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Chapter Two
The International Monetary
System

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 Overview
Evolution of the International Monetary System.
Bimetallism: Before 18 75.
Classical Gold Standard: 18 75 to 19 14.
Interwar Period: 19 15 to 19 44.
Bretton Woods System: 19 45 to 19 72.
Flexible Exchange Rate Regime: 19 73 to Present.
Current Exchange Rate Arrangements.
Cryptocurrencies.
Euro and European Monetary Union.
Mexican Peso Crisis.
Asian Currency Crisis.
Rise of Chinese R M B.
Fixed versus Flexible Exchange Rate Regimes.
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 International Monetary System
International monetary system is a complex set of
agreements, rules, and mechanisms regarding exchange
rates, international payments, and capital flow.

It is the institutional framework within which international

payments are made, movements of capital are
accommodated, and exchange rates among currencies are
determined.

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 Evolution of the International Monetary
System
International monetary system went through several distinct
stages of evolution, summarized as follows:
• Bimetallism: Before 1875.
• Classical gold standard: 1875 to 1914.
• Interwar period: 1915 to 1944.
• Bretton Woods system: 1945 to 1972.
• Flexible exchange rate regime: Since 1973.

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 Bimetallism: Before 1875
Bimetallism was a “double standard” in that free coinage
was maintained for both gold and silver.
• Exchange rates among currencies were determined by
their gold or silver contents.
Countries on the bimetallic standard often experienced the
well-known phenomenon referred to as Gresham’s law:
• Gresham’s law: Since the exchange ratio between the
two metals was officially fixed, the abundant metal was
used as money while the scarce metal was driven out of
circulation (usually temporarily).
Eventually however, gold prevail over silver because of its
relative stability and value, and market confidence as reliable
store of value compared to silver.
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 Classical Gold Standard: 1875 to 1914
An international gold standard exists when:
• Gold alone is assured of unrestricted coinage.
• There is two–way convertibility between gold and national
currencies at a stable ratio.
• Gold can be freely exported or imported.

Under the gold standard, the exchange rate between any two
currencies will be determined by the gold contents of the
currency.
London became the center of the international financial
system during the classical gold standard era.

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 Classical Gold Standard: An Example
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 above, £6 must equal ₣12.

• £6 = ₣12; therefore £1 = ₣2.

Exchange rate between the pound and the franc should then
be two francs per pound.

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 Classical Gold Standard: Advantages
• Highly stable exchange rates that are conducive for
international trade.
• Money supply cannot get out of control and cause inflation
because gold is naturally scarce.
• No country can have a persistent trade deficit or surplus
because countries’ balance of payments will be regulated
automatically via the movements of gold.
• Misalignment of exchange rates and international
imbalances of payment were automatically corrected by
the price-specie-flow mechanism

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 Price-Specie-Flow Mechanism
Suppose Great Britain exports more to France than France
export to Great Britain.
This cannot persist under a gold standard.
• 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 (more
supply of money in UK)
The resultant change in relative price levels will slow exports
from Great Britain and encourage exports from France

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 Price-Specie-Flow Mechanism

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 Classical Gold Standard: Shortcomings

• Lack of sufficient monetary reserves due to the restricted

supply of newly minted gold can hamper the growth of
world trade and investment.
• No mechanism to compel or enforce each major country to
abide by the rules of the game (fixed rate of gold content to
currency).
• Some argued that gold standard leads to more volatility in
inflation and GNP growth and less stable financial system
(eg banking crisis).

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 Interwar Period: 1915 to 1944
World War I ended the classical gold standard in August
1914.
Attempts were made to restore the gold standard, but they
ultimately failed.
Period marked by the Great Depression and other economic
and political instabilities.
No coherent international monetary system during this
period, with detrimental impact on international trade and
investment.

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 Bretton Woods System: 1945 to 1972 1

Named for the July 1944 meeting of 44 nations at Bretton Woods,

New Hampshire.
The purpose:
• To design a postwar international monetary system that would
provide exchange rate stability without the gold standard.

The result:
• Dollar–based gold exchange standard: U.S. dollar was pegged
to gold and other currencies were pegged to the U.S. dollar.
U.S. dollar was the only currency fully convertible to gold.
• Dominance of U.S. dollar as the global currency.
• Creation of the IMF and the World Bank.

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 The Design of the Gold–Exchange System

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 Bretton Woods System: 1945 to 1972 2

Advantages:
• Economizes on gold.
• Countries can earn interest on F X holdings.
• Lower transaction costs without the transportation of gold.
• Stable exchange rates.

Shortcomings (that is, Triffin paradox) that lead to the collapse of

the system in the early 19 70s:
• The reserve currency country has to run a balance of payments
deficit to satisfy the growing need for reserves from the rest of
the world.
• It can decrease confidence in the reserve currency (i.e. dollar)
and lead to the downfall of the system.
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 The Chronology…

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 The Flexible Exchange Rate Regime: 1973 to
Present
Flexible exchange rate regime was ratified in January 1976
when the IMF members met in Jamaica and agreed to a new
set of rules, referred to as the Jamaica Agreement:
1. Flexible exchange rates were declared acceptable to the I
MF members; Central banks could intervene in exchange
markets to iron out unwarranted volatilities.
2. Gold was officially abandoned (that is, demonetized) as
an international reserve asset.
3. Non–oil–exporting countries and less–developed
countries were given greater access to IMF funds.
No more gold-backed currency, but fiat currency.

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 Current Exchange Rate Arrangements 1

No separate legal tender:

• Currency of another country circulates as the sole legal tender (for example,
Ecuador, El Salvador, and Panama).

Currency board:
• An extreme form of the fixed exchange rate regime under which local currency
is fully backed by a foreign currency at a fixed exchange rate leaving little room
for discretionary monetary policy (for example, Hong Kong, Bulgaria, and
Brunei).

Conventional peg:
• Country formally pegs its currency at a fixed rate to another currency or basket
of currencies (for example, Jordan, Saudi Arabia, and Nepal).

Stabilized arrangement:
• Entails a spot market exchange rate that remains within a margin of 2% for 6
months or more (for example, Vietnam, Nigeria, and Lebanon).

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 Current Exchange Rate Arrangements 2

Crawling peg:
• The currency is adjusted in small amounts at a fixed rate or in
response to changes in selected indicators (for example, Honduras
and Nicaragua).

Crawl–like arrangement:
• Exchange rate must remain within a narrow margin of 2% relative to a
statistically identified trend for 6 months or more, and the exchange
rate cannot be considered floating (for example, Singapore, Romania,
and Tunisia).

Pegged exchange rate with horizontal bands:

• Value of the currency is maintained within certain margins of
fluctuation of at least +/− 1% around a fixed central rate, or the margin
between the maximum and minimum value of the exchange rate
exceeds 2%.
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 Current Exchange Rate Arrangements 3

Other managed arrangement:

• Residual category used when the exchange rate arrangement does
not meet the criteria for any of the other categories (for example,
China, Argentina, and Kuwait).

Floating:
• Exchange rate is largely market determined, without an ascertainable
or predictable path for the rate (for example, Brazil, Korea, Turkey,
India, South Africa, and Thailand).

Free floating:
• Intervention occurs only exceptionally and aims to address disorderly
market conditions; intervention has been limited to at most 3 instances
in the previous 6 months, each lasting no more than 3 business days
(for example, Australia, Canada, Mexico, Japan, U.K., U.S., and euro
zone).
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 Cryptocurrencies 1

Fiat currencies are put into circulation by governments and

have no intrinsic values backed by claims on underlying real
assets like gold, etc.
Cryptocurrency is a digital currency designed to function as
a “medium of exchange” through a decentralized network of
computers that keep public records of transaction data using
mostly cryptographic technology, without the involvement of
governments or central banks.
Central Bank Digital Currency (CBDC) is essentially a
digital version of the fiat currency issued by the central bank.
The majority of central banks are actively researching the
potential for CBDCs, but only a few (Bahamas, Jamica,
Nigeria) been formally adopted.
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 Cryptocurrencies 2

The first and most important cryptocurrency, Bitcoin, was

introduced as an open–source software in January 2009, followed
by many others like Ethereum and Litecoin, etc.
Given the extreme volatility of its price, Bitcoin was found to be
unsuitable to serve the functions of money:
• unit of accounting.
• medium of exchange.
• storage of value.

Instead, Bitcoin has been used as a highly speculative asset class.

Despite its extreme volatility, E l Salvador selected Bitcoin as legal
tender in September 2021 and Central African Republic in April
2022.

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 European Monetary System
The European Monetary System (E MS) was formally launched in
1979 with the following goals:
• To establish a “zone of monetary stability” in Europe.
• To coordinate exchange rate policies vis-à-vis the non-E MS
currencies.
• To pave the way for the eventual European monetary union.
Two main instruments of the E MS were:
• European Currency Unit (ECU), precursor of the euro.
• Exchange Rate Mechanism (ERM) – a system to manage
member’s currency value against others
The EMS went through a series of realignments and paved the
way for the European Monetary Union (EMU).

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 The Euro and the European Monetary
Union 1

On January 1, 1999, 11 of 15 EU countries adopted a

common currency, the euro.
• European Monetary Union (EMU) was created.

Each national currency of the euro–11 countries was

irrevocably fixed to the euro at a conversation rate as of
January 1, 1999.
Euro notes and coins were introduced to circulation on
January 1, 2002, while national bills and coins were being
gradually withdrawn.
The first time sovereign countries voluntarily have given up
their monetary independence to foster economic integration.

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 The Dollar–Euro Exchange Rate

Source: Datastream

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 The Euro and the European Monetary
Union 2

Monetary policy for the euro zone countries is conducted by

the European Central Bank (ECB), headquartered in
Frankfurt.
• Primary objective is to maintain price stability.
• Independence is legally guaranteed.
Eurosystem is made up of the ECB and central banks of the
euro–zone countries and is designed to:
• Define and implement common monetary policy of the
Union.
• Conduct foreign exchange operations.
• Hold and manage official foreign reserves of euro member
states.
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 Benefits and Costs of Monetary Union

Key benefits:
• Reduced transaction costs.
• Elimination of exchange rate uncertainty.
• Enhanced efficiency and competitiveness of the European
economy.
• Development of continental capital markets with depth and
liquidity comparable to those of the U.S.
• Political cooperation and peace in Europe.

Main cost:
• Loss of national monetary and exchange rate policy
independence, which makes it hard to deal with asymmetric
shocks.
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 Currency Crises
Three major currency crises revealed the fragility of the
international monetary system (IMS):
• Mexican peso crisis (1994 to 1995).
• Asian currency crisis (1997 to 1998).
• Argentine peso crisis (2002).

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 The Mexican Peso Crisis 1

On December 20, 1994, the Mexican government announced

a plan to devalue the peso against the dollar by 14 percent.
This decision caused pesos, as well as Mexican stocks and
bonds, to be sold rapidly.
• By early January 1995, the peso had fallen against the
U.S. dollar by as much as 40 percent, forcing the Mexican
government to float the peso.

Peso crisis rapidly spilled over to other Latin American and Asian
financial markets.

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 U.S. Dollar versus Mexican Peso Exchange Rate
(November 1, 1994 to January 31, 1995)

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 The Mexican Peso Crisis 2

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.
• Mexico excessively depended on foreign portfolio capital to
finance economic development when a higher priority
should have been placed on saving domestically.

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 The Asian Currency Crisis 1

On July 2, 1997, the Thai baht, which had been largely fixed
to the U.S. dollar, was suddenly devalued.
Sudden collapse of the baht touched off a panicky flight of
capital from other Asian countries.
It quickly escalated into a global financial crisis far more
serious than the Mexican peso crises.
It led to an unprecedented deep, widespread, and long-
lasting recession in East Asia, a region that has enjoyed the
most rapidly growing economy in the world over the previous
decades.

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 The Asian Currency Crisis 2

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 Origins of the Asian Currency Crisis
Factors responsible for the onset of the crisis:
• Weak domestic financial system with poor risk management and
supervision by regulators.
• Free international capital flows that resulted in a credit boom
and speculations in real estate and stock markets.
• Fixed or stable exchange rates encouraged unhedged financial
transactions and excessive risk–taking by both borrowers and
lenders.
• Booming economy with a fixed exchange rate also brought
about an appreciation of the real exchange rate, which led to a
slowdown in export growth.
• Japan’s long–lasting recession (and yen depreciation) hurt
neighboring countries too.
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 Lessons from the Asian Currency Crisis

Generally, liberalization of financial markets when combined

with a weak, underdeveloped domestic financial system
tends to create an environment susceptible to currency and
financial crises.
Incompatible trinity suggests it is very difficult, if not
impossible, to have all three conditions:
1. A fixed exchange rate.
2. Free international flows of capital.
3. Independent monetary policy.

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 Rise of the Chinese Renminbi
China has become one of the top trading powers and the second largest
economy in the world, but its currency, the renminbi (R MB), has not
achieved similar international prominence mainly due to the limited
openness of China’s capital markets.
IMF included RMB as one of the constituent currencies of the S DR since
2016.
China has been gradually lowering barriers to international capital flows
and promoting a greater usage of R MB in international transactions.
China’s currency has the potential to become a global currency, but
China will need to meet a few critical conditions:
• Full convertibility of its currency.
• Open capital markets with depth and liquidity.
• Rule of law and protection of property rights.
How much is RMB used in international trade now?

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 Fixed versus Flexible Exchange Rate
Regimes 1

In general, there are 2 system, i.e., fixed and flexible

exchange rate system. Arguments in favor of flexible
exchange rates:
• Easier external adjustments. No need to reduce aggregate
demand, market correct itself.
• No need to maintain large international reserves
• National policy autonomy - for e.g., interest rate change not to
adjust exchange rate, but for other macroeconomics goals like
employment and growth.
• Increase market efficiency – rates are determined by market
forces which reflect a country’s economic conditions such as
interest rates, inflation rates, etc.

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 Fixed versus Flexible Exchange Rate
Regimes
Some arguments against flexible exchange rates:
• Lead to exchange rate uncertainty and instability that may
hamper international trade.
• Less accountability of government who may increase
money supply at will, leading to economic instability.
• Vulnerable to inflation, as printing of currency without gold
back-up increase money supply and reduce purchasing
power of currency
• No safeguards to prevent crises.

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 Fixed versus Flexible Exchange Rate
Regimes 2

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

provide the following:
• Sufficient liquidity to support the growth of international
trade and investment.
• Mechanism for adjustment that restores the balance of
payments disequilibrium.
• Safeguard to prevent crises of confidence in the system.

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