INTERNATIONAL

MONETARY SYSTEM
 INTRODUCTION

• The international monetary system consists of

the laws, rules, monetary standards, instruments
and institutions that facilitate international trade
and cross-border flow of funds.

• As various nations may have varying monetary

standards, an international monetary system is
required to define a common standard of value
for various currencies.
• A monetary standard is a standard monetary unit that
acts as a medium of exchange and a measure of the
value of goods and services in a country.

• The monetary standard of a nation influences national

as well as international economic operations.
• As there are several instruments or devices that can be
used as a medium of exchange and a measure of the
value of goods and services, the monetary standard in a
country determines the standard monetary unit for the
exchange of goods and services.
 • A country’s standard
monetary unit or standard
money, may be made of
different things like gold, silver,
and paper.
• There have been different types of monetary
standards in the history of money, but metallic
and paper standards have been the most
widely used.
• If the monetary unit of a country is made of
only one metal, the system is known as
monometallism.

• Ex- for long time, the United Kingdom was on

the gold standard and India was on the silver
standard.
• Some countries followed a system in which the
monetary unit is made of two metals. Such
system is called as bimetallism.
• Both gold and silver coins circulated
simultaneously within the country and could be
exchanged for each other at the rate fixed by
the government.

• Ex:- United states, Switzerland and France

were on bimetallism during the 19th century.
• Paper standards refers to paper money that
has legal sanction for acceptance.
• Paper money is the main currency, and is
unlimited legal tender. Even if paper money is
not convertible into any metal, people accept
it, because it is the legal tender, and this is why
paper money is known as FIAT MONEY.
• Fiat money is money that derives its value
from government regulation or law. The term
derives from the LATIN fiat, meaning "let it be
done" or "it shall be [money]“
• CHINA was the first to issue paper money
• The value of the paper money is determined by
a government or public order and it is not
related to the intrinsic value of that paper.

• Along with paper money, token coins may also

be in circulation to meet smaller requirements.

• In the old days, as metals were the standard

monetary units of countries, they were also
used as international means of payments.
The international monetary system
has gone through several changes
over the years. Which are….
• Evaluation of the international Monetary System
can be analysed in FOUR STAGES as follows.

1. The GOLD STANDARD 1876-1913

2. The INTER-WAR YEARS 1914-1944

3. The BRETTON WOODS SYSTEM 1945-1973

4. FLEXIBLE EXCHANGE RATE REGIME SINCE

1973….
1876-1913
• This is the oldest system which was in
operation till the beginning of the FIRST
WORLD WAR and for a few years after that.

• Gold has been used as a medium of exchange

since time immemorial because of its special
qualities.

• According to the rules of the gold standard, the

value of monetary unit of a country (e.g., paper
money) was fixed in terms of a specified
quantity and fineness (good quality) of gold.
• Governments were committed to a policy of
converting gold into paper currency and paper
currency into gold, by buying and selling gold at
specified rates.

• The issue or circulation of paper money in a

country was backed by its gold reserve at a
specified ratio.

• Therefore, the stock of money in a country

would increase or decrease with changes in its
gold reserves.
• The exchange rate between any two
currencies was determined by the
ratio of the price of a unit of gold, in
terms of the respective units of each
currency.
• When the value of the monetary unit of each
country is fixed in terms of gold, the exchange
rate is also automatically fixed by the gold
parity (similarity).
• In reality, the exchange rate may be different
from the gold parity, leading to arbitrage
opportunities.
• If the gold rate is fixed at INR 13,000 per
ounce (1 ounce = 28.3495231 grams) in India
and at USD 300 in the United States, the
exchange rate between the Indian rupee and
the US dollar will be USD/INR 43.33.
• If the exchange rate, in reality is not INR 43.33,
arbitrageurs will bring it to that level through
their buying and selling operations.
• Ex:- 1. if INR 45 per dollar: let assume that the
exchange rate is INR 45. if arbitrageurs buy
gold in India at INR 13,000 per ounce, ship it
to the US, sell it at USD 300, and convert the
US dollars to Indian rupees, they can make an
arbitrage profit of INR 500 per ounce of gold.

2. if INR 42 per dollar.

• The gold standard was widely appreciated
because of certain inherent characteristics of
gold as well as the rules governing the
standards.
• Under the gold standard, any disequilibrium in
the balance of payments of a country gets
corrected automatically.
• As gold is the base for creation of money in
the economy, politicians cannot indulge in
unrestrained (uncontrolled) money creation.
• Thus, countries can maintain stability in prices
as well as exchange rates when they are under
the gold standard.

• Main demerit is this system do not allow the

government to increase the money supply in
the country without increasing gold reserves,
even when the expansion of money supply is
necessary to tide over the serious situations.
• The gold standard that existed till 1914 was
called the classical gold standard and it was
embraced by most nations.
• More particularly, during the period 1880-
1914, there was a rapid expansion of
international trade with stable domestic prices
and foreign exchange rates.
• Along with the free flow of goods, there was
also free flow of labour and capital across
countries.
DECLINE OF THE GOLD STANDARD
• There are several reason why the gold standard
could not function well over the long-run.
• One problem is that the currencies must be
valued in terms of gold.
• Other problem is that the flow of gold between
countries cannot be restricted.
• Gold is a scarce commodity, gold volume could
not grow fast enough to allow adequate
amounts of money to be created (printed) to
finance the growth of world trade.
 2.The INTER-WAR YEARS 1914-1944
• The gold standard as on International
Monetary System worked well until World War
- I, but later interrupted trade flows and
disturbed the stability of exchange rates for
currencies of major countries.

• There was widespread fluctuation in

currencies in terms of gold during World War I
and in the early 1920s.
• The United States began to assume the role of
the leading creditor nation.

• Number of countries made several attempts to

return to the gold standard.

• But the inter-war period was characterized by

half-hearted attempts and failure to restore the
gold standard, economic and political
instabilities, widely fluctuating exchange rates,
bank failures and financial crisis.
• The Great Depression in 1929 and the stock
market crash also resulted in the collapse of
many banks.
 3.The BRETTON WOODS SYSTEM 1945-1973

• Revival of the system was necessary and the

reconstruction of the post-war financial system
began with the Bretton Woods Agreement only.

• The main aim of the meeting of the

representatives of 44 countries at Bretton
Woods, New Hampshire in July, 1944 was to
bring about international financial order through
an effective monetary system.
• The negotiators at Bretton Woods made certain
recommendations in 1944:

• 1. Each nation should be at liberty to use

macroeconomic policies for full employment .

• 2.The extremes of both permanently fixed and

free floating rates should be avoided.

• 3. a monetary system was needed that would

recognize that exchange rates were both a
national and an international concern.
• The agreement established dollar based
International Monetary System and created
TWO NEW INSTITUTIONS.

• 1. THE INTERNATIONAL MONETARY FUND

(IMF), Washington.

• 2. THE INTERNATIONAL BANK FOR

RECONSTRUCTION AND DEVELOPMENT
(WORLD BANK)
• The basic role of the IMF would be to help
countries with balance of payments and
exchange rate problems .

• The world bank would help countries with post-

war reconstruction and general economic
development.

• The basic purpose of this new monetary system

was to facilitate the expansion of world trade
and to use the US dollar as a standard of value.
 The main points of Bretton Wood System are:
• A new institution, the IMF would be
established. Its purpose would be to lend
foreign exchange to any member whose
supply of foreign exchange had become
scarce.

• The US dollar would be designated as reserve

currencies, and other nations would maintain
their foreign exchange reserves principally in
the form of dollars or pounds.
• Each country would fix a par value of its
currency in relation to the US dollar.

• Member countries were expected to maintain

their exchange rates within a margin of 1% on
either side of the par value.

• The exchange rates were allowed to fluctuate

only with +/- 1% of the stated par value.
• Whenever the demand and supply factors in
the market caused exchanges rates to go
outside the permissible limits, countries other
than the United States would buy and sell US
dollars in the market in order to keep the
exchange rates within +/- 1% limits.
 POST-BRETTON WOODS SYSTEM
• The Bretton woods system worked almost
smoothly till the 1960s. There was stability in
exchange rates, which promoted international
trade and investment.

• In the early 1970s, however, it was realized

that Bretton Woods system was not working as
expected.
• Because of increase in prices, many countries
devalued their currencies by more than 30%
against the US dollar.
• With the increasing levels of world reserves, the
US balance of payments deficit increased.

• Initially, the US BOP deficit was not viewed as a

problem. However, as the US gold reserves
progressively came down and other countries’
holdings of US dollar balances increased.

• Many countries started putting pressure on the

US to convert its US dollar resources into gold,
but it did not have enough gold to honor its
commitments.
• Therefore, in mid-1971, the US decided to
give up its role as the anchor of the
international monetary system and
devaluated the US dollar to deal with the
mounting (increasing) trade deficit.
Alternative Exchange Rate Regimes (rules)
• The international monetary system plays a vital role
in the flow of goods, services, and capital across
countries.
• It influences international trade and investments to a
great extent. There is a wide choice of exchange rate
regimes to choose from, ranging from completely
fixed to freely floating, with a number of options in
between.
• A country can choose an exchange rate regime
depending on the long-term goals of its economic
policy.
 Foreign Exchange Rate
Systems

FIXED INTERMEDIATE FLEXIBLE

 FIXED
CURRENCY DOLLARIZA CURRENCY CURRENCY
BOARDS TION UNIONS BASKETS
 INTERMEDI
ATE
Crawling broad band Crawling narrow band
 FLEXIBLE
FREE FLOAT MANAGED FLOAT
 FIXED EXCHANGE RATE SYSTEMS
• It is an exchange rate regime (rule) in which
the government of a country is committed to
maintaining a fixed exchange rate for its
domestic currency.
• Under this system, the government of a
country announces an exchange rate, called
the parity ( equal) rate, and defends (protect)
it.
• To maintain the exchange rate, the government
is always ready to buy or sell unlimited
quantities of a foreign currency at a fixed rate.
• To prevent the exchange rate from
appreciating, the govt. buys foreign currency in
exchange for domestic currency.
• The increased supply of the domestic currency
lowers its value. Similarly, to prevent the
exchange rate from depreciating, the govt.
buys domestic currency using the foreign
currency.
• In order to make such transactions, the
government must have sufficient quantities of
foreign currency as well as domestic currency.
• When the government is not able to maintain
sufficient supplies of these currencies, it fails to
maintain the exchange rate.
• The gold standard is the classical example of
fixed exchange rate system.
 Currency Boards
• Currency board: It is a monetary authority that
issues its base money (notes and coins) and fixes
the exchange rate.
• a country commits, by law, to exchange
domestic currency for a specified foreign
currency at a fixed rate.
• The domestic currency is anchored to a foreign
currency, which is also known as the reserve
currency.
• The board selects a foreign currency which is strong, and
this currency is internationally traded as the anchor
currency.

• The value and stability of the local currency is directly

linked to the value and stability of the anchor currency.

• A currency board can function alone or work in parallel to

the central bank of the country. If is functions along with
the central bank, the central bank virtually loses its
monetary autonomy.
• Under this system the country holds reserves
of foreign currency (or gold or some other
liquid assets) equal at the fixed rate to at least
100% of the domestic currency issued.
• Countries such as Lithuania, Estonia and
Bosnia have their local currencies anchored to
the euro.
• Argentina had a currency board system
(anchored to the US dollar) until 2002.
• Example: Argentina adopted currency board
between 1991-2001 when one peso can be
exchanged to one dollar. To maintain the
currency board arrangement, the constitution
of Argentina specifies that the amount of
domestic money supply cannot exceed the
country’s foreign reserves.
• The main advantage of the currency board
system is that it offers the prospect of a stable
exchange rate.

• The major problem with the currency board

system is the loss of monetary independence.
It is argued that the currency board system
creates problems as it becomes very difficult
to respond to external shocks by using
monetary policy.
 Dollarization
• Dollarization is a generic term that refers to the
use of any other currency (dollar or not) in place
of a domestic currency as the legal tender.
• Some nations abandon their domestic currency
and use of the major reserve currencies.
• Panama has been using the US dollar as the legal
tender since 1904. countries like as Ecuador
dollarized in 1999. when a country is unable to
manage its own economic affairs, it may become
an attachment to the country issuing the currency.
 Currency Unions
• When a group of countries feel that multiple
currencies and exchange rate fluctuations are
seriously affecting their trade, they may adopt
an exchange rate regime known as a currency
union.
• In such a regime, countries decide to adopt a
common currency so that, by definition,
exchange rates between the member countries
of the union disappear.
• The largest currency union in the
world has been formed by 12
countries of the European Union,
using the euro as its common
currency.
 Currency Baskets
• Pegging (attaching) a currency to another
single currency might be risky at times.
• So, a country might peg its currency to a
basket of foreign currencies. A basket of
currencies is likely to be less variable than a
single currency.
• If the currencies for a basket are chosen
correctly, the resulting peg will be more
stable.
• However, managing such a peg can be quite
burdensome.
• When the currencies are not equally
important, weights should be assigned to each
currency in accordance with the economic
power of the nations included in the basket.

• For this reason, currency baskets often include

a small number of major currencies.
 4. FLEXIBLE EXCHANGE RATE REGIME SINCE 1973….
• The flexible exchange rate system has an
exchange rate between two currencies that is
determined by market forces.

• Which means rate is determined by the forces

of demand and supply for a currency vise-versa
another currency.

• The major advantages of the flexible exchange

rate system are:
• This system allows the foreign exchange market
to determine what a currency is worth, it keeps
the BOPs of all countries in equilibrium through
an automatic adjustment mechanism.

• Ex: if a country has a deficit in the BOPs, the

exchange rate of its currency depreciates. Which
means the depreciation of the home currency
encourages exports and discourages imports,
adjusting the country’s BOPs deficit.
• If a country is able to control its trade deficit
through the flexible exchange rate system, it
implies that it has a strong economic system.

• A country can boost its image and attract

foreign investments by adopting a flexible
exchange rate system

• Under this, there is no need to bother about

tariffs, subsidies and quotas, etc., as they are
automatically taken care of by market forces.
• Another great advantage of this system that, it
allows countries to pursue their own economic
policies and to maintain their economic
independence.
 THE FREE FLOATED
• In a free float, the government does not
announce a parity rate; therefore, there is no
intervention by the monetary authority in the
foreign exchange market.
• Exchange rates vary in accordance with
changes in the demand and supply of a
currency. Demand and supply are influenced
by several factors, which may include:
• Economic Factors
• Social Factors
• Political Factors and
• Technological Factors.
• In other words, any change in environmental
factors may result in a change in the demand
or supply of currency.
• The free float is also known as the Pure float
or the clean float system.
 THE MANAGED FLOAT
• In free float, exchange rates may change
drastically, making international transaction
very risky.
• Fluctuations in exchange rates can cause a lot
of uncertainty about the future spot rates for
market participants.
• A country may adopt a managed float system
to guard against such troublesomesituations.
• Under such system, the monetary authority of
the country may occasionally intervene in the
foreign exchange market, and buy and sell the
domestic currency.
• Intervention by the government in the foreign
exchange market to smooth out exchange rate
fluctuations is known as a managed float or a
dirty float.
• The managed float is primarily aimed at
eliminating excess volatility and reducing
uncertainty.
• Under managed float system, the government
intervenes in the foreign exchange market
whenever it wants the exchange rate to move
in a particular direction or to stabilize at a
target level.
 CURRENCY PEGGING
• Which involves fixing the value of a currency
in relation to the value of another currency.
• A currency can be pegged to another currency
or to a basket of currencies.
• A country with a pegged exchange rate
establishes a fixed exchange rate with another
currency or a basket of currencies. So, the
values of the pegged currencies move
together over time.
• Generally, a country may peg its currency to
the currency of its major trading partner in
order to stabilize its trade receipts and
payments.
• The effort required for making changes in
exchange rates can be minimized when a
currency is pegged to another strong currency,
because the value of the currency will
automatically move with the value of the other
currency, regarding which the other country
has made a through analysis.
 Currency pegging
types

Adjustable
Hard pegging Soft pegging
pegging
 Hard pegging
• In the case of hard pegging, exchange rates are
fixed and the government has not plans to
change them.
• Currency boards and dollarization are examples
of hard pegging.
• In reality, hard pegging corresponds to fixing the
exchange rate to a hard currency and holding
enough reserves to back up the peg. (attach)
 Adjustable pegging

• This system allows the government to revise

or adjust exchange rates periodically.
• The Bretton Woods System is example for this
case.
 Soft pegging
• Soft pegging involves frequent adjustment of
exchange rates.
• This may be high-frequency pegging (day-to-
day or week-to-week pegging) or low
frequency pegging (month-to-month or
quarter-to-quarter)
 INTERMEDI
ATE
Crawling broad band Crawling narrow band
 Crawling peg
• It is a hybrid system with some features of the
flexible exchange rate system and some
features of the fixed exchange rate system.
• It involves fixing a par value of a currency and
allowing the exchange rate to move within a
given percentage.
• Under this system, however, governments are
at liberty to revise the par value, as well as the
limits when required.
• The crawling peg system avoids violent
fluctuations in the exchange rate without being
flexible.
• Crawling peg system is divided into two:
• Crawling broad band: in this the limits around
the central parity (equality) are wide enough (+/-
20%) to provide more flexibility.
• Thus, exchange rates are fixed, but considerable
fluctuation is permitted around the central parity
rate.
• Crawling narrow band: it is almost equivalent
to the fixed exchange rate regime. (Ex: The
Bretton Woods system)
 EVALUATION OF FLOATING RATES
• A floating exchange rate is a type of an
exchange rate regime. It is also called the
flexible exchange rate.

• In case of a floating exchange rate, the value

of a currency keeps on fluctuating in
accordance with the movement of the foreign
exchange market.
• The floating exchange rate is the opposite of the fixed
exchange rate. Certain economic experts are of the
opinion that a floating exchange rate is more
preferable than a flexible exchange rate.
• EX:- Canada, where the value of the national currency
is determined by the movements of the foreign
exchange market.
• If there is a situation where the economic balance is
found to be disturbed, the central banks of the
particular country comes in to salvage (save) the
situation and floating rate is somehow kept
operational.
• Such cases are also called managed floats.
• A floating exchange rate or fluctuating exchange
rate is a type of exchange rate regime wherein a
currency’s value is allowed to fluctuate
according to the foreign exchange market.
• A currency that uses a floating exchange rate is
known as a floating currency.
• There are economists who think that, in most
circumstances, floating exchange rates are
preferable to fixed exchange rates. As floating
exchange rates automatically adjust, they enable
a country to dampen (reduce) the impact of
shocks and foreign business cycles,
• And to prevent the possibility of having a balance
of payments crisis.
• However, in certain situations, fixed exchange
rates may be preferable for their greater stability
and certainty.
• Depending upon the needs of its economy and
other factors, a country can design its own
exchange rate system or follow a system that
already exists.
• Each nation chooses an exchange rate regime
that will enable it to achieve its economic
objectives.
• A large number of countries including the United
States, the United Kingdom, Canada, Japan, New
Zealand, and Australia allow their currencies to
float independently in the foreign exchange
market.
• The exchange rates of these currencies are
essentially determined by the market forces.
• Countries such as Russia, Singapore, Pakistan,
India and Vietnam are under the managed
floating system. Some countries may also have a
mixture of fixed and floating exchange rate
regimes.
 EXCHANGE RATE REGIMES OF IMF
MEMBER COUNTRIES
90
80 79

70
60
60
50 48

40
30
20
10
0
HARD PEGS SOFT PEGS FLOATING PEGS
2006
EUROPEAN MONETARY UNION (EMU)
• The Heads of State and governments of
countries of the European Union decided at
Maastricht on 9th and 10th December 1991 to put
in place the European Monetary Union (EMU).
• Adhering (sticking) to the EMU means
irrevocable fixed exchange rates between
different currencies of the Union.
• The setting up of EMU has been step towards
the introduction of common currency in the
member states of EU as per the Maastricht
Treaty (agreement).
• It has been ratified by all the 12 countries, which
constituted the Union at the point of time.

• on 1 January 1999, the new single currency of

the European Union, the euro, was quoted for
the first time on the international exchange
markets under its international abbreviation,
‘EUR’

• http://ec.europa.eu/economy_finance/emu_history/index_en.htm
OBJECTIVES OF EMU:
• Adoption of an economic policy, based on a
close coordination between economic policies of
the member states.

• Fixing the irrevocable exchange rates leading to a

single currency.

• Development of a single policy having an

objective of price stability and the support to the
economic policies of the Member States in
general.
Advantages of European Monetary Union:
• The primary advantage of EMU is that it has
helped in establishing exchange rates in the
currencies of members states. Which means,
currencies cease to fluctuate.
• Elimination of the transaction costs, otherwise
required to be incurred in dealing with multiple
currencies; it also resolves uncertainties
associated with fluctuation in exchange rates.
• All prices will be in the common currency and,
therefore, obviously, it is likely to bring about a
greater transparency in prices.
• Better functioning of financial markets due to a
single currency. This apart, liquidity of financial
markets is going to be enhanced.
• Greater credibility with respect to the world
outside.
• EMU signifies giving up an independent
national monetary policy.
• There seems to be an agreement among the
member states that the effect of the European
Monetary System (EMS) will be beneficial for
the economic growth of Europe.
• Arguments
• For
• The Euro makes trade and travel between
Eurozone countries cheaper and easier.
• The Euro creates greater economic stability in
the countries that use it because it takes control
of monetary policy out of the hands of
politicians and gives it to the ECB. This
encourages confidence among investors.
• The Euro is a symbol of European identity and a
vital part of the process of political integration.
• Against
• The Eurozone is not an optimal currency area; the
economies that make it up are too different to make the
Euro work properly. This could result in more severe
unemployment during recessions and more inflation
during booms.
• EMU can't work because so many members fail to meet
the Stability and Growth Pact (SGP) rules. This will
eventually create uncontrollable splits.
• A national currency is a symbol of identity: adopting the
Euro means symbolically and practically giving up
sovereignty.
• The Euro is primarily a political, not an economic project.
• The three stages for the implementation of the EMU
were the following:
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 European Economic Community.
• The Treaty of Maastricht in 1992 establishes the
completion of the EMU as a formal objective and sets
a number of economic convergence criteria,
concerning the inflation rate, public finances, interest
rates and exchange rate stability.
• The treaty enters into force on the 1 November 1993.
 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 euro zone.
• 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.
• On 1 January 2002, the euro notes and coins are introduced.
• 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.
• On 1 January 2011, Estonia joins the third stage of the EMU.
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