International Business

The International Monetary System

© FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE

 Contents

>First introduction
>Gold Standard
>Bretton Woods System
>Floating currency exchange rates
>IMF’s current exchange rate arrangements
>European monetary integration

© FH AACHEN UNIVERSITY OF APPLIED SCIENCES 31. März 2022 | 2

 To begin with…

> Within countries of the developed world, people

and businesses almost exclusively use the
currency of that country
> As soon as business or travellers leave their
country, it is usually necessary to deal with
another currency
> The trading of currencies and their relative values
are the key aspects of the International Monetary
System

© FH AACHEN UNIVERSITY OF APPLIED SCIENCES 31. März 2022 | 3

History of the International Monetary System

> In 1717, Sir Isaac Newton established the price

of gold
> at 3 pounds, 17 shillings, 10.5 pence per ounce
> Britain had established the gold standard and
stood ready to buy or sell currency for gold at
this price
> The other trading nations each set the price of
gold at a fixed number of units of their own
currency

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The Gold Standard

> Gold or gold-backed notes were the money of the

countries on the gold standard
> If a country bought more abroad than it sold,
money would go abroad to pay for the excess
> Amount of money at home would decrease
> This would cause prices to fall – home country
products would become less expensive and thus
more competitive on world markets
> The opposite would occur in the country which
exported more than it imported
> Hence the gold standard tended to be self-
operating and automatic
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End of the Gold Standard

> The gold standard operated until the First World

War
> Attempts to revive it between then and the
Second World War
> These plans were not very successful
> Some economists and politicians continued to
advocate the gold standard:
> Desirable because it prevented inflation by
imposing discipline on politicians

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The Gold Exchange Standard

> 1944, in Bretton Woods, New Hampshire, US:

> 44 states agreed on a post-war monetary
system
> Bretton Woods System
> Main ideas:
> Fixed, stable exchange rates, rather than flexible
ones, which were said to cause too much uncertainty for
businesses
> Adjustments of agreed parities allowed, since
possibly necessary
> Currency controls allowed: for post-war
reconstruction and developing countries

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The Bretton Woods System

> Background:
> A more liberal system than Gold Standard desired
> Protectionism of the 1920s and 1930s to be
avoided
> The details:
> US$ only currency backed by gold
> Fixed conversion rate: $ 35 = 1 ounce of gold
> Other currencies were given par values in US$
terms:
> £ 1 = US$ 2.40
> FF 1 = US$ 0.18
> DM 1 = US$ 0.2732
> International Monetary Fund (IMF)
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 How Bretton Woods worked

Imports > Exports = BOP Deficit

> Domestic currency flows out
> Exchange rate goes down
> Temporary deficit:
> Central bank intervention
> Possibly IMF support
> Permanent deficit:
> Realignment

Exports > Imports = BOP surplus

> Functions the other way around
> Is not so politically sensitive
> Same consequences as above
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Problems with Bretton Woods

> Compared to Gold Standard:

> US$ only currency officially convertible into
Gold
> BOP deficit of the US became the biggest
worldwide
> Consequence?
> Many countries wanted to swap US$ for gold
> Possible problem?
> More US$ than gold!

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Problems with the Gold Exchange Standard

> Gold for dollars (golden line)

> Gold and dollars go abroad (green line)
1958 1971
$24.8 billion $62.2 billion

$13.6 billion The gold value was set at $35/ounce $12.2 billion

Accumulation of US$s in non-US resident hands and loss of US gold

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The end of Bretton Woods

> Around 1963: just enough gold in US to cover

every US$ in foreign hands
> Thereafter: not enough gold to cover every US$
at $35 per ounce
> By 1971: only US$0.22 worth of gold for every
US$1.00 held by foreign central banks
> August 15, 1971: ‘gold window’ closed
> Since then:
> No more gold for US $
> End of the Bretton Woods System
> Currency values began to ‘float’ according to
market supply and demand
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Post Bretton Woods

> Between 1971 and 1973: two attempts to

establish new fixed rates
> Both unsuccessful!
> Since then: free floating exchange rates – more
or less…
> Two kinds of currency floats:
> Free float
> Managed float

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Floating currency exchange rates

> Freely floating currencies fluctuate against each

other
> Values determined by market forces
> Fluctuations may be quite large
> Financial managers must understand
> how to protect against losses or
> how to optimise gains

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IMF’s current exchange rate arrangements

> Exchange arrangements with no separate legal

tender
> e.g. US$ in El Salvador
> Currency board arrangements
> e.g. Hong Kong
> Other conventional fixed peg arrangements
> fluctuations < 1% allowed. Saudi riyal - US$
> Pegged exchange rates within horizontal bands
> peg with fluctuation > 1%. Danish krone

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IMF’s current exchange rate arrangements

> Crawling pegs

> Readjusted at pre-announced rate periodically
> Exchange rates within crawling bands
> Readjusted to maintain fluctuation margins
> Managed float with no preannounced path for the
exchange rate
> Monetary authority intervention in FX without
disclosing goals or targets: Algeria, India
> Independently floating exchange rates
> Market drives exchange rates – US, Canada, Japan,
UK

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Summary of currency arrangements

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Foreign exchange terminology

> Foreign Exchange Quotation

> The price of one currency expressed in terms
of another
> Central reserve asset
> Asset, usually currency, held by a country’s
central bank
> Vehicle currency
> A non-domestic currency used for international
trade or investment
> Intervention currency
> A currency used by a country to intervene in
the foreign currency exchange markets
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 The situation in Europe

> 1970: Werner Plan for EMU (by 1980)

> Meaning fixed exchange rates, requiring an
“Optimum Currency Area”
> i.e. a high degree of economic integration
> EEC created its own Monetary System, the
“snake”
> Central rates were agreed upon
> Rates were allowed to diverge by a certain
margin before central banks had to intervene
> The snake turned out a disaster!

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The „Snake“

Reasons why the snake was not successful:

> Internal:
> No reference currency
> Permanent realignments (of fixed exchange
rates)
> Changing membership
> External:
> Smithsonian Agreement – „snake in the
tunnel“
> Oil crisis and its repercussions

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European Monetary System (EMS)

> Initiative: Roy Jenkins

> Political support: Schmidt/Giscard D‘Estaing
> New European Monetary System in 1979
> Members: all Member States of the ECs
> 3 components:
> Internal accounting unit, ECU
> Exchange Rate Mechanism
> European Monetary Fund

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 ECU – European Currency Unit

> Artificial currency:

> basket of participating currencies, weighted
according to the relative importance of
respective economy
> ~ 33% DM
> ~ 21% FF
> ~ 11% £ ...

> Necessary for political reasons

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Exchange Rate Mechanism (ERM)

> Unlike snake: central parities vis-à-vis ECU

> Fluctuations allowed within a margin of ± 2.25 %
(± 6 % for Italy)
> When actual exchange rate hit ceiling or floor of
fluctuation margin, central banks had to intervene
> In case of permanent disparities: realignment (of
central rates)

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From EMS to EMU

> Reasons for / aims of ERM & EMS:

> Exchange rate stability within the ECs
> Working towards the goal of Monetary Union
> Since the Single Market Programme „1992“:
> Demands for one currency for the Single
European Market
> A single currency requires monetary union (but
not vice versa!)
> Why Monetary Union?
> Why a single currency?

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Maastricht Convergence Criteria

> Price stability

> Inflation rate no higher than 1.5 % above the average of
the three member states with the lowest inflation rates
> Sound public finances
> National budget deficit no higher than 3 % and national
public debt no higher than 60% of GDP
> Interest rates
> Average nominal long-term interest rate should not
exceed by more than 2 percentage points that of the
three best-performing member states in terms of price
stability
> Exchange rate stability
> The national currency will have to have been inside the
ERM for at least 2 years without realignment
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Chronology of European monetary integration

> 1990 1st stage (treaty changes)

> 1994 2nd stage (institutional arrangements)
> 1999 3rd stage: monetary union for 11 states
> 2001 Greece joins
> 2002 National notes and coins are replaced
> 2007 Slovenia joins
> 2008 Malta and Cyprus join
> 2009 Slovakia joins
> 2011 Estonia joins
> 2014 Latvia joins
> 2015 Lithuania becomes the latest member
So, 19 out of today’s 27 EU members have the Euro...
...but what about the remaining 8?
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ERM II

> Open to EU members outside the Euro

> Fixed exchange rates with Euro
> Currently :
> Danish krone (margin: ±2.25%)
> Bulgarian lev (margin: ±15%)
> Croatian kuna (margin: ±15%)
> All other member states need membership of
ERM II to enter Eurozone
> Denmark has a so-called „Opt-Out“

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 Next topic:

International Organisations

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