CHAPTER 2 INTERNATIONAL MONETARY SYSTEM

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS
QUESTIONS
1. Explain Greshams Law.
Answer: Greshams law refers to the phenomenon that a! "a#n!ant$ mone% !ri&es 'oo!
"s(ar(e$ mone% o#t of (ir(#lation. This )in! of phenomenon was often oser&e! #n!er the
imetalli( stan!ar! #n!er whi(h oth 'ol! an! sil&er were #se! as means of pa%ments* with the
ex(han'e rate etween the two metals fixe!.
+. Explain the me(hanism whi(h restores the alan(e of pa%ments e,#iliri#m when it is
!ist#re! #n!er the 'ol! stan!ar!.
Answer: The a!-#stment me(hanism #n!er the 'ol! stan!ar! is referre! to as the pri(e.spe(ie.
flow me(hanism expo#n!e! % /a&i! 0#me. Un!er the 'ol! stan!ar!* a alan(e of pa%ment
!ise,#iliri#m will e (orre(te! % a (o#nter.flow of 'ol!. S#ppose that the U.S. imports more
from the U.1. than it exports to the latter. Un!er the (lassi(al 'ol! stan!ar!* 'ol!* whi(h is the
onl% means of international pa%ments* will flow from the U.S. to the U.1. As a res#lt* the U.S.
"U.1.$ will experien(e a !e(rease "in(rease$ in mone% s#ppl%. This means that the pri(e le&el will
ten! to fall in the U.S. an! rise in the U.1. 2onse,#entl%* the U.S. pro!#(ts e(ome more
(ompetiti&e in the export mar)et* while U.1. pro!#(ts e(ome less (ompetiti&e. This (han'e will
impro&e U.S. alan(e of pa%ments an! at the same time h#rt the U.1. alan(e of pa%ments*
e&ent#all% eliminatin' the initial 3O4 !ise,#iliri#m.
5. S#ppose that the po#n! is pe''e! to 'ol! at 6 po#n!s per o#n(e* whereas the fran( is pe''e!
to 'ol! at 1+ fran(s per o#n(e. This* of (o#rse* implies that the e,#iliri#m ex(han'e rate sho#l!
e two fran(s per po#n!. If the (#rrent mar)et ex(han'e rate is +.+ fran(s per po#n!* how wo#l!
%o# ta)e a!&anta'e of this sit#ation7 8hat wo#l! e the effe(t of shippin' (osts7
Answer: S#ppose that %o# nee! to #% 6 po#n!s #sin' 9ren(h fran(s. If %o# #% 6 po#n!s
!ire(tl% in the forei'n ex(han'e mar)et* it will (ost %o# 15.+ fran(s. Alternati&el%* %o# (an first
#% an o#n(e of 'ol! for 1+ fran(s in 9ran(e an! then ship it to En'lan! an! sell it for 6 po#n!s.
In this (ase* it onl% (osts %o# 1+ fran(s to #% 6 po#n!s. It is th#s enefi(ial to ship 'ol! !#e to
the o&erpri(in' of the po#n!. Of (o#rse* %o# (an ma)e an aritra'e profit % sellin' 6 po#n!s for
15.+ fran(s in the forei'n ex(han'e mar)et. The aritra'e profit will e 1.+ fran(s. So far* we
ass#me! that shippin' (osts !o not exist. If it (osts more than 1.+ fran(s to ship an o#n(e of 'ol!*
there will e no aritra'e profit.
:. /is(#ss the a!&anta'es an! !isa!&anta'es of the 'ol! stan!ar!.
Answer: The a!&anta'es of the 'ol! stan!ar! in(l#!e: "I$ sin(e the s#ppl% of 'ol! is restri(te!*
(o#ntries (annot ha&e hi'h inflation; "+$ an% 3O4 !ise,#iliri#m (an e (orre(te! a#tomati(all%
thro#'h (ross.or!er flows of 'ol!. On the other han!* the main !isa!&anta'es of the 'ol!
stan!ar! are: "I$ the worl! e(onom% (an e s#-e(t to !eflationar% press#re !#e to restri(te!
s#ppl% of 'ol!; "ii$ the 'ol! stan!ar! itself has no me(hanism to enfor(e the r#les of the 'ame*
an!* as a res#lt* (o#ntries ma% p#rs#e e(onomi( poli(ies "li)e !e.moneti<ation of 'ol!$ that are
in(ompatile with the 'ol! stan!ar!.
=. 8hat were the main o-e(ti&es of the 3retton 8oo!s s%stem7
Answer: The main o-e(ti&es of the 3retton 8oo!s s%stem are to a(hie&e ex(han'e rate stailit%
an! promote international tra!e an! !e&elopment.
6. One (an sa% that the 3retton 8oo!s s%stem was pro'ramme! to an e&ent#al !emise. 2omment
on this proposition.
Answer: The answer to this ,#estion is relate! to the Triffin para!ox. Un!er the 'ol!.ex(han'e
s%stem* the reser&e.(#rren(% (o#ntr% sho#l! r#n 3O4 !efi(its to s#ppl% reser&es to the worl!
e(onom%* #t if the !efi(its are lar'e an! persistent* the% (an lea! to a (risis of (onfi!en(e in the
reser&e (#rren(% itself* e&ent#all% (a#sin' the !ownfall of the s%stem.
>. Explain how the spe(ial !rawin' ri'hts "S/?$ is (onstr#(te!. Also* !is(#ss the (ir(#mstan(es
#n!er whi(h the S/? was (reate!.
Answer: S/? was (reate! % the I@9 in 1A>B as a new reser&e asset* partiall% to alle&iate the
press#re on the U.S. !ollar as the )e% reser&e (#rren(%. The S/? is a as)et (#rren(% (omprise!
of fi&e ma-or (#rren(ies* i.e.* U.S. !ollar* German mar)* Capanese %en* 9ren(h fran(* an! 3ritish
po#n!. 2#rrentl%* the !ollar re(ei&es a :BD wei'ht* mar) +1D* %en 1>D* fran( 11D* an! po#n!
11D. The wei'hts for !ifferent (#rren(ies ten! to (han'e o&er time* refle(tin' the relati&e
importan(e of ea(h (#rren(% in international tra!e an! finan(e.
E. Explain the arran'ements an! wor)in's of the E#ropean @onetar% S%stem "E@S$.
Answer: E@S was la#n(he! in 1A>A in or!er to "I$ estalish a <one of monetar% stailit% in
E#rope* "ii$ (oor!inate ex(han'e rate poli(ies a'ainst the non.E@S (#rren(ies* an! "iii$ pa&e the
wa% for the e&ent#al E#ropean monetar% #nion. The main instr#ments of E@S are the E#ropean
2#rren(% Unit "E2U$ an! the Ex(han'e ?ate @e(hanism "E?@$. Li)e S/?* the E2U is a as)et
(#rren(% (onstr#(te! as a wei'hte! a&era'e of (#rren(ies of EU memer (o#ntries. The E2U
wor)s as the a((o#ntin' #nit of E@S an! pla%s an important role in the wor)in's of the E?@.
The E?@ is the pro(e!#re % whi(h E@S memer (o#ntries mana'e their ex(han'e rates. The
E?@ is ase! on a parit% 'ri! s%stem* with parit% 'ri!s first (omp#te! % !efinin' the par &al#es
of E@S (#rren(ies in terms of the E2U. If a (o#ntr%s E2U mar)et ex(han'e rate !i&er'es from
the (entral rate % as m#(h as the maxim#m allowale !e&iation* the (o#ntr% has to a!-#st its
poli(ies to maintain its par &al#es relati&e to other (#rren(ies. E@S a(hie&e! a (omplete
monetar% #nion in 1AAA when the (ommon E#ropean (#rren(%* the e#ro* was a!opte!.

A. There are ar'#ments for an! a'ainst the alternati&e ex(han'e rate re'imes.
a. List the a!&anta'es of the flexile ex(han'e rate re'ime.
. 2riti(i<e the flexile ex(han'e rate re'ime from the &iewpoint of the proponents of the fixe!
ex(han'e rate re'ime.
(. ?e#t the ao&e (riti(ism from the &iewpoint of the proponents of the flexile ex(han'e rate
re'ime.
Answer: a. The a!&anta'es of the flexile ex(han'e rate s%stem in(l#!e: "I$ a#tomati(
a(hie&ement of alan(e of pa%ments e,#iliri#m an! "ii$ maintenan(e of national poli(%
a#tonom%.
. If ex(han'e rates are fl#(t#atin' ran!oml%* that ma% !is(o#ra'e international tra!e an!
en(o#ra'e mar)et se'mentation. This* in t#rn* ma% lea! to s#optimal allo(ation of reso#r(es.
(. E(onomi( a'ents (an he!'e ex(han'e ris) % means of forwar! (ontra(ts an! other te(hni,#es.
The% !ont ha&e to ear it if the% (hoose not to. In a!!ition* #n!er a fixe! ex(han'e rate re'ime*
'o&ernments often restri(t international tra!e in or!er to maintain the ex(han'e rate. This is a
self.!efeatin' meas#re. 8hats 'oo! ao#t the fixe! ex(han'e rate if international tra!e nee! to
e restri(te!7
1B. In an inte'rate! worl! finan(ial mar)et* a finan(ial (risis in a (o#ntr% (an e ,#i()l%
transmitte! to other (o#ntries* (a#sin' a 'loal (risis. 8hat )in! of meas#res wo#l! %o# propose
to pre&ent the re(#rren(e of a Asia.t%pe (risis.
Answer: 9irst* there sho#l! e a m#ltinational safet% net to safe'#ar! the worl! finan(ial s%stem
from the Asia.t%pe (risis. Se(on!* international instit#tions li)e I@9 an! the 8orl! 3an) sho#l!
monitor prolemati( (o#ntries more (losel% an! pro&i!e timel% a!&i(e to those (o#ntries.
2o#ntries sho#l! e re,#ire! to f#ll% !is(lose e(onomi( an! finan(ial information so that
!e&al#ation s#rprises (an e pre&ente!. Thir!* (o#ntries sho#l! !epen! more on !omesti( sa&in's
an! lon'.term forei'n in&estments* rather than short.term portfolio (apital. There (an e other
s#''estions.
11. /is(#ss the (riteria for a F'oo! international monetar% s%stem.
Answer: A 'oo! international monetar% s%stem sho#l! pro&i!e "i$ s#ffi(ient li,#i!it% to the worl!
e(onom%* "ii$ smooth a!-#stments to 3O4 !ise,#iliri#m as it arises* an! "iii$ safe'#ar! a'ainst
the (risis of (onfi!en(e in the s%stem.
1+. On(e (apital mar)ets are inte'rate!* it is !iffi(#lt for a (o#ntr% to maintain a fixe! ex(han'e
rate. Explain wh% this ma% e so.
Answer: On(e (apital mar)ets are inte'rate! internationall%* &ast amo#nts of mone% ma% flow in
an! o#t of a (o#ntr% in a short time perio!. This will ma)e it &er% !iffi(#lt for the (o#ntr% to
maintain a fixe! ex(han'e rate.
15. Assess the possiilit% for the e#ro to e(ome another 'loal (#rren(% ri&alin' the U.S. !ollar.
If the e#ro reall% e(omes a 'loal (#rren(%* what impa(t will it ha&e on the U.S. !ollar an! the
worl! e(onom%7
Answer: In li'ht of the lar'e transa(tions !omain of the e#ro* whi(h is (omparale to that of the
U.S. !ollar* an! the man!ate for the E#ropean 2entral 3an) "E23$ to '#arantee the monetar%
stailit% in E#rope* the e#ro is li)el% to e(ome another 'loal (#rren(% o&er time. A ma-or
#n(ertaint% ao#t this prospe(t is the la() of politi(al inte'ration of E#rope. If E#rope e(omes
politi(all% more inte'rate!* the e#ro is more li)el% to e(ome a 'loal (#rren(%. If the e#ro
e(omes a 'loal (#rren(%* it will (ome at the expense of the !ollar. 2#rrentl%* the U.S. !eri&es
s#stantial enefits from the !ollars stat#s as the !ominant 'loal (#rren(% G for instan(e* the
U.S. (an r#n tra!e !efi(its witho#t ha&in' to maintain s#stantial forei'n ex(han'e reser&es* (an
(arr% o#t international (ommer(ial an! finan(ial transa(tions in !ollars witho#t earin' ex(han'e
ris)* et(. If the e#ro is to e #se! as a ma-or !enomination* reser&e* an! in&oi(e (#rren(% in the
worl! e(onom%* !ollar.ase! a'ents will start to ear more ex(han'e ris)* amon' other thin's.