INTERNATIONAL

MONETARY SYSTEM
Module 1

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Topics to be covered:
• International Monetary System- Introduction

• Gold Rate

• Bretton Woods

• Exchange Rate Systems

• IMF

• World Bank

• Institutions in International Financial Systems

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International Monetary System- Introduction

▪ Money sustains and boosts trade and investment activities in an economy.

▪ National Economy = Money Supply

▪ Management of the monetary system is vested with the Central Bank of the country.

▪ Globalisation has led to ever increasing volumes of international trade, transnational services,
and international borrowing and investment.

▪ An international monetary system that caters to the needs of a globalised economic system is
necessary for efficient operation of the global economy as well as the domestic economies
which are becoming integrated into the global economic system.

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• The International Monetary System consists of elements
such as laws, rules, agreements, institutions,
mechanisms and procedures which affect foreign
exchange rates, balance of payments adjustments,
international trade and capital flows.

• Evolution of the International Monetary System can be

analyzed in four stages as follows:

o The Gold standard, 1876–1913

o The Inter-war Years, 1914–1944

o The Bretton Woods System, 1945–1973

o Flexible Exchange Rate Regime since 1973

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 THE BARTER SYSTEM
▪ Here the method of settlement of payment was
the exchange of one commodity for another in
domestic as well as in International trade.

▪ The Barter system indirectly determines the prices

of goods which means the price of one commodity
in terms of another commodity.

✓ 1 barrel of oil = 10 tonnes of wheat

✓ 1 tonnes of wheat = 2 tonnes of rice

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The Gold standard (1876 –1913)
• Silver was the first metal to be used as money which was
DURABILITY

later replaced with gold.

• Gold Standard – The monetary system, which used gold as

the base for determining the value of money of a country.
STANDARDIZABILITY STORABILITY

• Under the gold standard, the value of the domestic

currency of a country is stated in terms of weight of gold.
GOLD
The exchange rate between the two countries depends on
the relative weight of gold specified for each currency.

• This rate of exchange which is the ratio of weight of gold of DIVISIBILITY PORTABILITY

the currencies is known as mint parity or the mint

exchange rate.
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❑ Three important features of the gold standard were
▪ the government of each country defines its national monetary unit in terms of gold.
▪ free import or export of gold
▪ two-way convertibility between gold and national currencies at a stable ratio.
❑ The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67/ ounce of
old. The British pound was pegged at £ 4.2474/ounce of gold. Thus, the dollar-pound exchange rate would
be determined as follows:
($20.67/ounce of gold) / (£4.2474/ounce of gold) = $4.86656/£2
❑ The fluctuation limit would then be 2 cents either above or below that par value.
❑ The upper limit was known as the ‘gold export point’. The lower limit known as the ‘gold import point’.
❑ Each country’s government then agreed to buy or sell gold at its own fixed parity rate on demand. This
helped to preserve the value of each individual currency in terms of gold and hence, the fixed parities
between currencies. Under this system, it was extremely important for a country to back its currency value
by maintaining adequate reserves of gold.

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 DECLINE OF THE GOLD STANDARD
• One rule is that the currencies must be valued in terms of gold. Another rule is that the flow of gold
between countries cannot be restricted. The last rule requires the issuance of notes in some fixed
relationship to a country’s gold holdings. Such rules, however, require the nations’ willingness to place
balance of payments and foreign exchange considerations above domestic policy goals and this assumption
is, at best, unrealistic.

• Because gold is a scarce commodity, gold volume could not grow fast enough to allow adequate amounts of
money to be created (printed) to finance the growth of world trade. The problem was further aggravated by
gold being taken out of reserve for art and industrial consumption, not to mention the desire of many
people to own gold.

• Another problem of the system was the unrealistic expectation that countries would subordinate their
national economies to the dictates of gold as well as to external and monetary conditions. In other words, a
country with high inflation and/or trade deficit was required to reduce its money supply and consumption,
resulting in recession and unemployment. Nations insisted on their rights to intervene and devalue domestic
currencies in order to meet nationwide employment objectives

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 THE INTER-WAR YEARS (1914-1944)
• The gold standard as an International Monetary
System worked well until World War I interrupted
trade flows and disturbed the stability of exchange
rates for currencies of major countries.
• There was widespread fluctuation in currencies in
terms of gold during World War I and in the early
1920s. As countries began to recover from the war
and stabilise their economies, they made several
attempts to return to the gold standard.
• Increased unemployment and economic stagnation in
Britain. resulted in many of the world’s major
currencies losing their convertibility.
• The period was characterised by half-hearted
attempts and failure to restore the gold standard,
economic and political instabilities, widely fluctuating
exchange rates, bank failures and financial crisis.
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 The Bretton Woods System, 1945–1973
• Revival of the system was necessary and the reconstruction of the post-war financial system began with the
Bretton Woods Agreement that emerged from the International Monetary and Financial Conference of the
United and Associated nations in July 1944 at Bretton Woods, New Hampshire.

• There was a general agreement that restoring the gold standard was out of question, that exchange rates
should basically be stable, that governments needed access to credits in convertible currencies if they were
to stabilise exchange rates and that governments should make major adjustments in exchange rates only
after consultation with other countries.

• A monetary system was needed that would recognise that exchange rates were both a national and an
international concern. The agreement established a dollar based International Monetary System and created
two new institutions: The International Monetary Fund (IMF) and The International Bank for
Reconstruction and Development (World Bank).

• The basic role of the IMF would be to help countries with balance of payments and exchange rate problems
while the World Bank would help countries with post-war reconstruction and general economic
development.
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Thus, the main points of the post-war system evolving from the Bretton Woods Conference were as follows:

o A new institution, the International Monetary Fund (IMF), would be established in Washington DC. Its
purpose would be to lend foreign exchange to any member whose supply of foreign exchange had
become scarce. This lending would not be automatic but would be conditional on the member’s pursuit
of economic policies consistent with the other points of the agreement, a determination that would be
made by IMF.

o The US dollar (and, de facto, the British pound) would be designated as reserve currencies, and other
nations would maintain their foreign exchange reserves principally in the form of dollars or pounds.

o Each Fund member would establish a par value for its currency and maintain the exchange rate for its
currency within one per cent of par value. The US dollar was thus pegged to gold and any other
currency pegged to the dollar was indirectly pegged to gold at a price determined by its par value.

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DECLINE OF THE BRETTON WOODS SYSTEM
• There was much imbalance in the roles and responsibilities of the surplus and deficits nations. Countries
with persistent deficits in their balance of payments had to undergo tight and stringent economic policy
measures if they wanted to take help from the IMF and stop the drain on their reserves. However, countries
with surplus positions in their balance of payments were not bound by such immediate compulsions.

• The basic problem here was the rigid approach adopted by the IMF to the balance of payments disequilibria
situation. The controversy mainly centres around the ‘conditionality issue,’ which refers to a set of rules and
policies that a member country is required to pursue as a prerequisite to use the IMF’s resources.

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 Exchange Rate…
• To facilitate international transactions, currencies of
different countries have to be exchanged for each
other. For this purpose, the value of one currency in
terms of the other currencies has to be determined.
• Exchange Rate: “An exchange rate is the value of one
currency in terms of another”.
• Exchange Rate Regime: It refers to the mechanism,
procedures and institutional framework for
determining exchange rates at a point of time and
changes in them over time, including the factors which
induce the changes.
• There are twin market forces which determine the
foreign exchange rate in the foreign exchange market.
F. E. R. = f (Df, Sf)
• F. E. R. stands for Foreign Exchange Rate; f stands for
functional relationship; Df stands for Demand for
foreign exchange and Sf stands for Supply of foreign
exchange.

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 Fixed Exchange Rate
▪ The fixed exchange rate system is also known as stable exchange rate system or pegged exchange rate
system.
▪ A fixed exchange rate is a regime applied by a government or central bank that ties the country's
official currency exchange rate to another country's currency or the price of gold. The purpose of a fixed
exchange rate system is to keep a currency's value within a narrow band.
▪ A fixed exchange rate is a system in which the government tries to maintain the value of its currency. In
other words, the government or central bank tries to maintain its currency’s value in relation to another
currency.
▪ Main Features:
❑ The basic purpose of adopting this system is to ensure stability in foreign trade and capital movements.

❑ To achieve stability, government undertakes to buy foreign currency when the exchange rate becomes
weaker and sell foreign currency when the rate of exchange gets stronger.

❑ For this, government has to maintain large reserves of foreign currencies to maintain the exchange rate
at the level fixed by it.
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Floating Exchange Rate
Flexible exchange rate system refers to a system in which exchange rate is determined by forces of demand
and supply of different currencies in the foreign exchange market. Under this form of foreign exchange rate
system the foreign exchange rate is determined freely by the twin market forces of demand for and supply of
foreign exchange in the foreign exchange market.

Main Features:

• The value of currency is allowed to fluctuate freely according to changes in demand and supply of
foreign exchange.

• There is no official (Government) intervention in the foreign exchange market.

• The exchange rate is determined by the market, i.e. through interactions of thousands of banks, firms
and other institutions seeking to buy and sell currency for purposes of making transactions in foreign
exchange.
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FLEXIBLE EXCHANGE RATE SYSTEM (Since
1973)
The IMF classifies member countries into seven categories according to the exchange rate regime they have
adopted, these include:
❖ Exchange Arrangements with no Separate Legal Tender(41): A country either adopts the currency of
another country as its legal tender or a group of countries share a common currency. The member
nations cannot have an independent monetary policy since its money supply is tied to the regulations
of the country whose currency it has adopted and the norms of the respective central bank. Eg: The
European Union; and Ecuador, Micronesia and El Salvador use the US Dollar as legal tender.
❖ Currency Board Arrangements(7): A regime under which there is a legislative commitment to exchange
the domestic currency against a specified foreign currency at a fixed exchange rate which is
accompanied with restrictions on the monetary authority of the member nation to honour the
agreement. Eg: Bosnia and Herzegovina, Brunei, Bulgaria, Djibouti, Estonia, Hong Kong and Lithuania
fall under a currency board arrangement.
❖ Conventional Fixed Peg Arrangement(49): Under this, a country pegs its currency to another or to a
basket of currencies with a band of variation not exceeding +1 or -1 around the central parity. Eg: Qatar,
Saudi Arabia and the United Arab Emirates pegged to US Dollar.
❖ Pegged Exchange rates within Horizontal Bands(6): Under this, a country pegs its currency to another
or to a basket of currencies with a band of variation that is more than +1 or -1 around the central parity.
Eg. Tonga pegged to US Dollar.

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❖ Crawling Peg(5): Under this arrangement, the currency is pegged to another currency or a basket of
currencies but the peg is adjusted periodically. The adjustments may be pre-announced and according to a
well specified criterion or discretionary such as towards quantitative factors like inflation rate differentials.
Eg: Nicaragua and Botswana.

❖ Managed floating with no pre-announced path for the exchange rate(53): The central bank influences or
attempts to influence the exchange rate by means of active intervention in the foreign exchange market
through buying and selling foreign currency against the home currency- without any commitment to
maintain the rate at any particular level. Eg: India, Brazil and New Zealand.

❖ Independently Floating(26): The exchange rate is market determined with the central bank intervening only
to moderate the speed of change and to prevent excessive fluctuations but not attempting to maintain it at,
or drive it towards any particular level. Eg: Australia, Canada and Japan.

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THE INTERNATIONAL MONETARY
FUND(IMF)
❑ The IMF was organized in 1946 and it commenced its operation in March 1947. The
International monetary system introduced at Bretton woods rested on two pillars viz.
the maintenance of stable exchange rates and a multilateral credit mechanism
institutionalized in the IMF and supervised by it.
❑ The primary purpose of the IMF is to ensure the stability of the international
monetary system, the exchange rate system and the international payments that
enables countries to buys goods and services from each other.
❑ Membership of IMF is open to every country of the world that controls its foreign
relations and is able and prepared to fulfill the obligations of membership.
❑ The initial quantum of reserves was contributed by the members according to the
quotas fixed for each. The size of the quota for a country depends upon its GNP, its
importance in International Trade and related considerations. Each member country
was required to contribute 25% of its quota in gold/foreign currencies/Special
Drawing Rights(SDR) and the rest in its own currency. The quotas were revised from
time to time after being approved by 85% of the IMF members.
❑ Member Nations: 190 member countries
❑ Managing Director: Kristalina Georgieva
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IMF- Objectives
• To promote international monetary co-operation through a permanent institution which provides
machinery for consultation and collaboration on international monetary problems.
• To facilitate the expansion of balanced growth of international trade and to contribute thereby to the
promotion and maintenance of high level of employment and real income.

• To promote exchange stability to maintain orderly exchange arrangements among members and to avoid
competitive exchange depreciation.
• To assist in the establishment of a multilateral system of payments is respect of current transactions
between member countries and in the elimination of foreign exchange restrictions which hamper the
growth of world trade.
• To lend confidence to members by making the Fund resources available to them under adequate
safeguards, thus providing them with opportunity to correct adjustments in the balance of payments
without resorting to measures destructive to national and international prosperity.

• In accordance with the above to shorten the duration and lessen the degree of disequilibrium in the
balance of payments of the member countries.
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 IMF- Functions
• The IMF operates in such a way as to fulfil its objectives as laid down in the Bretton Woods Articles of Agreements. It is
the IMFs duty to see that these provisions are observed by member countries.
• The fund gives short-term loans to its members, so that they may correct their temporary balance of payments
disequilibrium.
• It aims at reducing tariff and other trade restrictions by the member countries. Article VII of the Charter provides that no
member shall ,without the approval of the fund, imposes restrictions on the making of payments or engage in
discriminatory currency arrangement or multiple currency practices.
• The fund also renders technical advice to its members on monetary and fiscal policies.
• It conducts research studies and publishes them in IMF staff papers, Finance and Development, etc.

• It provides technical assistance to member countries having balance of payment difficulties and other problems.
• It also conducts short training courses on fiscal, monetary and balance of payments for personnel from member nations
through its Central Banking Services Development, the Fiscal Affairs Department, the Bureau of Statistics and the IMF
institute

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IMF - LENDING
• Loans are intended to help the member nations to tackle balance of payments problems, stabilise their
economies and restore sustainable economic growth.
• Most of the resources for IMF loans are provided by member countries, primarily through their payment of
quotas.
o Subscriptions: A member’s quota subscription determines the maximum amount of financial resources
the member is obliged to provide to the IMF. A member must pay its subscription in full on joining the
fund- upto 25% must paid in SDR(Special Drawing Rights) or widely accepted currencies(such as US
Dollar, Euro, Yen or Pound Sterling) while the rest is the member’s own currency.
o Voting power: Each IMF member has 250 basic votes plus one additional vote for each SDR 1,00,000 of
quota.
o Access to Financing: The amount of financing a member can obtain from the IMF is based on its quota..
A member can borrow up to 100% of its quota annually and 300% cumulatively.
• To be able to make use of these facilities, the member country must agree to a policy package worked out in
consultation with the fund. Resources are made available in instalments and the IMF monitors the
country’s performance with regard to the commitments it has given. The next instalment being released
only after the fund is satisfied that the agreed upon policies are being implemented.

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SDR LENDING RIGHTS
▪ International liquidity: It refers to the stock of means of international payments.
▪ International Reserves: The assets which a country can use in settlement of payments imbalances that arise
in its transactions with other countries. These are held by the monetary authority of a country and are used
by them in carrying out interventions on the forex market. Reserve assets include gold, foreign exchange,
SDRs and Reserve positions.
▪ At the 1967 Rio de Janeiro Annual Meeting of the IMF, it was decided to create “international money” which
is to be the principal reserve asset. The asset was called as the Special Drawing Rights(SDRs).
▪ SDR was therefore the unit of account for par values of member currencies, denomination of quotas and
payment of the 25% reserve tranche portion of quotas.

INDIA AT IMF:
o 13,114.4 Millions of SDRs
o 132,603 Votes
o Debt of $5.4 Billion.

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THE WORLD BANK
▪ The bank was founded on December 27th,1945.
▪ The World Bank Group is a family of five international organisations responsible
for providing finance and advice to countries for economic development and to
eliminate poverty. These include:
❑ International Bank for Reconstruction and Development(IBRD) [1945]:
Provides debt financing on the basis of sovereign guarantees.
❑ International Development Association(IDA)[1960]: Provides concessional
financing(interest-free loans or grants) usually with sovereign guarantees.
❑ International Finance Corporation(IFC)[1956]: Provides various forms of
financing without sovereign guarantees, primarily to the private sector.
❑ Multilateral Investment Guarantee Agency(MIGA)[1988]: Provides
insurance against certain types of risks, including political risk, primarily to
the private sector.
❑ International Centre for Settlement of Investment Disputes(ICSID)[1966]:
Works with governments of various countries to reduce investment risk.

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Loans and Grants
Two basic types of loans include: Grants have been used to:

❖ Investment Loans: They are provided to countries
for goods, works and services in support of
economic and social development projects.
❖ Development policy loans: They provide quick-
disbursing financing to support countries’ policy
and institutional reforms.
❖ Relieve the debt burden of heavily indebted poor
countries,
❖ Improve sanitation and water supplies,
❖ Combat HIV/AIDS pandemic,
❖ Support civil society organisations, and
❖ Create initiatives to cut the emission of
greenhouse gases.

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THE WORLD BANK- OBJECTIVES
• To provide long term capital to members countries
for economic reconstruction and development.
• To induce long term capital investment for assuring
BOP equilibrium and balanced development of
international trade.
• To promote capital investment in members
countries by following ways:
o To provide a guarantee on private loans or
capital investment.
o If capital is not available even after providing
a guarantee, then IBRD provides loans for
productive activities on considerate
conditions.
o To ensure the implementation of
development projects so as to bring about a
smooth transference from wartime to a
peaceful economy.
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THE WORLD BANK- FUNCTIONS
• Bank can grant loans to members countries up to
20 % of its share in paid-up capital.
• Bank also provides loans to private investors
belonging to the members on its own guarantee,
but private investors need to take permission of its
native country.
• Banks charge 1% to 2% as service charge.
• The quantum of loan service, interest rate, terms
and conditions are decided by the World Bank
itself.
• Generally bank grant loans for a particular project
duly submitted to the bank by the member
country.
• The debtor nation has to repay either in reserve
currencies or in the currencies in which the loan
was sanctioned.
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ECONOMIC REFORM PROGRAMMES OF IMF
• The severity and structural nature of the economic problems to be addressed suggested a need for longer-
term financial support than that available under the IMF's conventional instrument for members' use of its
resources, the Stand-By Arrangement. At the same time, given the low per capita incomes and typically large
external debts of the countries concerned, there was a desire in the international community to ease the
burden of new IMF loans by offering them to eligible borrowers on highly concessional terms.

• Those benefiting would be expected to combine strong macroeconomic policies with extensive reform of
their economic systems, to remove distortions, enhance efficiency, and redirect the role of government in
the economy. These circumstances led to the creation of the IMF's Structural Adjustment Facility (SAF) in
1986, followed a year later by its successor, the Enhanced Structural Adjustment Facility (ESAF). By the end
of 1994, 36 countries had drawn on the ESAF, in support of 68 multiyear programs. The ESAF was itself
replaced by the Poverty Reduction and Growth Facility.
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RECENT TRENDS @ IMF AND WORLD BANK
• IMF and Bank staff jointly prepare country debt sustainability analysis under the Debt Sustainability Framework
(DSF)developed by the two institutions. In April 2020, the G20 endorsed the Debt Service Suspension Initiative
(DSSI) in response to a call by the IMF; and the World Bank and the IMF to grant debt service suspension to
the poorest countries to help them manage the severe impact of the COVID-19 pandemic. Since then, the
initiative has delivered about $5 billion in relief to more than 40 eligible countries. The suspension period,
originally set to end on December 31, 2020, has been extended through June 2021.

• The International Monetary Fund, on July 27, cut India's gross domestic product (GDP) growth forecast to
9.5 percent for fiscal year 2021-22, from the previous forecast of 12.5 percent, citing the hit on economic
activity and demand due to the deadly 'second wave' of the COVID-19 pandemic. The report said that steady
recovery is not assured anywhere so long as segments of the population remain susceptible to the virus and
its mutations.
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INSTITUTIONS IN INTERNATIONAL
FINANCIAL SYSTEMS
• An international financial institution (IFI) is
a financial institution that has been established
(or chartered) by more than one country, and
hence is subject to international law.
• Its owners or shareholders are generally national
governments, although other international
institutions and other organizations occasionally
figure as shareholders.
• The most prominent IFIs are creations of multiple
nations, although some bilateral financial
institutions (created by two countries) exist and
are technically IFIs.

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 TYPES OF INTERNATIONAL FINANCIAL
INSTITUTIONS
• Multilateral Development Banks: A multilateral development bank (MDB) is an institution, created by a
group of countries, that provides financing and professional advice to enhance development. MDBs finance
projects through long-term loans at market rates, very-long-term loans below market rates (also known as
credits), and grants.
• Bilateral development banks and agencies: A bilateral development bank is a financial institution set up by
one individual country to finance development projects in a developing country and its emerging market,
hence the term bilateral, as opposed to multilateral.
• Bretton Woods institutions: The best-known IFIs were established after World War II to assist in the
reconstruction of Europe and provide mechanisms for international cooperation in managing the global
financial system. They include the World Bank, the IMF, and the International Finance Corporation.

• Regional development banks: The regional development banks consist of several regional institutions that
have functions similar to the World Bank group's activities, but with particular focus on a specific region.
Shareholders usually consist of the regional countries plus the major donor countries.

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