IBF301- INTERNATIONAL FINANCE

CHAPTER 2
International Monetary System

Taught by Que Anh Nguyen - FPT School of

Business (FSB)

Original Slides by Cheol S. Eun and Bruce G.

Resnick, 8th.

Based on: Cheol S. Eun and Bruce G. Resnick, 9th,

International Financial Management
Agenda
1. Evolution of the International Monetary System from 1875 to Present
2. The Current Exchange Rate Arrangements
3. European Monetary System
4. The Euro and the European Monetary Union
5. The Mexican Peso, Asian Currency, Argentine Peso Crises
6. Fixed versus Flexible Exchange Rate Regimes
Chapter Objective:

1. This chapter examines the international monetary system, which defines the
overall financial environment in which multinational corporations and
international investors operate.
2. In this chapter, we will review the history of the international monetary system
and contemplate its future prospects.
3. In addition, we will compare and contrast the alternative exchange rate
systems, that is, fixed versus flexible exchange rates.
 1. Evolution of the International Monetary System
1.1. International Monetary System
▪ International Monetary System
Institutional framework within which
international payments are made,
movements of capital are accommodated,
and exchange rates among currencies
are determined.
▪ Institutional framework: A complex whole
of agreements, rules, institutions,
the che mechanisms, and policies regarding
exchange rates, international payments,
and the flow of capital.
1. Evolution of the International Monetary System
1.2. Evolution of the International Monetary System
• The international monetary system went through several distinct stages of evolution:

1875-1914 1945-1972 1973 - Now

Before 1875 1915-1944 The Flexible
Classical Gold Bretton Woods
Bimetallism Interwar Period
Standard System Exchange Rate
 1. Evolution of the International Monetary System
1.3. Bimetallism: Before 1875
▪ Bimetallism was a “double standard” in the sense that free coinage was maintained for
both gold and silver.
▪ In Great Britain, bimetallism was maintained until 1816 (after the Napoleonic Wars) when
Parliament passed a law maintaining free coinage of gold only. In the United States, until
1873, Congress dropped the silver dollar only.
bad money
▪ Gresham’s law: under the bimetallic standard, the abundant metal was used as money
while the scarce metal was driven out of circulation, because the ratio of the two
metals was officially fixed good money
-> bad money van hanh tren thi truong

When gold from newly discovered mines in California and Australia poured
into the market in the 1850s, the value of gold became depressed, causing
overvaluation of gold under the French official ratio. As a result, the franc
effectively became a gold currency.

[Link]
1. Evolution of the International Monetary System
1.4. Classical Gold Standard: 1875-1914 -> duoc van chuyen vang

▪ First full-fledged gold standard, a monetary system in which currencies are defined in
terms of their gold content, was established in 1821 in Great Britain
du tru vang
▪ Majority of countries moved away from gold in 1914 when World War I began
▪ Under the gold standard, the exchange rate between any two currencies will be
determined by the gold contents

▪ Suppose the pound (£) is pegged to gold at six pounds (£6) per
ounce, whereas one ounce of gold is worth 12 francs (₣)
▪ £6 = 1 oz. gold
▪ ₣12 = 1 oz. gold
▪ Deducing from the information given above, £6 must equal ₣12
▪ 6/12 reduces to 1/2; therefore £1 = ₣2
▪ Exchange rate between the pound and the franc should then be two
francs per pound
1. Evolution of the International Monetary System
1.4. Classical Gold Standard: Adjustment Mechanism
▪ Price-specie-flow mechanism was an automatic correction of payment imbalanced
between countries operating under the gold standard
▪ Based on the fact that domestic money stock rises or falls as the country experiences
inflows or outflows of gold
▪ Misalignment of exchange rate will be automatically adjusted by cross border flow of
gold.
Suppose Great Britain exported more to France than France imported from Great Britain.
◦ Net export of goods from Great Britain to France will be accompanied by a net flow of
gold from France to Great Britain.
◦ This flow of gold will lead to a lower price level in France and, at the same time, a higher
price level in Britain.

The resultant change in relative price levels will slow exports from Great Britain and
encourage exports from France.
1. Evolution of the International Monetary System
1.4. Classical Gold Standard
Key supportive points:
▪ The money supply cannot get out of control and cause inflation
thanks to gold scarcity.
▪ Countries’ balance of payments will be regulated automatically via the
movements of gold.
→ no country may have a persistent trade deficit or surplus

Key shortcomings:
▪ Supply of newly minted gold is so restricted that the growth of
world trade and investment can be seriously hampered for lack of
sufficient monetary reserves. Deflationary pressure.
▪ No mechanism to compel each major country to abide by the rules
of the game

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1. Evolution of the International Monetary System
1.5. Interwar Period: 1915–1944
▪ After WWI, many countries (i.e. Germany, Austria, Hungary, Poland, and Russia), suffered
hyperinflation.
▪ Exchange rates were fluctuating in the early 1920s. Countries used “predatory” depreciations
of their currencies to gain advantages in the world export market.
▪ The US, which replaced Great Britain as the dominant financial power, spearheaded efforts
to restore the gold standard.
▪ In the wake of the Great Depression in 1929, the restored gold standard crumbled down as
many banks, especially in Austria, Germany, and the United States, suffered sharp declines
in their portfolio values, touching off runs on the banks.
❑ In Sep 1931, the British government suspended gold payments and let the pound float.
❑ Countries such as Canada, Sweden, Austria, and Japan followed by the end of 1931.
❑ The US got off gold in April 1933 after experiencing bank failures and outflows of gold.
❑ Lastly, France abandoned the gold standard in 1936 because of the flight from the franc.
1. Evolution of the International Monetary System
1.6. Bretton Woods System:1945-1972
▪ Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire, to design a
postwar international monetary system, which was described as a dollar-based gold-
exchange standard.
▪ Representatives succeeded in drafting and signing the Articles of Agreement of the
International Monetary Fund (IMF).
▪ Delegates also created a sister institution better known as the World Bank chiefly responsible
for financing individual development projects German
British mark French
pound franc
Par
Design of the Gold- Value
Exchange System
U.S. dollar

Pegged at $35/oz.
Gold
1. Evolution of the International Monetary System
1.6. Bretton Woods System:1945-1972

▪ Advocate of Bretton woods system:

❑ Countries can use not only gold but also foreign exchanges as an international
means of payment.
❑ Foreign exchange reserves offset the deflationary effect
❑ Countries earn interest on foreign exchange holding.
❑ Countries can save transaction cost.
▪ Triffin paradox explains the collapse of this system in the early 1970s
Reserve-currency country (US) should run a balance of payments deficit to
supply the dollar to the rest of the world, but this can decrease confidence in the
reserve currency and lead to the downfall of the system

2-12
 1. Evolution of the International Monetary System
1.6. Bretton Woods System:1945-1972

• Special Drawing Rights (SDR), which is a basket currency comprising major

individual currencies, was allotted to the members of the IMF based on export
contribution, who could then use it for transactions among themselves or with the IMF.

The SDR was greatly simplified

to comprise only 5 major
currencies: U.S. dollar, German The Chinese yuan
mark, Japanese yen, British was added to the
1970 pound, and French franc. 1999
SDR basket

The SDR was designed to be the With the advent of the euro in
weighted average of 16 currencies 1981 1999, the SDR became 2016
of those countries whose shares in composed of just 4 major
world exports were more than 1%. currencies: the U.S. dollar,
The weight of each currency in the the euro, the British pound,
SDR ~ the country’s share in and the Japanese yen.
world exports.
 1. Evolution of the International Monetary System
1.7. The Flexible Exchange Rate Regime: 1973–Present
• The flexible exchange rate regime following the demise of the Bretton Woods system was
ratified in January 1976 when the IMF members met in Jamaica to set new monetary system.
The Jamaica Agreement:
EXHIBIT 2.3 The Trade-Weighted Value of the U.S. Dollar
since 1964 1. Flexible exchange rates
were accepted. Central banks
were allowed to intervene in
the exchange rate markets to
iron out unwarranted
volatilities.
2. Gold was abandoned as an
international reserve asset.
3. Non-oil-exporting countries
and less-developed
countries were given greater
access to IMF funds.
 2. Current Exchange Rate Arrangements

According to IMF annual report (2018), the IMF classifies exchange rate arrangements into 10 regimes:

khong co dong tien rieng Ecuador, El Salvador,

No exchange 1. No separate The currency of another country circulates as the
Panama using the US
rate flexibility legal tender sole legal tender.
dollar.
usd bien dong -> xnk cua nuoc do bien dong -> tham nhung -> khkt
Legislative commitment to exchange domestic
2. Currency Hong Kong, Bulgaria,
currency for a specified foreign currecy at a fixed
board and Brunei.
exchange rate.
The country formally (de jure) pegs its currency at a
fixed rate to another currency or a basket of
3. Conventional currencies, where the basket is formed, for Jordan, Saudi Arabia,
fixed pegs example, from the currencies of major trading or and Morocco.
financial partners and weights reflect the geographic
distribution of trade, services, or capital flows.
A spot market exchange rate that remains within a
4. Stabilized Cambodia, Singapore,
margin of 2 percent for 6 months or more and is not
arrangement and Lebanon.
floating.
 2. Current Exchange Rate Arrangements
According to IMF annual report (2018), the IMF classifies exchange rate arrangements into 10 regimes:
The currency is adjusted in small amounts at a fixed
rate or in response to changes in selected
Some exchange quantitative indicators, such as past inflation Honduras and
5. Crawling peg
rate flexibility differentials vis-à-vis major trading partners or Nicaragua.
differentials between the inflation target and
expected inflation in major trading partners.
The exchange rate must remain within a narrow
6. Crawl-like margin of 2% relative to a statistically identified trend Ethiopia, China, and
arrangement for 6 months or more, and the exchange rate Croatia
arrangement cannot be considered as floating.
The value of the currency is maintained within
7. Pegged
certain margins of fluctuation of at least ±1% around
exchange rate
a fixed central rate, or the margin between the Tonga
within horizontal
maximum and minimum value of the exchange rate
banks
exceeds 2%.
8. Other This category is a residual, and is used when the
Algeria, Nigeria, and
managed exchange rate arrangement does not meet the
Malaysia.
arrangement criteria for any of the other categories.
 2. Current Exchange Rate Arrangements
According to IMF annual report (2018), the IMF classifies exchange rate arrangements into 10 regimes:

A floating exchange rate is largely market

determined, without an ascertainable or
predictable path for the rate. In particular, an
Flexible exchange rate that satisfies the statistical criteria Brazil, Korea, Turkey,
9. Floating
exchange rates for a stabilized or a crawl-like arrangement will and India
be classified as such unless it is clear that the
stability of the exchange rate is not the result of
official actions.
If intervention occurs only exceptionally and aims
to address disorderly market conditions and if the
Canada, Mexico, Japan,
authorities have provided information or data
10. Free floating the U.K., United States,
confirming that intervention has been limited to at
and euro zone.
most three instances in the previous 6 months,
each lasting no more than 3 business days.
3. European Monetary System

• European countries maintain exchange rates among their currencies

within narrow bands (±1.125% although Smithsonian Agreement
stipulated a band of ±2.25%) → snake
• The euro jointly floats against outside currencies.
• The snake arrangement was replaced by the European Monetary
System (EMS) in 1979

Objectives of the EMS:

◦ To establish a “zone of monetary stability” in Europe.
◦ To coordinate exchange rate policies vis-à-vis non-European
currencies.
◦ To pave the way for the eventual European Monetary Union.

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3. European Monetary System

▪ The European Currency Unit (ECU) is a “basket”

currency constructed as a weighted average of the
currencies of member countries of the European
Union (EU) based on each currency’s relative
GNP and share in intra-EU trade.
▪ The ECU serves as the accounting unit of the EMS.
▪ ECU was the monetary unit used by the European
Monetary System (EMS) before being replaced by
the euro.
3. European Monetary System

▪ The Exchange Rate Mechanism (ERM)

refers to the procedure by which EMS member
countries collectively manage their exchange
rates.
▪ When the EMS was launched in 1979, a
currency was allowed to deviate from the
parities with other currencies by a maximum of
± 2.25%, with the exception of the Italian lira,
for which a maximum deviation of ± 6 % was
allowed.
▪ In September 1993, however, the band was
widened to a maximum of plus or minus 15
percent.
4. The Euro and the European Monetary Union
4.1. Brief history of the Euro

▪ According to Maastricht Treaty in 1991, EMS would irrevocably fix exchange rates among
the member currencies by January 1, 1999 and subsequently introduce a common European
currency, replacing individual national currencies
• Monetary policy for euro zone countries is now conducted by the European Central Bank
(ECB) (head quartered in Frankfurt, Germany)
• Primary objective is to maintain price stability
• Independence is legally guaranteed
• Eurosystem is made up of ECB and central banks of euro-zone countries; governors of
national central banks will sit on the Governing Council of the ECB
• Eurosystem tasks include:
1. Defining and implementing common monetary policy of the Union
2. Conducting foreign exchange operations
3. Holding and managing official foreign reserves of euro member states
4. The Euro and the European Monetary Union
4.1. Brief history of the Euro
As the euro was introduced, each national currency of the euro-11 countries was
irrevocably fixed to the euro at a conversion rate as of January 1, 1999.
4. The Euro and the European Monetary Union
4.2. Benefits and Costs of Monetary Union
Key benefits:
▪ Reduced transaction costs
▪ Elimination of exchange rate uncertainty
▪ Enhanced efficiency and competitiveness of the European economy
▪ Conditions conducive to the development of continental capital
markets with depth and liquidity comparable to those of the U.S.
▪ Political cooperation and peace in Europe

Key shortcomings:
▪ Loss of national monetary and exchange rate policy independence
 5. The Currency Crises
5.1. The Mexican Peso Crisis

▪ On December 20, 1994, the Mexican government under new president Ernesto Zedillo
announced its decision to devalue the peso against the dollar by 14%.
▪ By early Jan 1995 the peso had fallen against the U.S. dollar by 40%, forcing the Mexican
government to float the peso.

▪ Faced with an impending default by the

Mexican government and the possibility of a
global financial meltdown, the Clinton
administration, and the IMF and the Bank for
International Settlement (BIS), put together
a $53 billion package to bail out Mexico.

U.S. Dollar versus Mexican Peso Exchange

Rate (Nov1, 1994– Jan31, 1995)
 5. The Currency Crises
5.1. The Mexican Peso Crisis

▪ The Mexican peso crisis is significant in that it is perhaps the first serious international
financial crisis touched off by cross-border flight of portfolio capital.
▪ International mutual funds are known to have invested more than $45 billion in Mexican
securities during a 3-year period prior to the peso crisis.

▪ 2 lessons:
1. It is essential to have a multinational safety net in place to safeguard the world financial
system from the peso-type crisis.
2. A flood of foreign money had two undesirable effects. It led to an easy credit policy on
domestic borrowings, which caused Mexicans to consume more and save less. Foreign
capital influx also caused a higher domestic inflation and an overvalued peso, which hurt
Mexico’s trade balances.
 5. The Currency Crises
5.2. The Asian Currency Crisis (1997)
Far more serious than the crises of the EMS and Mexican peso 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

Origins
• As capital markets were opened, large inflows of private capital
resulted in a credit boom in the Asian countries in the early or mid-
1990s.
• Fixed or stable exchange rates also encouraged unhedged financial
transactions and excessive risk-taking by both borrowers and lenders
• The real exchange rate rose, which led to a slowdown in export
growth.
• Also, Japan’s long-lasting recession (and yen depreciation) hurt trade
balances of neighboring countries
 5. The Currency Crises
5.2. The Asian Currency Crisis (1997)
▪ On Jul 2, 1997, the Thai baht, largely fixed to the U.S. dollar, was suddenly devalued.
▪ As the run on the baht started, the Thai central bank initially injected liquidity to the system and
tried to defend the exchange rate by drawing on its foreign exchange reserves.
▪ Sudden collapse of the bhat touched off a panicky flight of capital from other Asian countries

EXHIBIT 2.10 (page 110) – Asian Currency Crisis EXHIBIT 2.11 (page 112) – Financial Vulnerability Indicators
 5. The Currency Crises
5.2. The Asian Currency Crisis (1997)
Lessons
1. A fixed, but adjustable, exchange rate is problematic in the face of integrated international
financial markets, which invites speculative attack at the vulnerable time.
A fixed
→ If the Asian currencies had been allowed to depreciate in real
exchange rate
terms, the sudden and catastrophic changes in exchange rates
in 1997 might have been avoided

2. A number of measures should be undertaken to

strengthen a nation’s domestic financial system
(Basel Standards, reliable timely data)
3. It should encourage FDI and equity and long-term Free international Independent
bond investments; it should not encourage short-term flows of capital monetary policy
investments that can be cause financial turmoil.
Incompatible trinity suggests it is very difficult/
impossible, to have all 3 conditions:
 5. The Currency Crises
5.3. The Argentine Peso Crisis (2002)
The 2002 crisis of the Argentine peso shows that even a currency board arrangement cannot be
completely safe.
There are at least three factors that are related to the collapse of the currency board
(i) lack of fiscal discipline: the government
encountered increasing difficulty with
rising debts, eventually defaulting on its
internal and external debts.
(ii) labor market inflexibility: powerful labor
union also made it difficult to lower wages
and thus cut production costs.
(iii) contagion from the financial crises in
Russia and Brazil: a slowdown of
international capital inflows following the
financial crises in Russia and Brazil.
6. Fixed versus Flexible Exchange Rate Regimes

In favor of flexible exchange rates:

▪ Easier external adjustments.
▪ National policy autonomy (independence).

Against flexible exchange rates:

▪ Exchange rate uncertainty may hamper international trade.
▪ No safeguards to prevent crises.

• A “good” (or ideal) international monetary system should provide:

(i) liquidity: should be able to provide the world economy with sufficient monetary
reserves to support the growth of international trade and investment.
(ii) adjustment: provide an effective mechanism that restores the balance-of-payments
equilibrium whenever it is disturbed;
(iii) confidence: offer a safeguard to prevent crises of confidence in the system that result
in panicked flights from one reserve asset to another
Summary
IBF301 – Chapter 2
Summary

1. The international monetary system can be defined as the institutional framework

within which international payments are made, the movements of capital are
accommodated, and exchange rates among currencies are determined.
2. The international monetary system went through five stages of evolution: (a)
bimetallism, (b) classical gold standard, (c) interwar period, (d) Bretton Woods system,
and (e) flexible exchange rate regime.
3. The classical gold standard spanned 1875 to 1914. Under the gold standard, the
exchange rate between two currencies is determined by the gold contents of the
currencies. Balance-of-payments disequilibrium is automatically corrected through the
price-specie-flow mechanism. The gold standard still has ardent supporters who believe
that it provides an effective hedge against price inflation. Under the gold standard,
however, the world economy can be subject to deflationary pressure due to the limited
supply of monetary gold.
Summary

4. To prevent the recurrence of economic nationalism with no clear “rules of the game” witnessed during the
interwar period, representatives of 44 nations met at Bretton Woods, New Hampshire, in 1944 and adopted
a new international monetary system. Under the Bretton Woods system, each country established a par
value in relation to the U.S. dollar, which was fully convertible to gold. Countries used foreign exchanges,
especially the U.S. dollar, as well as gold as international means of payments. The Bretton Woods system
was designed to maintain stable exchange rates and economize on gold. The Bretton Woods system
eventually collapsed in 1973 mainly because of U.S. domestic inflation and the persistent balance-of-
payments deficits.
5. The flexible exchange rate regime that replaced the Bretton Woods system was ratified by the Jamaica
Agreement. Following a spectacular rise and fall of the U.S. dollar in the 1980s, major industrial countries
agreed to cooperate to achieve greater exchange rate stability. The Louvre Accord of 1987 marked the
inception of the managed-float system under which the G-7 countries would jointly intervene in the foreign
exchange market to correct over- or undervaluation of currencies.
6. In 1979, the EEC countries launched the European Monetary System (EMS) to establish a “zone of
monetary stability” in Europe. The two main instruments of the EMS are the European Currency Unit (ECU)
and the Exchange Rate Mechanism (ERM). The ECU is a basket currency comprising the currencies of the
EMS members and serves as the accounting unit of the EMS. The ERM refers to the procedure by which
EMS members collectively manage their exchange rates. The ERM is based on a parity grid that the
member countries are required to maintain.
Summary

7. On January 1, 1999, 11 European countries, including France and Germany, adopted a common
currency called the euro. Greece adopted the euro in 2001. Subsequently, five other countries—Cyprus,
Malta, Slovakia, Slovenia, and Estonia—adopted the euro. The advent of a single European currency,
which may eventually rival the U.S. dollar as a global vehicle currency, will have major implications for the
European as well as world economy. Euro-zone countries will benefit from reduced transaction costs and
the elimination of exchange rate uncertainty. The advent of the euro will also help develop continentwide
capital markets where companies can raise capital at favorable rates.
8. Under the European Monetary Union (EMU), the common monetary policy for the euro-zone countries is
formulated by the European Central Bank (ECB) located in Frankfurt. The ECB is legally mandated to
maintain price stability in Europe. Together with the ECB, the national central banks of the euro-zone
countries form the Euro system, which is responsible for defining and implementing the common monetary
policy for the EMU.
9. While the core EMU members, including France and Germany, apparently prefer the fixed exchange rate
regime, other major countries such as the United States and Japan are willing to live with flexible exchange
rates. Under the flexible exchange rate regime, governments can retain policy independence because the
external balance will be achieved by the exchange rate adjustments rather than by policy intervention.
Exchange rate uncertainty, however, can potentially hamper international trade and investment. The choice
between the alternative exchange rate regimes is likely to involve a trade-off between national policy
autonomy and international economic integration..