Chapter 4

The Monetary System

 INTRODUCTION

• The monetary system of today influencing trade,

investment, and even daily private and public sector
operations can be traced back to to early nineteenth
century

• Monetary system evolved from gold as a holder of

value to paper currency in the late eighteenth century

• How the current monetary system developed into its

current form, and it affects a company’s global activities,
and what will be the future of monetary system
 WHAT IS THE INTERNATIONAL
MONETARY SYSTEM?
An Association of Many Loosely Coordinated
Banks
•There are around 200 independent nations today, and around
180 of these countries are members of three interrelated
organizations:
•The United Nations
•The Word Bank
• International Monetary fund (IMF)
IMF and other international, supranational financial institutions
interact with a loose association of national and regional banks
to create monetary environment that is what we call “the
monetary system”
Two Hundred Independent National Banking
Systems with Separate Currencies
• Most of the nations has its own banking system and
individual currency to assist people in financial transaction
including business, investment and international business
and trade
• Billions of dollars in cross-border currency trading takes
place daily
• The level of foreign exchange transaction rises almost
geometrically as the globalization of economic transactions
accelerates
Foreign Currencies Lead Their Own
Lives
• Money and interest rates are increasingly treated
today by banks, traders, and investors like
speculative commodities
• Foreign currencies have a life and value of their own
apart from the demand and supply of the currencies
• That’s why Malaysian Prime Minister Mahathir
Mohamed Complain that foreign exchange trading
should be made “illegal”
The Monetary System to the Rescue
• The monetary system as it exists today is an informal
association of public and private banks
• This informal association function under a set of
national and international understanding (protocols),
rules and regulation, procedures, and laws to maintain
discipline and order in monetary markets
• Discipline in the monetary market is maintained by
managing cross-border currency flows, foreign
exchange prices, and interest rates through the
coordinated activates of central banks, private banks,
and the IMF
 HISTORICAL BACKGROUND

Two Hundred Years of Scrip With and

Without Gold backing
•Historical people use gold and silver for trading
domestically and internationally
•Governments around the world started issuing gold and
silver coins to people who were doing business with the
government
•Issuing money was a monopoly of the government as it is
today
•Between 1800 and 1815 the continuing war in Europe
made the movement of gold hazardous.
•Paper money (fiat money) backed by the gold became a
alternative to the risky process of shipping gold
 HISTORICAL BACKGROUND

Two Hundred Years of Scrip With and

Without Gold backing
•Governments started issuing credit notes, fully backed by
gold held in government vaults
•These credit notes became legal tender and gradually
gained popular acceptance
•This practice eventually replaced gold as the legal holder
of value
 HISTORICAL BACKGROUND

Backing Paper Money with Pure Gold

•The current monetary system is based upon gold
standard which started in the early 1800s.
•The purpose of creating a stable exchange rates for
commonly traded currencies being printed on paper
•Gold was the first universally accepted standard backing
all major paper currencies
•The gold standard turned into gold exchange standard in
1934 continued until 1971
•The floating rate exchange was introduced in 1971 and
still in use today
 HISTORICAL BACKGROUND

The Gold Standard and Fixed Exchange

Rate System
•The gold standard was based on system of fixed
currency exchange rates in which currencies prices were
based on nation’s monetary unit as defined by a given
weight and quantity of gold
•A country’s money supply was limited to the amount of
gold held by the government’s national bank
•Gold standard countries generally agreed that all paper
money backed by gold could exchanged for gold on
demand
•However government’s promise was not always right
 HISTORICAL BACKGROUND

The Central Banking System

•International foreign exchange was largely controlled by
government-owned banks called central banks
•Before wealthy families used to control the financial
activities of state and provide funds to governments
mainly for wars
•In the early nineteenth century governments found it
cheaper and reliable to become their own banks, this also
stopped the private banking powers who were
occasionally responsible for economic collapse
•In the United States Federal Reserve system was formed
in 1913
 Historical Background

Privatization of Economic Enterprise

•In nineteenth century international commerce
beginning to separate itself from state ownership or
franchise
•During that time private traders were dependent upon
emerging central banks for licenses to send and receive
money
•Still European central banks handle the foreign
currency and monetary gold affairs for the governments
 Historical Background
Exchange Control Authority
•The power of a central bank to control international
financial flows is called “exchange control authority”.
•Exchange Control authority of a central bank can allocate
foreign exchange reserves (foreign currency) to
individuals and companies
•Through exchange control authority central bank can
participate in international currency market to support its
national currency or or currencies of other nations
•But the US federal reserve has no excange control
authority like other countries
 Historical Background
How the Gold Standard Worked with Central
Banking
•A Country money supply was determined by the central
bank’s stock of monetary gold
•A surplus in inflow of net gold would allow the trade
surplus country to print more money or up-value its
currency
•A trade deficit country would lose monetary gold and
would have to reduce its money supply or devalue its
currency
 Historical Background
Determining the foreign Exchange Rate
•Central bank controlled their nations money supply in
the same manner as they do today
•A country that insisted on issuing as much currency as
another country but had less gold would possess
cheaper currency
 Historical Background
Central Bank Intervention in Monetary
Stability
•Corporation among central banks to preserve
international currency price stability has continues to the
present day
•Central banks mutually support system that consists of
purchasing weaker currencies with stronger ones to
stabilize foreign exchange market
•Stable currency prices are the key to maintain stability
in international monetary market.
•This support system is called central bank intervention
 Historical Background
Central Bank Intervention in Monetary
Stability
•Central bank intervention made it possible for trade
and investments to grow in their respective nation
•Foreign exchange rates were fixed, and they could not
be changed without the intervention of central banking
system
 Historical Background
The Gold Exchange Standard 1934–71
•Most countries abandon the gold standard by the early 1920s
•Because of rapid increase in world trade and investment, this
system was no longer practical
•Decrease in the demand of some currency destroyed the
trading value of those currencies that were no longer backed by
gold
•People started losing trust in the national currencies
•Gold standards started in 1934 with a unilateral declaration by
the United States
•United States declare it would buy any US dollar at the
officially price of 35$ per troy ounce
 Historical Background
The Gold Exchange Standard 1934–71
•This was an effort to increase the dollars value by backing it
directly with gold, thus giving new life to the aging gold
standard
•This system was finally abandoned when the IMFwas created
in 1944
 Historical Background

The U.S. Dollar Dominance

•This was a major change under the new system
•US dollar became the currency of the world and hence the
world’s key international reserve currency
•Because the US dollar was so strong, therefore, it was
considered as good as gold, and therefore could be used as
legal tender by the rest of the world
 Historical Background
Central Banks Coordinate Their Activities with the IMF
•The countries who joined IMF allowed more coordination in their
currency support process
•Finally foreign exchange rates were allowed to fluctuate freely within
prescribed fixed exchange rate
•Exchange rate was no longer an inflexible price maintain by a Central
Bank
•The fluctuation in currencies across the border was viewed as a
barometer of what was going on in the world of international commerce
 Historical Background
Central Banks Coordinate Their Activities with
the IMF
•When a national currency price was falling toward minimum, so
central banks and IMF would buying up quantities of the weaker
currency with stronger ones to support it
•If a national currency price move to the maximum point, so IMF
and central banks would selloff the currency at lower price to
bring down the foreign exchange rate
 Historical Background
The Floating Rate system,1971 to Present
•The gold exchange standard ended in 1971 because of the
speculation that the US might not be able to fulfill its 1934
promise
•People on powerful positions in the U.S. starting to believe that
if paper money is managed properly it can reflect the economic
strength and position
 Historical Background

The End of Fixed Foreign Exchange Rates

•The fix exchange rate was ended in 1971
•All currencies started maintaining its prices based on a global
supply and demand
•This system which is still followed today is called floating rate
system
 Historical Background
How Floating Rates Work?
•The use of gold is a baking for currency is minimized under
floating rate system
•Monetary gold or gold held as international reserve assets by
nations in the system has been essentially demonetized since
1970s
•Under a floating rate system, currency prices are determined
by the supply and demand for a specific currency, based upon
inflation, trade and investment, and other events
 Historical Background
Hard Currencies and Soft Currencies
•Hard Currency
•Definition: A stable and widely accepted currency.
•Characteristics:
• Strong and reliable.
• High liquidity.
• Used in international trade.
•Examples: US Dollar (USD), Euro (EUR).
 Historical Background
Hard Currencies and Soft Currencies
•Soft Currency
•Definition: A less stable and less accepted currency.
•Characteristics:
• Prone to inflation and volatility.
• Limited international use.
• May require exchange controls.
•Examples: Argentine Peso (ARS), Venezuelan Bolívar (VES).
 Historical Background
Pegged Currencies
•A pegged currency is a currency whose value is directly fixed,
or "pegged," to the value of another currency, typically a
stronger and more stable one.
•Purpose: Pegging helps stabilize the exchange rate and
reduce currency volatility, making it more predictable for
international trade and investment.
•Examples:
• The Bahamian dollar is pegged to the U.S. at one-to-one
ratio
• The Chinese Yuan (CNY) is pegged to a basket of
international currencies.
 INTERNATIONAL LIQUIDITY, INTERNATIONAL
RESERVE ASSETS, AND THE OFFICIAL
SETTLEMENT OF INTERNATIONAL OBLIGATIONS
What Country Do to Pay Their International
Obligations
•Countries just like people have bills to pay
•They must hold a quantity of international liquidity, also known
as international or reserves assets, that can be used to
discharge official international debts
 INTERNATIONAL LIQUIDITY, INTERNATIONAL
RESERVE ASSETS, AND THE OFFICIAL
SETTLEMENT OF INTERNATIONAL OBLIGATIONS
A country’s checking account
•Country’s checking account is just like a personal checking
account, when the account is debited liquidity will go
•Four countries liquidity can be in the shape of gold, special
drawing rights, reserved position with the IMF, and foreign
exchange reserves
•When a country’s international reserves assets are low, then it
becomes necessary to borrow from foreign sources
•A country such as China having net surpluses in its
international transaction enjoys high foreign exchange
reserves can lend money to other countries in need
 INTERNATIONAL LIQUIDITY, INTERNATIONAL
RESERVE ASSETS, AND THE OFFICIAL
SETTLEMENT OF INTERNATIONAL OBLIGATIONS
Borrowing and Lending Funds
•Countries also engage in borrowing and lending operation
with each other
•A country with low financial assets may borrow reserves from
other country
•Borrowing reserves from other countries will increase its
international liquidity, but it will also increase its international in
debt
 INTERNATIONAL LIQUIDITY, INTERNATIONAL
RESERVE ASSETS, AND THE OFFICIAL
SETTLEMENT OF INTERNATIONAL OBLIGATIONS
Monetary Gold
•The use of monetary gold was widespread until the 1970s.
•Country rarely use gold today to Settle international payments
•The United States does not back its own currency with gold
and other nations do not need feel the need to do so either
•Gold has been largely demonetized, and the efforts to restore
a gold or gold exchange standards have been unsuccessful.
•The reason behind gold demonetization is that international
financial structure should not rely on gold
 INTERNATIONAL LIQUIDITY, INTERNATIONAL
RESERVE ASSETS, AND THE OFFICIAL
SETTLEMENT OF INTERNATIONAL OBLIGATIONS
Special Drawing Rights(SDR’s)
•SDR’S are an international reserve asset created by the
International Monetary Fund (IMF) in 1969 to supplement other
reserve assets of member countries. The SDR is not a currency,
but a potential claim on the freely usable currencies of IMF
members. SDR’s can be used to:
•To settle international payments
•To supplement foreign exchange reserves
•To obtain loans from the IMF
•To contribute to the IMF's resources
•SDRs can help countries to build up their foreign exchange reserves and
reduce their reliance on debt.
•SDRs can help countries to meet their balance of payments obligations.
•SDRs can help countries to access IMF financing on more favorable terms.
 INTERNATIONAL LIQUIDITY, INTERNATIONAL
RESERVE ASSETS, AND THE OFFICIAL
SETTLEMENT OF INTERNATIONAL OBLIGATIONS
Deposits with the IMF
•IMF deposits are initially made by countries joining the fund.
They are classified as reserves assets. These funds are
unavailable for normal use.
•Countries can borrow from the IMF against their local
currency deposits
•If a country wants to draw down its deposits from IMF, it will
also be reducing the opportunity to borrow funds from IMF
 INTERNATIONAL LIQUIDITY, INTERNATIONAL
RESERVE ASSETS, AND THE OFFICIAL
SETTLEMENT OF INTERNATIONAL OBLIGATIONS
Foreign Exchange
•Foreign exchange reserves are assets held by a central bank
or other monetary authority in the form of foreign currencies,
gold, and other financial assets. They are used to support a
country's currency, settle international payments, and provide
liquidity in the foreign exchange market.
•Foreign exchange reserves are not always located in the
nation banks, for example, U.S. banks open hold their foreign
exchange in overseas banks to make it easier for foreign base
exporters to be paid on time
 INTERNATIONAL LIQUIDITY, INTERNATIONAL
RESERVE ASSETS, AND THE OFFICIAL
SETTLEMENT OF INTERNATIONAL OBLIGATIONS
Foreign Exchange
•They can help to stabilize a country's currency and prevent it from
depreciating too sharply.
•They can help to meet a country's balance of payments obligations.
•They can help to protect a country from economic shocks, such as a sudden
decline in exports or a financial crisis.
•They can help to boost investor confidence in a country's economy.

The largest foreign exchange reserves in the world are held by China, Japan,
and the United States.

Foreign exchange reserves are a vital tool for central banks and other
monetary authorities in managing their economies. They can help to stabilize
currencies, settle international payments, and protect countries from
economic shocks.
 CONCLUSION AND SUMMERY
• Current monetary system is expanding because of
political borders are rearranged, new nations and the
disappearance of old states
• One of the more popular recommendation to simplify
the complexities of dealing with so many currencies
is to crate a single currency zones
• “Euro” was inspired from the idea of single currency
zones
• Some countries were reluctant to join European
monetary system because this would means giving
away the authority over monetary policy
 KEY TERMS AND CONCEPTS
• Fixed exchange rate
• Floating exchange rate
• Foreign exchange reserves
• Gold exchange standard
• Gold standard
• Hard currency country
• International liquidity
• International monetary system
• Pegged currencies
• Soft currency country
• Variable fixed-exchange rate
 DISCUSSION QUESTIONS

1. Discuss the advantages of returning to

a gold standard what steps might be
taken to move in that direction?
2. Discuss the possibility and probability
of ASEAN countries developing a
single currency to be used in ASEAN
countries, what steps might be taken to
move in the direction?