
 interest rates
 economic growth
 Alternate exchange rate systems:
Managed Float (“Dirty Float”)
► Market forces set rates unless excess volatility
occurs, then, central bank determines rate by
buying or selling currency. Managed float isn’t
really a single system, but describes a continuum
of systems
 Smoothing daily fluctuations
 “Leaning against the wind” slowing the change to a
different rate
Alternate exchange rate systems:
Managed Float (“Dirty Float”)
 Unofficial pegging: actually fixing the rate
without saying so.
 Target-Zone Arrangement: countries agree to
maintain exchange rates within a certain bound
What makes target zone arrangements special is
the understanding that countries will adjust real
economic policies to maintain the zone.
 Alternate exchange rate
systems: Fixed Rate System
► One way to do this is to dictate an exchange
rate and shoot people who try to trade
currency at anything other than the official
exchange rate. Price controls are hard to
enforce (and even if they could be enforced
lead to a misallocation of resources)
 An alternative is to simply instruct the monetary
authority to buy stand willing to buy or sell currency
at the desired rate

►A fixed rate system is the ultimate good news

bad news joke. The good is very good and the
bad is very bad.
 Advantage: stability and predictability
 Disadvantage: the country loses control of monetary
policy (note that monetary policy can always be used
to control an exchange rate).
 Current Exchange Rate
Arrangements (IMF Classification)
► No national currency (e.g., dollars in
Panama and Euros in Italy)
► Currency Board: Explicit commitment to fix
exchange rates to some foreign currency
(Hong Kong fixed to dollar)
► Other fixed rate systems fixing the countries
currency to a single currency or some
basket of currencies (allowing some narrow
fluctuations of less than 1%)
 Current Exchange Rate
Arrangements (IMF Classification)
► Crawling pegs: exchange rate adjusted at a
pre-announced rate, usually in response to
some objective qualitative indicator (e.g.,
Costa Rica).
► Floating within crawling bands
► Managed float: authorities manipulate the
exchange rate but do not announce their
intentions
► Independent float
 The Mexican Peso Crisis
► On 20 December, 1994, the Mexican
government announced a plan to devalue
the peso against the dollar by 14 percent.
► This decision changed currency trader’s
expectations about the future value of the
peso.
► They stampeded for the exits.
► In their rush to get out the peso fell by as
much as 40 percent
 The Mexican Peso Crisis
► The Mexican Peso crisis is unique in that it
represents the first serious international
financial crisis touched off by cross-border
flight of portfolio capital.
► Two lessons emerge:
 It is essential to have a multinational safety net
in place to safeguard the world financial system
from such crises.
 An influx of foreign capital can lead to an
overvaluation in the first place.
The Asian Currency Crisis (1997)
► In 1996 several Asian countries experienced an
inflow of nearly $100 billion in foreign capital.
► This explosion of credit led to a kind of speculative
bubble in some sectors (e.g., real estate).
► In mid-1997 the Thai bhat came under much
pressure. The Thai Central Bank tried to defend
the bhat by drawing down foreign exchange
reserves. In the end, however, they had to
devalue and the bhat lost about 40% of its value
The Asian Currency Crisis (1997)
► The Asian currency crisis turned out to be
far more serious than the Mexican peso
crisis in terms of the extent of the contagion
and the severity of the resultant economic
and social costs.
► Many firms with foreign currency bonds
were forced into bankruptcy.
► The region experienced a deep, widespread
recession.
 The Argentinean Peso Crisis
► In 1991 the Argentine government passed a
convertibility law that linked the peso to the U.S.
dollar at parity.
► The initial economic effects were positive:
 Argentina’s chronic inflation was curtailed
 Foreign investment poured in
► As the U.S. dollar appreciated on the world
market the Argentine peso became stronger as
well
 The Argentinean Peso Crisis
► The strong peso hurt exports from Argentina and
caused a protracted economic downturn that led
to the abandonment of peso–dollar parity in
January 2002.
 The unemployment rate rose above 20 percent
 The inflation rate reached a monthly rate of 20
percent
 The Argentinean Peso Crisis
► There are at least three factors that are related to
the collapse of the currency board arrangement
and the ensuing economic crisis:
 Lack of fiscal discipline
 Labor market inflexibility
 Contagion from the financial crises in Brazil and
Russia
 Benefits of Single Currency
► Reduces exchange rate risk
► Allows for larger capital markets which may
provide greater liquidity
► May promote a sense of political unity among
nations sharing the currency
 Costs of a Single Currency
► Lack of national monetary flexibility.
► Leaving countries vulnerable to “asymmetric
shocks” (problems in one country not
common to all)