Chapter 21:

The International Monetary System:

Past, Present and Future
 International Monetary System:
Refers to rules, customs, instruments, facilities and
organizations for affecting international payments. It can be
classified according to:
1- The exchange rate system:
- Fixed with narrow band (Bretton Woods)
- Fixed with wide band
- Adjustable peg
- A crawling peg
- A managed floating
- A freely floating
2- International reserves :
- Gold standard (only gold)
- Pure fiduciary (paper currency only)
- Gold & exchange standard (a combination of the two)
 Fixedexchange rate o Maximizes the flow
without gold (e.g., of world trade
using $ instead as
reserves) o Maximized the
investment

 Adjustablepeg ( or o Guarantees an
equitable
managed float) with distribution of the
gold and foreign gains from trade
exchange, or foreign among the nations.
exchange only.
Adjustment; correct for Balance-Of-Payment

(BOP) disequilibria.

Liquidity; provide adequate reserves to

nations to correct BOP deficits without

a need to devalue their currencies.

Confidence; the adjustment mechanism

works adequately and international

reserves retain their absolute

(quantity) and relative values (no or

very limited devaluations).

 Firs gold standard – 1880 – out
break of World War I in 1914
 Flexible Exchange Rates –
1919 – 1924

(1880 – 1914)
 Each nation defines the gold
content of its currency (mint
parity)
 Stands ready to buy or sell
any amount of gold at that
price (mint parity)
 The tendency of the
currency to depreciate
(past the gold export
point), will be halted by
gold outflows, which
represent the deficit of
the nation.

 The tendency of the

currency to appreciate
(past the gold import
point) will be halted by
gold inflows, which
represent the surplus of
the nation.
 The nation’s money supply is
composed of gold or paper
currency backed by gold.
 Money supply will fall in the
deficit nation (prices will fall)
and rise in the surplus nation
(price will rise) – remember
the quantity theory.
 Exports of the deficit nation
would be encouraged and its
imports discouraged until
deficit is eliminated. The
opposite in the surplus
nation.
 The money supply will
change for BOP
considerations. Therefore the
country will not have a
monetary policy to achieve
full employment without
inflation. This is a basic
classical hypothesis.
 The gold standard ended by the outbreak of the
WWI.
 During 1914-1924, exchange rates fluctuated
widely and there was a desire to return to stability

The United Kingdom:

 In 1925, the UK returned back to the gold
standard at the pre-war price, as well as other
nations.
 (US has already returned to gold in 1919)
 The system was more of a gold-
exchange standard, than pure gold
standard, where gold and other
convertible currencies (£, $ and
FFR) are used. This economizes the
use of gold which supply has
become a smaller percentage of
the world trade (not enough gold to
finance deficits).

 Losing much of its competitiveness,

the UK liquidated most of its
international investments to
reestablish the pound PPP, the
pound was relatively overvalued
which led to BOP deficits and
deflation.
 Faced large Balance-Of-Payment surplus after
the stabilization of the Franc.
 Seeking to make Paris an international financial
center, France decided to settle its BOP surplus
in gold rather than pounds,
 This put more pressures on the gold reserves of
the UK, such that the latter decided in 1931 to
suspend converting the pound into gold,
devalued the pound and the gold-exchange
standard came to an end.
 Lack of adequate adjustment mechanism as
nations sterilized the effect of BOP disequilibria
in the face of inappropriate practices.

 The huge destabilizing capital flows between

London and the emerging international
monetary centers in Paris and New York.

 The outbreak of the Great Depression in 1929.

 By1936 exchange rates among major currencies
were the same as 1930, due to the devaluation race.

 The value of gold reserves increase and most

foreign exchange reserves were eliminated by mass
conversions into gold to protect against devaluation.

 Nations also impose very high tariffs and other

serious import restrictions and international trade
was cut almost in half.