International Monetary

System
Week 5
Introduction
• The international monetary system refers to the operating system of
the financial environment, which consists of financial institutions,
multinational corporations, and investors.

• The international monetary system provides the institutional

framework for determining the rules and procedures for
international payments, determination of exchange rates, and
movement of capital
• The major stages of the evolution of the international monetary
system can be categorized into the following stages.
The era of bimetallism
• Before 1870, the international monetary system consisted of
bimetallism, where both gold and silver coins were used as the
international modes of payment. The exchange rates among
currencies were determined by their gold or silver contents. Some
countries were either on a gold or a silver standard.
Gold standard
The international gold standard prevailed from 1875 to 1914. In a gold standard
system, gold alone is assured of unrestricted coinage. There was a two-way
convertibility between gold and national currencies at a stable ratio. No restrictions
were in place for the export and import of gold. The exchange rate between two
currencies was determined by their gold content.
• The gold standard ended in 1914 during World War I. Great Britain, France,
Germany, and many other countries imposed embargoes on gold exports and
suspended redemption of bank notes in gold. The interwar period was between
World War I and World War II (1915-1944). During this period the United States
replaced Britain as the dominant financial power of the world. The United States
returned to a gold standard in 1919. During the intermittent period, many
countries followed a policy of sterilization of gold by matching inflows and
outflows of gold with changes in domestic money and credit.
Gold exchange standard
The Bretton Woods System was established after World War II and was in existence during the period 1945-1972. In
1944, representatives of 44 nations met at Bretton Woods, New Hampshire, and designed a new postwar international
monetary system.
This system advocated the adoption of an exchange standard that included both gold and foreign exchanges. Under this
system, each country established a par value in relation to the US dollar, which was pegged to gold at $35 per ounce.
Under this system, the reserve currency country would aim to run a balance of payments (BOPs) deficit to supply
reserves. If such deficits turned out to be very large then the reserve currency itself would witness crisis. This condition
was often coined the Triffin paradox.
Eventually in the early 1970s, the gold exchange standard system collapsed because of these reasons. From 1950
onward, the United States started facing trade deficit problems. With development of the euro markets, there was a
huge outflow of dollars. The US government took several dollar defense measures, including the imposition of the
Interest Equalization Tax (IET) on US purchases of foreign stock to prevent the outflow of dollars.
The international monetary fund created a new reserve asset called special drawing rights (SDRs) to ease the pressure
on the dollar, which was the central reserve currency. Initially, the SDR were modeled to be the weighted average of 16
currencies of such countries whose shares in the world exports were more than 1%. In 1981, the SDR were restructured
to constitute only five major currencies: the US dollar, German mark, Japanese yen, British pound, and French franc.
The SDR were also being used as a denomination currency for international transactions. But the dollar-based gold
exchange standard could not be sustained in the context of rising inflation and monetary expansion. In 1971 the
Smithsonian Agreement signed by the Group of Ten major countries made changes to the gold exchange standard. The
price of gold was raised to $38 per ounce. Other countries revalued their currency by up to 10%. The band for exchange
rate fluctuation was increased to 2.25% from 1%. But the Smithsonian agreement also proved to be ineffective and the
Bretton Woods System collapsed.
The Bretton Woods Era: 1944–1973
• British and American policy makers began to plan the post-war international monetary
system in the early 1940s. The objective was to create an order that combined the benefits of
an integrated and relatively liberal international system with the freedom for governments to
pursue domestic policies aimed at promoting full employment and social wellbeing.
• The principal architects of the new system, John Maynard Keynes and Harry Dexter White,
created a plan which was endorsed by the 42 countries attending the 1944
Bretton Woods conference, formally known as the United Nations Monetary and Financial
Conference.
• The plan involved nations agreeing to a system of fixed but adjustableexchange rates so that
the currencies were pegged against the dollar, with the dollar itself convertible into gold.
• So in effect this was a gold – dollar exchange standard.
• There were a number of improvements on the old gold standard. Two international
institutions, the International Monetary Fund (IMF) and the World Bank were created.
• The Bretton Woods Agreement and System created a collective
international currency exchange regime that lasted from the mid-1940s to
the early 1970s.
• The Bretton Woods System required a currency peg to the U.S. dollar which
was in turn pegged to the price of gold.
• The Bretton Woods System collapsed in the 1970s but created a lasting
influence on international currency exchange and trade through its
development of the IMF and World Bank.
• https://www.investopedia.com/terms/b/brettonwoodsagreement.asp
• https://
www.investopedia.com/articles/forex/122215/bretton-woods-system-how-i
t-changed-world.asp
Flexible exchange rate regime
• European and Japanese currencies became free-floating currencies in 1973. The flexible
exchange rate regime was formally ratified in 1976 by IMF members through the Jamaica
Agreement. The agreement stipulated that central banks of respective countries could intervene in
the exchange markets to guard against unwarranted fluctuations. Gold was also officially abandoned
as the international reserve asset. In 1985, the Plaza Accord envisaged the depreciation of the dollar
against most major currencies to solve US trade deficit problems.
• In general there are many flexible exchange rate systems. In a free-floating or independent-floating
currency, the exchange rate is determined by the market, with foreign exchange intervention
occurring only to prevent undue fluctuations. For example, Australia, the United Kingdom, Japan,
and the United States have free-floating currencies. In a managed-floating system, the central
monetary authority of countries influences the movement of the exchange rate through active
intervention in the forex market with no preannounced path for the exchange rate. Examples
include China, India, Russia, and Singapore. In a fixed-peg arrangement, the country pegs its
currency at a fixed rate to a major currency or to a basket of currencies. For example, many GCC
countries such as UAE and Saudi Arabia have pegged their currencies to the US dollar.