INTERNATIONAL MONETARY SYSTEM

SUBMITTED BY SUBMITTED TO

REETIKA VAID Mr DIGVIJAY KATOCH

BBA LLB ASSISTANT PROFESSOR OF

(3RD SEMESTER) MANAGEMENT

 ACKNOWLEDGEMENT

I would like to thank Mr Digvijay Katoch for giving me an opportunity to research on the topic,
International Monetary System.
 INTRODUCTION

International monetary system refers to a well-designed system that facilitates the valuation and
exchange of money across countries. It looks after the cross-border payments, exchange rates and
mobility of capital. This system has some rules and regulation which helps in operating the
exchange rate and terms of international payments. International Monetary System moves the
capital from one country to the other by felicitating trade.

The main purpose of International Monetary System is to enhance high growth in the world with
stable price levels. Earlier, the scope was limited to exchange rates but now the system has a wider
scope because financial stability being taken into consideration. International Monetary System
established International Monetary Fund and World Bank in 1944.

EVOLUTION OF INTERNATIONAL MONETARY SYSTEM

Over the past 75 years, the International Monetary System has modified according to the situations
that prevailed. Even though the scope has evolved over all these years, the purpose stands firm.
The evolution of the International Monetary System is discussed below.

1. Bimetallism

This system was a double standard system where both gold and silver were used as money. It was
in force before 1875. Under this system, some countries adopted the gold standard and some were
using the silver standard whereas, there were some countries that adopted both at the same time.

Both gold and silver were used as international means of payment and the exchange rates among
currencies were determined either by gold or silver. During this time there was a Gresham Law
that implied that it would be the least valuable metal which would tend to circulate among the
countries.

Gresham’s Law is an economic principle that states, “if coins containing metalof different values
have the same value as a legal tender, the coins composed of the cheaper metal will be used for
payments, while those coins made of expensive metals will be hoarded and exported and thus tend
to disappear from circulation.”
 2. Classic Gold Standard

Classis gold standard was the first phase of International Monetary System that lasted from 1816
to 1914. This standard was adopted by only a handful of countries at its initial stage, but was
accepted by almost all countries after some time. Coins and bullions of gold were used in this
standard. This gold standard gave rise to fixed exchange rate system. Because of the most fixed
exchange rate, international trade saw a rise during this time. This gold standard also made
countries abide by the strict monetary policy. This standard was also used in minimising the trade
imbalances in the countries. The other name for Classic Gold Standard is International Gold
Standard.

The advantages of Classic Gold system were that it provided stability of price. By tying the money
supply to the supply of gold, central banks were unable to expand the money supply. It also
facilitated the balance of payment adjustment automatically. This system was a price-specific-flow
mechanism.

There were some arguments put forth which highlighted the disadvantages of this system. The
growth of output and the growth of gold supplies were closely linked. Volatility in the supply of
gold could cause adverse shocks to the economy. In this system, the monetary authorities were not
forced to tie their hands in limiting the creation of money. Countries with respectable monetary
policy makers could not use monetary policies to fight domestic issues like unemployment.

The Classic Gold Standard witnessed downfall after the end of World War I. during the World
War, many countries printed more money with the hope to finance their military requirements.
Due to this, the money in circulation exceeded the gold reserves of the country resulting in the
downfall of gold standard. The only country who didn’t give up on the gold standard was the
United States of America.

3. Interwar Period

The time period between World War 1 and World War 2 is known as the interwar period. This
was the next stage of the evolution of the International Monetary System which lasted from 1915
to 1944. During the interwar period, Britain was replaced by the US as the dominant financial
powerhouse across the world. During this period, all the economies had gone into depression with
a higher inflation rate. The fixed exchange rate system also collapsed with a higher supply of
money. Most of the countries started focussing on domestic revamping and not on international
trade.
 4. Bretton Woods System

The period after World War II gave rise to the Bretton Woods System which existed from 1945 to
1972. The representatives from 44 countries in 1944 came together and met at Bretton Woods of
the United States to come up with a new international monetary system. The main objective of this
system was to establish a uniform and liberal international finance architecture with independence
on domestic policies. The agreement gave existence to the US dollar based Monetary System or
gold-exchange standard. This system also put forth the pegging of domestic currency in terms of
US Dollars. A price of $35 was set for 1 ounce of gold. The countries linked their currencies to
the US dollar.

The downfall of the Bretton Woods System:

In early post-war period, the US government had to provide dollar reserves to all the countries
who wanted to in the currency market. The increasing supply of dollars world-wide made available
through programs like the Marshall Plan meant that the credibility of gold backing of the dollar
was in question.

US dollars grew abruptly and this represented a claim on US gold stocks and cast some doubt on
the US’s ability to convert dollars into gold upon request. The domestic US policies resulted in
more printing of dollars and forced foreign governments to run up holdings of dollar reserves. The
dollar was overvalued in 1960s.

All the countries that were the members of the Bretton Woods System had to maintain their
currencies value within 1% upward or downward variation in comparison to the fixed exchange
rate. This agreement gave the governments the opportunity to turn their gold into the US dollar at
any point in time. But soon the countries started ignoring the link between US dollar and gold and
started exchanging rates directly. In case the same situation prevailed, the Bretton Woods
Agreement had the power to devalue a country’s currency by 10% straight.

The countries were reluctant to devalue their currencies because they had to export more goods in
order to pay for imports from other countries. This led countries to rely on deflation to cure balance
of payments deficits through expenditure-reducing monetary-fiscal policies.

The world moved from a gold standard to a dollar standard, from Bretton Woods to the
Smithsonian Agreement. Growing increase in the amount of dollars printed further eroded faith in
the system and the dollar’s role as a reserve currency.
By 1793, the world had moved to search for a new financial system, one that no longer relied on
a world-wide system of pegged exchange rates.

5. Current International Monetary System

After the downfall of the Bretton Woods system, there has not been any formal International
Monetary System in place. The present day International Financial Architecture is a managed float
system. All the currencies of all the countries can freely float against one another in open market
under the managed float system. The government intervenes only when the currency needs to be
stabilized. At the beginning of March 1973, India, Canada, Japan, Switzerland, the UK and several
other smaller countries had floating exchange rates. However, the “joint float” of the EEC
countries continued even after March 1973 and was now called the “snake in the lake”, as there
was no band within which the currencies could fluctuate relative to other currencies.

In March 1979, the European Monetary System was formed which created the European Currency
Unit which is also known as the “basket” currency of a unit of account which consisted the major
European currencies. The EMS limits the internal exchange rate movement of the member
countries to not more than 2.25 % from the central rates with the exception of Italy whose lira can
fluctuate up to 6 %.

Managed float system is place since 1976 with the Jamaican Agreement. Later in 1980, the
International Finance Architecture was regulated by G-5 countries. This G-5 group has currently
turned into G-20, with a group of 20 countries managing the exchange rate on managed float
system.

The Jamaica Agreement of January 1976 was ratified in in April 1978 and formalised the regime
of floating exchange rates under the name of International Monetary Fund. Many factors forced
the member countries of the IMF to float their currencies. There was a large short-term capital
movement and the central banks failed to stop speculation in the currencies during the regime of
adjustable pegs. The oil crisis in 1973 and the increase in oil prices in 1974 led to the great
recession of 1974-75 in the industrial countries of the world. Due to this, the dollar went into a
rapid decline which by late 1978, forced the government to finally make a policy to stop the dollar
from losing its value.
Finally, the system of managed floating exchange system had come into existence by 1978. By the
second amendment of the IMF Charter Act in 1978, the member countries are not expected to
maintain and establish values with gold or dollar.

ADVANTAGES OF CURRENT INTERNATIONAL MONETARY SYSTEM

• It enhances financial stability and maintains the price level on a global scale. It also boosts
the global growth.
• International Monetary System mobilizes money across the countries and determines the
exchange rate.
• This system encourages the government of the respective countries to manage their
Balance of Payment by reducing the trade deficit.
• IMS is a well-regulated system that makes the whole process of international trading
smooth and organised.
• The system relocates the capital from one country to another by enhancing cross-border
investments.
• International Financial Architecture provides liquidity to the countries of the world and
tries to avoid any short or long-run disruptions in the world economy.

PROBLEMS OF THE CURRENT INTERNATIONAL MONETARY SYSTEM

• The present international monetary system consists of many fluctuations and large
disequilibrium in exchange rates.
• The current international monetary system is incompetent to avoid any global financial
crisis. There have been four serious financial crises over the past few years.
• Mexico in the years 1994 and 1995 has suffered from major economic and financial
downfall. These crises came to an end in December 1996.
• Similarly in the year 1997, Southeast Asia had suffered from a major economic breakdown.
Russia and Brazil also had to go through serious financial crises in the year 1998 and 1999
respectively.
 • In 2007-2009, the Global Economic Crisis questioned the current International Financial
Architecture. There have been many such major financial breakdowns over the past few
years, which the International Financial Architecture was unable to avoid.
• Often countries, both developed and developing, have been facing with either excessive
appreciation or depreciation of their currencies in relation to the dollar which continues to
dominate the world monetary system.
• The newly created Euro or the EU, which was supposed to be a strong currency, has been
depreciating considerably since its inception against the dollar, which affects the world
trade adversely.
• One more problem of the current international monetary system is that sometimes the
exchange rates remain misaligned. Managed float system sometimes gets misaligned due
to its internal and external factors.

SUGGESTIONS TO REFORM THE PRESENT MONETARY SYSTEM

1. Reserve Currencies

Over the last few years, many questions have been asked about the credibility of the current
system—and in particular, questions about the U.S. dollar’s role as the principal reserve currency.
Some people worry that the United States’ economic and financial problems, such as its large
fiscal imbalances, pose serious risks to the value of the dollar, and therefore, of a disorderly
adjustment in the international monetary system. Creating multi-currency reserves using Euro,
Yen and Renminbi, serving as c0-anchors to dollars can turn out to be useful.

2. Coordination and Cooperation of Policies

Economist McKinnon suggested international coordination and cooperation of policies among the
leading developed countries for exchange rate stability. According to McKinnon, the countries
like US, Germany and Japan should have the optimal degree of exchange rates of stability by
fixing the exchange rates among their currencies at the equilibrium level based on the purchasing
power parity. Thus, they would coordinate their monetary policies for exchange rate stability.
 3. Establishing of Target Zones

Williamson called for establishment of target zones within which fluctuations in exchange rates of
major currencies may be permitted. According to him, the forces of demand and supply, should
determine the equilibrium exchange rate. There should be an upper target zone of 10% above the
equilibrium rate and a lower target zone of 10% below the equilibrium rate.

The exchange rate should not be allowed to move outside the two target zones by official
intervention. In February 1987, the leading five developed countries agreed under the Louvre
Agreement to have some sort of target zones for the stability of exchange rates among their
currencies. Despite official intervention by these countries, the exchange rates continued to
fluctuate within wide margins than agreed upon at Louvre. Thus, Williamson’s proposal has
since been discarded for being impracticable.

4. Improving Global Liquidity

The main aim for reforming the present monetary system should be improving global liquidity.
Both BOP deficit and surplus countries should take steps to reduce imbalance through exchange
rates changes via policy measures. They should also cooperate in curbing large flows of “hot
money” that destabilise their currencies. They should be willing to settle their BOP imbalances
through SDRs rather than through gold or dollar as reserve assets. There should be increasing flow
of resources to the developing countries.

SUMMARY

The international monetary system had many informal and formal stages. For more than one
hundred years, the gold standard provided a stable means for countries to exchange their
currencies and facilitate trade. With the Great Depression, the gold standard collapsed and
gradually gave way to the Bretton Woods system.

The Bretton Woods system established a new monetary system based on the US dollar. This
system incorporated some of the disciplinary advantages of the gold system while giving
countries the flexibility they needed to manage temporary economic setbacks, which had led
to the fall of the gold standard.
The Bretton Woods system lasted until 1971 and provided the longest formal mechanism for
an exchange-rate system and forums for countries to cooperate on coordinating policy and
navigating temporary economic crises.

While no new formal system has replaced Bretton Woods, some of its key elements have
endured, including a modified managed float of foreign exchange, the International Monetary
Fund (IMF), and the World Bank—although each has evolved to meet changing world
conditions.

CASE STUDY-28

1. Tariffs are the taxes or duties placed on an imported good by a domestic government
that are usually levied as a percentage of the declared value of the good, similar to a
sales tax. Unlike a sales tax, tariff rates are often different for every good and tariffs do
not apply to domestically produced goods. Except in all but the rarest of instances,
tariffs hurt the country that imposes them, as their costs outweigh their benefits. Tariffs
kill jobs and raise prices for the consumers.
Even though the workers might be free to move across sectors of economy, they might
not easily or transferred without spending a cost. Workers in one industry are
accustomed to being paid a wage proportional to their performance or productivity. As
a result, they might be unwilling to accept a lower wage in another industry even
though the lower wage would reflect their productivity in that industry. A worker’s
reluctance to transfer could lead to a long search time between jobs as the worker
continues to look for an acceptable job at an acceptable wage.
During the search period, a variety of adjustment costs would be incurred by the
unemployed worker would and the government. The government would compensate
for some of the reduced income by providing unemployment compensation. This
compensation would be paid out of tax revenues and thus represents a cost to others in
the economy.
The costs of the training undertaken by the unemployed worker might also be borne by
an employer who hires initially low-productivity workers but trains them to raise their
 skills and productivity in the new industry. In any case, the economy is assumed to
have an unemployment imperfection that arises whenever resources must be
transferred across industries. Any tariff or quota on imports, although beneficial to the
import-competing industry, will reduce aggregate efficiency—that is, the aggregate
losses will exceed the aggregate benefits.
Imports are considered as leakage in a country’s economy and thus are responsible for
reduction of employment. Greater competitive pressure from imports as well the access
to better quality intermediate inputs would exert a positive influence on the
productivity levels of domestic firms, which, in turn, would lead to higher production,
export and employment growth.
Lower tariffs on intermediate inputs would also encourage MNCs to undertake export
promoting investments in the country and domestic industries to participate in GVCs.
Greater participation in GVCs in turn would lead to higher exports and employment.

2. Protectionism refers to government policies that restrict international trade to help

domestic industries. Protectionist policies are usually implemented with the goal to
improve economic activity within a domestic economy but can also be implemented
for safety or quality concerns.
Protectionist policies are typically focused on imports but may also involve other
aspects of international trade such as product standards and government subsidies. The
merits of protectionism are the subject of debate.
Critics argue that over the long term, protectionism often hurts the people and entities
it is intended to protect by slowing economic growth and increasing price inflation,
making free trade a better alternative. Proponents of protectionism argue that the
policies can help to create domestic jobs, increase gross domestic products (GDP),
and make a domestic economy more competitive globally.
The most common protectionist strategy is to enact tariffs that tax imports. That
immediately raises the price of imported goods. They become less competitive when
compared to local goods. This method works best for countries with a lot of imports,
such as the U.S.
Even as it sharply criticized rising protectionism in the US under the Trump
administration, India itself raised tariff walls in the last two budgets, ostensibly to
 promote domestic manufacturing. Such unilateral restrictions on trade affect all
economies, and arguably isolate India more than the decision to opt out of any one
trade deal. Expensive imports after all make even our exports costlier since much of
what we export is based on imported inputs. They also hurt consumer interests since
consumers end up paying higher prices.
First, tariff increases in any one industry (say, steel or electronics components) can hurt
other firms in another industry (say auto-makers and electronics assemblers). Second,
such tariff walls erode the competitiveness of domestic firms over the long run and
raise the ‘cost’ of entering any trade pact, such as Regional Comprehensive Economic
Partnership, since the gap between India’s tariff rates and those of others remain wide.
Finally, such tariff walls end up inviting retribution from trading partners.
Protectionism leads to retribution and therefore higher import prices and higher
consumer prices.
There are a few advantages of protectionism. It can protect new industries against free
trade. Protectionism can enable some industries to survive. Diversifies the economy.
Tariffs and protectionism can help develop new industries to give more diversify to the
economy. Raise revenue for the government. Protect certain key industries from
international competition to try and safeguard jobs.
But in a country like India, rising protectionism, arbitrary taxation, and excessive
regulation could limit India’s potential and hinder growth. India does not have enough
highly productive firms, which in turn leads to less lobbying for trade liberalisation. It
keeps trade barriers high, and leads to India’s exclusion from most of global
manufacturing.

3. A tariff is a tax or duty imposed by one nation on the imported goods or services of another
nation. Tariffs are a political tool that have been used throughout history to control the
number of imports that flow into a country and to determine which nations will be granted
the most favourable trading conditions. High tariffs create protectionism, shielding a
domestic industry's products against foreign competition. High tariffs usually reduce the
importation of a given product because the high tariff leads to a high price for the customers
of that product.
There are two basic types of tariffs imposed by governments on imported goods. First is
the ad valorem tax which is a percentage of the value of the item. The second is a specific
tariff which is a tax levied based on a set fee per number of items or by weight.
Tariffs are generally imposed for one of following reasons. To protect newly established
domestic industries from foreign competition. To protect aging and inefficient domestic
industries from foreign competition. To protect domestic producers from "dumping" by
foreign companies or governments.
Dumping occurs when a foreign company charges a price in the domestic market which is
below its own cost or under the cost for which it sells the item in its own domestic market.
To raise revenue. Many developing nations use tariffs as a way of raising revenue. For
example, a tariff on oil imposed by the government of a company that has no domestic oil
reserves may be a way to raise a steady flow of revenue.
Despite these arguments that tariffs are eventually harmful to all parties in a trade
relationship, they have been used by all nations from time to time. Most developing
countries use tariffs to try and protect their fledgling industries or industries they feel the
nation needs domestically in order to remain independent.
Protective tariffs are taxes, duties, or other roadblocks (generally in the form of monetary
fees) placed on foreign goods by a national or state government in order to protect domestic
products and markets. The increased fees levied on foreign goods are generally passed on
to the consumer, making the foreign goods considerably more expensive than similar goods
produced within the country.
Protective tariffs are considered positive because they raise the price of imports. Protective
tariffs are enacted with the aim of protecting a domestic industry. They aim to make
imported goods cost more than equivalent goods produced domestically, thereby causing
sales of domestically produced goods to rise; supporting local industry.
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