Chapter 04

The International Monetary System

The international monetary system refers to the system and rules that govern the use and
exchange of money around the world and between countries.

International Monetary System (IMS) is a well-designed system that regulates the valuations and
exchange of money across countries. It is a well-governed system looking after the cross-border
payments, exchange rates, and mobility of capital. This system has rules and regulations which
help in computing the exchange rate and terms of international payments. In other words,
International Monetary System mobilizes the capital from one nation to another by felicitating
trade.  There are many participants like MNCs (Multinational Corporations), Investors, Financial
Institutions, etc in the International Monetary System.

The main purpose of the International Monetary System today is, to enhance high growth in the
world with stable price levels. Earlier the scope was only up to exchange rates, now the system
has a broader scope by taking financial stability into consideration. International Monetary
System has established International Monetary Fund (IMF) and the World Bank in the year
1944.

There have been four phases/ stages in the evolution of the international monetary system:

 The Era Of Bimetallism (Before 1970s)

 Flexible exchange rate regime (1976)

 Gold Standard (1875-1914)
 Inter-war period (1915-1944)
 Bretton Woods system (1945-1972)
 Present International Monetary system (1972-present)
The main purpose of the International Monetary System today is, to enhance high growth in the
world with stable price levels. Earlier the scope was only up to exchange rates, now the system
has a broader scope by taking financial stability into consideration. International Monetary
System has established International Monetary Fund (IMF) and the World Bank in the year
1944.

 The Era Of Bimetallism

Before 1870, the international monetary system consisted of bimetallism, where both gold and
silver coins were used as the international modes of payment. The exchange rates among
currencies were determined by their gold or silver contents. Some countries were either on a gold
or a silver standard. One problem with bimetallism occurs when the face value of a coin is lower
than the actual value of the metal it contains. While this stabilized the economy, it also moved
the country towards monometallism (the use of a single metal in currency) and the Gold
Standard. Silver was no longer seen as an attractive currency because the coins were not worth
their face value. Then, during the Civil War, hoarding of both gold and silver prompted the
United States to temporarily switch to what’s known as “fiat money.” Fiat money, which is what
we use today, is money that the government declares to be legal tender, but that's not backed or
convertible to a physical resource like metal. At this time, the government stopped redeeming
paper money for gold or silver.

 Flexible Exchange Rate Regime (1976)

European and Japanese currencies became free-floating currencies in 1973. The

flexible exchange rate regime was formally ratified in 1976 by IMF members through the
Jamaica Agreement. The agreement stipulated that central banks of respective countries could
intervene in the exchange markets to guard against unwarranted fluctuations. Gold was also
officially abandoned as the international reserve asset. In 1985, the Plaza Accord envisaged the
depreciation of the dollar against most major currencies to solve US trade deficit problems.

In general there are many flexible exchange rate systems. In a free-floating or independent-
floating currency, the exchange rate is determined by the market, with foreign
exchange intervention occurring only to prevent undue fluctuations. For example, Australia, the
United Kingdom, Japan, and the United States have free-floating currencies. In a managed-
floating system, the central monetary authority of countries influences the movement of the
exchange rate through active intervention in the foreign market with no preannounced path for
the exchange rate. Examples include China, India, Russia, and Singapore. In a fixed-peg
arrangement, the country pegs its currency at a fixed rate to a major currency or to a basket of
currencies. For example, many GCC countries such as UAE and Saudi Arabia have pegged their
currencies to the US dollar.

 Classic Gold Standard .

The first phase of the International Monetary System was the Classic Gold Standard from
1816 to 1914. In the initial years of the Gold Standard, only a few countries adopted this
standard. Later almost all countries accepted it. Usually, coins and billions of gold were
 useful during this standard. This gold standard gave birth to a fixed exchange rate system
with minimal fluctuations. Because of the most fixed exchange rate, International trade
saw a boost during this time. Gold Standard also made all countries of the world abide by
strict monetary policy. This standard was helpful in correcting trade imbalances in the
country. The other name of Classic Gold Standard is International Gold Standard.

Why Classic Gold Standard Collapsed? After the end of World War 1, the Classic
Gold Standard collapsed. During World War, many countries printed more money in
order to finance their military requirements. As a result of this, the money in circulation
exceeded the gold reserves of the country and so, those countries have to give up on
Classic Gold Standard. The only United States of America didn’t give up on Classic Gold
Standards.

 Interwar Period

The period between World War 1 and World War 2 is known as the Interwar Period. This was
the next episode of the International Monetary System from 1915 to 1944. During this time,
Britain was replaced by the United States of America as the dominant financial powerhouse
across the globe. During this period, all the economies had gone into a depression with a higher
inflation rate. The fixed exchange rate system collapsed with a higher supply of money. Almost
all countries started focusing on domestic revamping and not on international trade.

 Bretton Woods System.

The period after World War 2, gave birth to Bretton Woods System. This monetary system was
in existence from 1945 to 1972. Representatives from 44 countries, in the year 1944 met at
Bretton Woods of United States and came up with a new International Monetary System. The
focus of the Bretton Woods Agreement was to establish a uniform and liberal International
Financial Architecture, with independence on domestic policies. This agreement gave birth to the
US Dollar-based Monetary System or Gold-Exchange Standard. This system gave birth to the
pegging of domestic currency in terms of US Dollars. A price of $35 was set for 1 ounce of gold.
The countries rather than linking their currency to the gold-linked it to US Dollars.
All the member countries of Bretton Woods had to maintain their currencies value within 1%
upward or downward variations in comparison to Fixed Exchange Rate. This agreement also
allowed the Governments of the country to convert their gold into the US Dollar, at any point in
time. Eventually, countries and businesses have started ignoring the link between US Dollar and
Gold, and have started considering exchange rates directly. If the situation prevailed then Bretton
Woods Agreement allowed the country to devalue its currency by more than 10% straight.
Although, it didn’t allow countries to use this mechanism to benefit from imports and exports of
the country.

Downfall of the Bretton Woods System.

Post-World War situation, the supply of US Dollars suddenly increased in the world economy.
As a result of it, many countries started questioning the quantum of gold reserves of the US
Government with the supply of the US Dollar. By 1973, many countries started losing
confidence in the US Dollar and started searching for some other reliable source.

 Current/ Present International Monetary System.

The Bretton Woods system collapsed in 1971. The United States had to stop the convertibility to
gold due to high inflation and trade deficit in the economy. Inflation led to an increase in the
price of gold. Hence, the US could not maintain a fixed value of 35 dollars to 1 ounce of gold. In
1973, the world moved to a flexible exchange rate system.
In 1976, the countries met in Jamaica to formalize the new system.
After the downfall of the Bretton Woods System, 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 an open market under the managed float system. The government
intervenes only when the currency needs to be stabilized. Managed Float System is in place since
1976 with the Jamaica Agreement. Later in 1980, the International Financial 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 floating exchange rate
system means that the exchange rate of a currency is determined by the market forces of demand
and supply.

Advantages of Current International Monetary System

Following are a few advantages of the International Monetary Market

 IMS enhances financial stability and maintains the price level on a global scale. It also
boosts global growth.
 International Monetary System mobilizes money across countries and determines the
exchange rate.
 This system encourages the governments of 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.
 This 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.
 This system tries and avoids any short or long-run disruptions in the world economy.
These advantages are non-exhaustive in nature.

Criticisms of Current International Monetary System

The biggest criticism of the present International Monetary System is that it is incompetent in
avoiding global financial crises. 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.
The second criticism with respect to the current International Financial Architecture is that
sometimes the exchange rate remains misaligned. Managed Float System, sometimes gets
misaligned due to either internal or external factors.

Conclusions
International Monetary System has evolved over the years and has adjusted according to the
prevailing conditions. There have been many criticisms of the prevailing International Monetary
System. Sometimes it becomes difficult to manage Exchange Rate Stability, Monetary Policy
Independence, and Free Capital Mobility altogether. According to experts, these criticisms can
be overcome by filling the gaps in the national monetary system of each country and the
International Financial Architecture at a large. Rather than completely replacing the current
system, a little modification in the regulations would make the current International Financial
Architecture foolproof.