Topic 2 - 2021 - The International Monetary System - SLIDES

TOPIC 2: THE INTERNATIONAL SCHOOL OF BUSINESS DEPARTMENT
MONETARY SYSTEM OF ACCOUNTING AND FINANCE, 2021
FIN 325: INTERNATIONAL FINANCE

BAF III (BS & PS)
TOPIC 2
THE INTERNATIONAL
MONETARY SYSTEM
Introduction
 Trade and exchange are probably older than the
invention of money.
 But in the absence of this wonderful contrivance, the
volume of trade and gains from specialization would
have been rather miniscule.
 What is true of trade and capital flows within a
country, is true – perhaps more strongly – of
international trade and capital flows
 Both need an efficient World Monetary Order (e.g.
transfer of funds) to flourish and yield their full
benefits
DEPARTMENT OF ACCOUNTING AND

SCHOOL OF BUSINESS FINANCE 2021 1-2
The History of Money 1/2

 The history of money consists of three
phases:
1. Commodity money, in which actual valuable
objects are bartered
 Inconvenient to store and transport and is
subject to hoarding.
 It also does not allow the government to control
or regulate the flow of commerce within their
dominion with the same ease that a standardized
currency does.

KOMBA GABRIEL 1
The History of Money 2/2

2. Representative money, in which paper
notes (often called 'certificates') are
used to represent real commodities
e.g. gold, silver etc, stored elsewhere
3. Fiat money, in which paper notes are

backed only by the traders' "full faith
and credit" in the government.

The Classical Gold Standard 1/8

 The history of the International Monetary
System (IMS) dates back to late1880s …
 when the first Modern International Monetary
System –
 the Classical Gold Standard (a standard
economic unit of account was a fixed weight
of gold) –
 gained acceptance in the western Europe


 Gold was a common form of representative
money due to its rarity, durability, divisibility,
fungibility, and ease of identification, often in
conjunction with silver.
 Silver was typically the main circulating
medium, with gold as the metal of
monetary reserve.

KOMBA GABRIEL 2

 The “rules of the game” under the gold
standard were clear and simple:
 Each country sat the rate at which its
currency unit (paper or coin) could be
converted to a weight of gold
 The US declared the $ to be convertible to gold at
a rate of $20.67 per ounce
 The British pound was pegged at £4.2474 per
ounce of gold
 The dollar/pound exchange rate was $20.67/ounce
divide by £4.2474 per ounce =$4.8665/£


 Three (3) versions of the gold standard:
1. The Gold Specie Standard –
 the actual currency in circulation consisted of gold coins
with a fixed gold content.

2. The Gold Bullion Standard -
 The basis of money remained to be a fixed weight of
gold
 The currency in circulation consisted of paper notes
 The authorities could convert on demand, unlimited
amount of paper currency, into gold and vice versa, at
a fixed conversion ratio.

3. The Gold Exchange Standard -
 Paper currencies issued by one country could
be converted into the paper currency of
another country which operated a gold-specie
or gold bullion standard
 Most nations fixed their currencies to the U.S.

dollar and retained dollar reserves in the
United States, which was known as the "key
currency" country

KOMBA GABRIEL 3

 The implication/impact of the gold
standard:
1. The exchange rates between
currencies was fixed – because the
value of each individual currency was
fixed in terms of gold
2. Each country was required to maintain
adequate reserves of gold to back its
currency value

 A major defect in such a system was its
inherent lack of liquidity
 the world's supply of money would necessarily be
limited by the world's supply of gold.
 Moreover, any unusual increase in the
supply of gold, such as the discovery of a
rich lode, would cause prices to rise abruptly
 INFLATION …
 But also when discovered deposits of gold are
mined/extracted to exhaustion
 DEFLATION …

 The International Gold Standard
broke down in 1914, …
 when the British government ended
the convertibility of Bank of England
notes to gold, …
 to fund military operations during
the First World War.

KOMBA GABRIEL 4
The Inter-War Years and WWII 1/3

 Currencies fluctuated widely in terms
of gold and each other (flexible
exchange rates)
 However, the flexible exchange rate led
to international speculation – where
weak currencies were sold short.
 This caused weak currencies to fall
further in value that warranted by real
economic factors.


 In 1934, the US adopted a modified gold
standard – when the US$ was devalued to
$35/ounce from the $20.67/ounce.
 During the WWII many of the main trading
currencies lost their convertibility into other
currencies
 The US dollar was the only major trading
currency that continued to be convertible.


 The strength of the US economy, the
fixed relationship of the dollar to gold ($35
an ounce), and the commitment of the
U.S. government to convert dollars into
gold at that price made the dollar as
good as gold.
 In fact, the dollar was even better than
gold: it earned interest and it was more
flexible than gold.
KOMBA GABRIEL 5
The Bretton Woods System

 Following the 2nd WW, policy makers from the
victorious allied powers (the US & UK), met
at Bretton Woods (1944), to create a new
post-war International Monetary System.
 The outcome was the so called “Bretton
Woods System” and the birth of two new
Supra-National Institutions:
 The International Monetary Fund (IMF)
 The International Bank for Reconstruction and
Development (IBRD) – the World Bank


The IBRD
 Helped to fund post-war
reconstruction
 Since then has supported

general economic development


The IMF 1/6
 The key institution in the new International
Monetary System
1. Established to render assistance to member
countries trying to defend their currencies against
cyclical, seasonal, or random occurrences.
2. It assists countries having structural trade
problems if they promise to take adequate
corrective actions
3. Helps countries in financial crises – provides loans
and advice
4. Cannot save a country from eventual devaluation.
KOMBA GABRIEL 6

The IMF 2/6
 The exchange rate that was put in place under the
original provisions of the agreement, can be
characterized as the Gold Exchange Standard
 All countries fixed the value of their currencies in
terms of gold, but not required to exchange them for
gold. Only the US$ remained convertible into gold
(at $35/ounce)
 Participating countries agreed to fix the parities of
their currencies within 1% of par by buying or
selling forex or gold to any extent required to keep
the exchange within the limits


The IMF 3/6
 The parity of a currency against the dollar
could be changed in the face of a
fundamental disequilibrium.
 Changes up to 10% could be made without
formal approval by the fund (e.g.
devaluation). Larger changes required IMF
approval.
 However, this degree of freedom was not
available to the US – it had to maintain the
gold value of the dollar.

The IMF 4/6
 The U.S. currency was now effectively
the world currency, the standard to which
every other currency was pegged.
 Other countries accumulated and held
dollar balances to settle their international
debts
 The US could by goods from other
countries by paying with its own money.
KOMBA GABRIEL 7

The IMF 5/6
 This system could only work as long as other
countries had confidence in the stability of the
US dollar and the ability of the US treasury to
convert dollars into gold on demand at the
specified conversion rate.
 The system came under pressure and
ultimately broke down when this
confidence was shaken due to various
political and economic factors

The IMF 6/6
 On August 15, 1971 – the US govt abandoned
its commitment to convert $ into gold at
$35/ounce - the dollar was tremendously
overvalued with respect to gold (reserve deficit
of $56 Billion dollars) - the "Nixon Shock".
 By March 1976, all the major currencies were
floating—in other words, exchange rates were
no longer the principal method used by
governments to administer monetary policy.

The Exchange Rate Regimes

 The IMF classifies member countries into
eight (8) categories according to the
exchange rate regime they have adopted
 These categories are hybrids between rigidly
fixed and floating rate.
 A fixed exchange rate = Government endeavour
to maintain target exchange rate through the
national monetary authorities (i.e. central banks or
treasury agencies)
 A floating exchange rate = freely fluctuating
exchange rate

KOMBA GABRIEL 8

Exchange Arrangements with No Separate Legal Tender
 Includes:
 Countries which are members of a monetary or
currency union share a common currency
o e.g. the European Economic and Monetary Union (EMU) –
16 countries – have adopted the Euro (€) except UK;
Denmark and Sweden
 Countries which have adopted the currency of
another country as their sole legal tender
o e.g. the West African Economic and Monetary Union:
Benin, Burkina Faso, Mali etc adopted the French Franc
as their currency,


Currency Board Arrangements
 Under this regime, there is a legislative

commitment to exchange the domestic
currency against a specified foreign currency
at a fixed exchange rate
 Combined with restrictions on the monetary
authority to ensure that this commitment will
be honoured
 e.g. Argentina and Hong Kong tied there currency
to the US dollar


Conventional Fixed Peg Arrangements
 This is identical to the Bretton Woods

system where a country pegs its currency
(formally or de facto) to another, or to a
basket of currencies (a composite),
 With a band of variation not exceeding
±1% around the central parity
 The peg is adjustable at the discretion of
the domestic authorities
KOMBA GABRIEL 9

Pegged Exchange Rates within Horizontal Bands
 Here there is a peg but the formal or

de fact variation is permitted within
wider bands
 It can be interpreted as a sort of a
compromise between a fixed peg and a
floating exchange rate.


Crawling Pegs
 Another variant of a limited flexibility regime;
 The currency is pegged to another currency
or a basket but the peg is periodically
adjusted.
 The adjustments may be:
 pre-announced and according to a well
specified criterion,
 Discretionary in response to changes in
selected quantitative indicators e.g. inflation


Exchange Rates within Crawling Pegs
 The currency is maintained within
certain fluctuation margins around a
central rate (crawling bands)
 it is adjusted periodically at a fixed pre-
announced rate or in response to
change in selective quantitative
indicators

KOMBA GABRIEL 10

Managed Floating with No Pre-determined Path
for Exchange -rate
 The monetary authorities influences the
exchange rate movements by means of
active intervention by …
 Buying and selling foreign currency against
the home currency…
 Without any commitment to maintain the rate
at any particular level or keep it on any pre-
announced trajectory.


Independent Floating
 The exchange rate is market
determined, e.g. $; €; Yen; £
 With the authorities intervening ONLY
TO moderate the speed of change and
prevent excessive fluctuations
 But not attempting to maintain it at or
drive it towards any particular level


Is there an Optimal Ex-rate Regime 1/2
 The choice as to which currency regime
to follow reflects national priorities about
all facets of the economy including:
 Inflation, unemployment, interest rate
levels, economic growth etc
 Ceteris peribus, countries would prefer
fixed exchange rate to floating,
because:
KOMBA GABRIEL 11

Is there an Optimal Ex-rate Regime 2/2
i. Fixed rates provides exchange rate
stability - growth international trade & less
risks
ii. Fixed rates are anti-inflationary – since
they require countries to follow restrictive
monetary and fiscal policies.
iii. Fixed rate regimes necessitates countries
maintain large quantities of international
reserves for use in the occasional defence
of the fixed rate.

Attributes of the Ideal Currency 1/4
 An ideal currency possesses three (3)
attributes:
1. Exchange rate stability
 Fixing the value of one currency in relation to other
major currencies - the issue of forex certainty
2. Full Financial Integration
 A financial system integrated with the global
financial system to allow complete freedom of
monetary flows – in response to perceived
economic opportunities and risks

3. Monetary Independence
 Freedom to conduct an independent
monetary policy
 To pursue desired national economic
policies e.g. limiting inflation, fostering full
employment etc

KOMBA GABRIEL 12

 There is a school of thought that in the years
to come there will be only two types of ex-
rates regime: truly fixed arrangements e.g.
the EMU and the truly market determined
rates.
 The “middle ground” rates will pass in history.
 This argument for the impossibility of the
middle ground is referred to as the
“Impossible Trinity”

 It asserts that a country can achieve any
two of the attributes of the ideal currency but
not all three.
 (i) and (ii) can be achieved with a currency
union or board,
 (ii) and (iii) with an independently floating
exchange rate,
 (i) and (iii) with capital controls
 See exhibit 1

The European Economic and Monetary Union

(EMU) 1/3
 After several years of managed floating rates,
many countries appeared to be headed back to
some form of fixed exchange rate system.
 After failing to redefine the Bretton Woods

system, another adjustable peg system was
born among the countries belonging to the
European Economic Community (EEC) in 1972
 Exchange rates were kept within narrower bands of

1.125%
KOMBA GABRIEL 13

(EMU) 2/3
 In 1979, the EEC became the European
Monetary System (EMS) with 15 members
except the Britain (±2.25% exchange rate bands
among members)
 In 1991, the members of the European Union

met at Maastricht and finalized a treaty that
changed Europe’s currency
 Finally, the single currency “Euro” came into
existence on January 1, 1999.

(EMU) 3/3
 During the transition period, 1999 to 2002 –
the Euro co-existed with the national
currencies of the eleven countries which
joined the single currency.
 As of now, the national currencies have

legally already ceased to exist.
 The EMU countries which have not joined the

market are: the UK, Sweden, and Denmark.
Stages for the Implementation of the EMU

Stage One: 1 July 1990 to 31 December 1993
 On 1 July 1990, exchange controls were abolished,
thus capital movements were completely liberalised
in the EEC.
 The Treaty of Maastricht in 1992 established the

completion of the EMU as a formal objective and set
a number of economic convergence criteria,
concerning the inflation rate, public finances,
interest rates and exchange rate stability.
 The treaty entered into force on the 1 November

1993.
KOMBA GABRIEL 14

Stage Two: 1 January 1994 to 31 December 1998
 The European Monetary Institute is established as the forerunner of the
European Central Bank, with the task of strengthening monetary
cooperation between the member states and their national banks, as
well as supervising ECU banknotes.
 On 16 December 1995, details such as the name of the new currency
(the euro) as well as the duration of the transition periods are decided.
 On 16-17 June 1997, the European Council decides at Amsterdam to
adopt the Stability and Growth Pact, designed to ensure budgetary
discipline after creation of the euro, and a new exchange rate
mechanism (ERM II) is set up to provide stability above the euro and
the national currencies of countries that haven't yet entered the
eurozone.
 On 3 May 1998, at the European Council in Brussels, the 11 initial
countries that will participate in the third stage from 1 January 1999 are
selected.
 On 1 June 1998, the European Central Bank (ECB) is created, and in
31 December 1998, the conversion rates between the 11 participating
national currencies and the euro are established.

Stage Three: 1 January 1999 and continuing
 From the start of 1999, the euro is now a real currency, and
a single monetary policy is introduced under the authority of
the ECB. A three-year transition period begins before the
introduction of actual euro notes and coins, but legally the
national currencies have already ceased to exist.
 On 1 January 2001, Greece joins the third stage of the
EMU.
 The euro notes and coins are introduced in January 2002.
 On 1 January 2007, Slovenia joins the third stage of the

EMU.
 On 1 January 2008, Cyprus and Malta join the third stage
of the EMU.
 On 1 January 2009, Slovakia joins the third stage of the
EMU.
Why Monetary Union?
 Allowing people, goods, services, and capital

to move without restrictions
 Eliminate currency risks of cross-boarder

commerce
 Enable customers and companies treat

individual markets equally
 Etc
KOMBA GABRIEL 15
The End

KOMBA GABRIEL 16

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TOPIC 2: THE INTERNATIONAL SCHOOL OF BUSINESS DEPARTMENT

MONETARY SYSTEM OF ACCOUNTING AND FINANCE, 2021

FIN 325: INTERNATIONAL FINANCE

DEPARTMENT OF ACCOUNTING AND

The History of Money 1/2

DEPARTMENT OF ACCOUNTING AND

The History of Money 2/2

3. Fiat money, in which paper notes are

DEPARTMENT OF ACCOUNTING AND

The Classical Gold Standard 1/8

DEPARTMENT OF ACCOUNTING AND

The Classical Gold Standard 2/8

DEPARTMENT OF ACCOUNTING AND

The Classical Gold Standard 3/8

DEPARTMENT OF ACCOUNTING AND

The Classical Gold Standard 4/8

with a fixed gold content.

The Classical Gold Standard 5/8

 Most nations fixed their currencies to the U.S.

DEPARTMENT OF ACCOUNTING AND

The Classical Gold Standard 6/8

The Classical Gold Standard 7/8

The Classical Gold Standard 8/8

DEPARTMENT OF ACCOUNTING AND

The Inter-War Years and WWII 1/3

DEPARTMENT OF ACCOUNTING AND

The Inter-War Years and WWII 2/3

DEPARTMENT OF ACCOUNTING AND

The Inter-War Years and WWII 3/3

The Bretton Woods System

DEPARTMENT OF ACCOUNTING AND

The Bretton Woods System

 Since then has supported

DEPARTMENT OF ACCOUNTING AND

The Bretton Woods System

The Bretton Woods System

DEPARTMENT OF ACCOUNTING AND

The Bretton Woods System

The Bretton Woods System

The Bretton Woods System

The Bretton Woods System

DEPARTMENT OF ACCOUNTING AND

The Exchange Rate Regimes

DEPARTMENT OF ACCOUNTING AND

The Exchange Rate Regimes

DEPARTMENT OF ACCOUNTING AND

The Exchange Rate Regimes

 Under this regime, there is a legislative

DEPARTMENT OF ACCOUNTING AND

The Exchange Rate Regimes

 This is identical to the Bretton Woods

The Exchange Rate Regimes

 Here there is a peg but the formal or

DEPARTMENT OF ACCOUNTING AND

The Exchange Rate Regimes

DEPARTMENT OF ACCOUNTING AND

The Exchange Rate Regimes

DEPARTMENT OF ACCOUNTING AND

The Exchange Rate Regimes

DEPARTMENT OF ACCOUNTING AND

The Exchange Rate Regimes

DEPARTMENT OF ACCOUNTING AND