1. The International Monetary System2
Chapter Two
The International Monetary System
Chapter Objective:
This chapter serves to introduce the student to the institutional framework within which: (1) International payments are made, (2) The movement of capital is accommodated, (3) Exchange rates are determined.
Chapter Outline
Evolution of the International Monetary System
Current Exchange Rate Arrangements
European Monetary System
Euro and the European Monetary Union
Fixed versus Flexible Exchange Rate Regimes

2. Evolution of the International Monetary System
Definition: IMS is institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined
Bimetallism: Before 1875
Classical Gold Standard:
Interwar Period:
Bretton Woods System:
The Flexible Exchange Rate Regime: 1973-Present

3. Evolution of the International Monetary System
Bimetallism (prior to 1875)
Gold and Silver used as international means of payment and the exchange rate among currencies was determined by either their gold or silver content.
Gresham’s law - exchange ratio between two metals was officially fixed, therefore only more abundant metal was used, driving the more scarce metal out of circulation

4. Evolution of the International Monetary System (contd.)
Classic Gold Standard ( )
During this period in most major countries:
gold alone is assured of unrestricted coinage
two-way convertibility between gold and national currencies at a stable ratio
gold is freely exported or imported
The exchange rate between two country’s currencies would be determined by their relative gold contents
Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment.
Price-specie-flow mechanism corrected misalignment of exchange rates and international imbalances of payment
Might lead to deflationary pressures 4 4

5. Evolution of the International Monetary System (contd.)
Interwar period (1915 – 1944)
characterized by:
Economic nationalism
Attempts and failure to restore gold standard
Economic and political instability
These factors highlighted some of the shortcomings of the gold standard
The result for international trade and investment was profoundly detrimental.

6. Evolution of the International Monetary System (contd.)
Bretton Woods System (1944 – 1973)
Creation of the International Monetary Fund (IMF) and the World Bank
Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar.
Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary.
US dollar based gold exchange standard

7. Evolution of the International Monetary System (contd.)
Bretton Woods System (1944 – 1973)
German mark
British pound
French franc
Par Value
Par Value
Par Value
U.S. dollar
Pegged at $35/oz.
Gold

8. Evolution of the International Monetary System (contd.)
Bretton Woods System (1944 – 1973)
Problem with the system is that U.S. constantly incurred trade deficits as other countries wanted to maintain US$ reserves (Triffin Paradox)
Special Drawing Rights (SDR) – new reserve asset, (US$, FF, DM, BP, JY)
Smithsonian Agreement (1971) – US$ devalued to $38/oz.
European, Japanese currencies allowed to float–Mar 1973

9. Evolution of the International Monetary System (contd.)
Flexible Exchange Rate Regime (1973–present)
Jamaica Agreement (1976)
Flexible exchange rates were declared acceptable to the IMF members.
Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities.
Gold was abandoned as an international reserve asset.
Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

10. Contemporary Currency Regimes
Free Float
The largest number of countries, about 36, allow market forces to determine their currency’s value.
Managed Float
About 50 countries combine government intervention with market forces to set exchange rates.
Pegged to (or horizontal band around) another currency
Such as the U.S. dollar or euro
No national currency
About 40 countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

11. Fixed vs. Flexible Exchange Rate Regimes
Arguments in favor of flexible exchange rates:
Easier external adjustments.
National policy autonomy.
Arguments against flexible exchange rates:
Exchange rate uncertainty may hamper international trade.
No safeguards to prevent crises.
Currencies depreciate (or appreciate) to reflect the equilibrium value in flexible exchange rates
Governments must adjust monetary or fiscal policies to return exchange rates to equilibrium value in fixed exchange rate regimes

12. Fixed versus Flexible Exchange Rate Regimes
Suppose the exchange rate is $1.40/£ today.
In the next slide, we see that demand for British pounds far exceed supply at this exchange rate.
The U.S. experiences trade deficits.
Under a flexible ER regime, the dollar will simply depreciate to $1.60/£, the price at which supply equals demand and the trade deficit disappears.

13. Fixed versus Flexible Exchange Rate Regimes
Demand (D)
Supply (S)
Dollar price per £ (exchange rate)
$1.40 S D
Trade deficit
Q of £

14. Fixed versus Flexible Exchange Rate Regimes
Supply (S)
Dollar price per £ (exchange rate)
$1.60
Dollar depreciates (flexible regime)
Demand (D)
$1.40
Demand (D*)
D = S
Q of £

15. Fixed versus Flexible Exchange Rate Regimes
Instead, suppose the exchange rate is “fixed” at $1.40/£, and thus the imbalance between supply and demand cannot be eliminated by a price change.
The US Federal Reserve Bank may initially draw on its foreign exchange reserve holdings to satisfy the excess demand for British pounds.
If the excess demand persists the government would have to shift the demand curve from D to D*
In this example this corresponds to contractionary monetary and fiscal policies.

16. Fixed versus Flexible Exchange Rate Regimes
Supply (S)
Contractionary policies
Dollar price per £ (exchange rate)
(fixed regime)
Demand (D)
$1.40
Demand (D*)
D* = S
Q of £

17. European Monetary System (EMS)
EMS was created in 1979 by EEC countries to maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies.
Objectives:
Establish zone of monetary stability
Coordinate exchange rate policies vis-à-vis non-EMS countries
Develop plan for eventual European monetary union
Exchange rate management instruments:
European Currency Unit (ECU)
Weighted average of participating currencies
Accounting unit of the EMS
Exchange Rate Mechanism (ERM)
Procedures by which countries collectively manage exchange rates

18. What Is the Euro (€)? Euro Conversion Rates
The euro is the single currency of the EMU which was adopted by 11 Member States on 1 January 1999.
These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.
Prominent countries initially missing from Euro :
Denmark, Greece, Sweden, UK
Greece: did not meet convergence criteria, was approved for inclusion on June 19, 2000 (effective Jan. 2001)
Euro Conversion Rates
1 Euro is Equal to:
BEF
Belgian franc
DEM
German mark
ESP
Spanish peseta
FRF
French franc
IEP
Irish punt
ITL
Italian lira
LUF
Luxembourg franc
NLG
Dutch guilder
ATS
Austrian schilling
PTE
Portuguese escudo
FIM
Finnish markka

19. Benefits and Costs of the Monetary Union
Transaction costs reduced and FX risk eliminated
Creates a Eurozone – goods, people and capital can move without restriction
Compete with the U.S.
Approximately equal in terms of population and GDP
Price transparency and competition
Loss of national monetary and exchange rate policy independence
Country-specific asymmetric shocks can lead to extended recessions

20. The Long-Term Impact of the Euro
If the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a “United States of Europe” feasible.
It is likely that the U.S. dollar will lose its place as the dominant world currency.
The euro and the U.S. dollar will be the two major currencies.