CHAPTER 2 – THE

INTERNATIONAL
MONETARY SYSTEM
LEARNING OBJECTIVES
oDetail how the International Monetary Fund categorizes the many
different exchange rate regimes operating across the globe today
oExamine how the choice of fixed versus flexible exchange rate
regimes is made by a country in the context of its desires for
economic and social independence and openness
WHAT IS EXCHANGE RATE?
” The exchange rate is the price of one currency expressed in terms of
another currency”
•The demand for foreign currencies generates a supply of domestic
currency; and demand for the domestic currency generates a supply
of foreign currencies
•In a simple two-currency example using pounds and yen, it follows
that:
demand for pounds ⇔ supply of yen
demand for yen ⇔ supply of pounds
FIXED vs. FLEXIBLE
EXCHANGE RATES
WHAT IS FIXED
EXCHANGE RATE?
oA country's exchange
rate regime under which the
government or central bank ties
the official exchange rate to
another country's currency or to
the price of gold.
oThe purpose of a fixed exchange
rate system is to maintain a
country's currency value within
a very narrow band.
WHAT IS FLEXIBLE
EXCHANGE RATE?
oAlso known as “Floating
exchange rate”
oA regime where
the currency price is set by
the forex market based
on supply and
demand compared with
other currencies.
 ◦ Benefits:
◦ Exchange rate stability – high level of certainty
WHY DO MOST ◦ Inherent anti-inflationary nature of fixed prices
COUNTRIES ◦ Problems:
◦ Need for central banks to defend the fixed rate
PREFER FIXED with hard currencies and gold
EXCHANGE ◦ Fixed rates can be maintained at rates that are
RATES? inconsistent with economic fundamentals
CONTEMPORARY CURRENCY REGIMES
Category 3:
Category 1: Hard Category 2: Soft Category 4:
Floating
Pegs Pegs Residual
Arrangements

Mostly market driven, The remains of

Countries that have Also called fixed
these may be free currency arrangements
given up their own exchange rates, with
floating or floating with that don’t well fit the
sovereignty over five subcategories of
occasional government previous
monetary policy classification
intervention categorizations

E.g., dollarization or
currency boards
IMF Exchange
Rate
Classifications
IMF Exchange
Rate
Classifications
PEGGED EXCHANGE RATE CONDITIONS
The following conditions are likely to favor the adoption by a country of
some form of pegged exchange rate regime:
• its degree of involvement with international capital markets is low;
• its share of trade with the country to whose currency a peg is being considered is high;
• the economic shocks it faces are similar to those facing the country to whose currency
a peg is being considered;
• it is willing to give up monetary independence for its partner's monetary credibility;
• its economy and financial system already extensively rely on its partner's currency;
• because of high inherited inflation, exchange-rate-based stabilization is attractive;
• fiscal policy is flexible and sustainable;
• labor markets are flexible;
• it has high international reserves.