14242911 History of International Monetary System

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Assignment on--

History of International Monetary System

Prepared For-

Md. Shariat Ullah

Lecturer, Dept. Management Studies

Faculty of Business Studies

University of Dhaka

Prepared By-

Md. Azim Ferdous

Roll No: 121, Section: B, Batch: 11th

Dept. of Management Studies

University of Dhaka

Date of Submission-

May 7, 2008


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The international monetary system establishes the rules by which countries value andexchange their currencies. It also provides a mechanism for correcting imbalancesbetween a countrys international payments and its receipts. Further, the cost ofconverting foreign money into firms home currency-a variable critical to theprofitability of international operations depends on the smooth functioning of the

international monetary system.

The history of monetary system started when in ancient time (seventh century B.C.1)tribes & city-states of India, Babylon & Phoenicia used gold & silver as media of exchangein trade. The total history of international monetary system is discussed below in achronological order.

1.The Gold StandardMeaning: Buying and selling of paper currency in exchange for gold on the request ofany individual of firm2. The theory of the gold standard rests on the idea that inflation iscaused by an increase in the supply of money, an idea advocated by David Hume, andthat uncertainty over the future purchasing power of currency depresses businessconfidence and leads to reduced trade and capital3.

First to Adopt: In United Kingdom at 1821.

Upshot: It created a fixed exchange rate system because each country tied the value ofits currency.

Advantage: The gold standard created a fixed exchange rate system.For example, the United Kingdom pledged to buy or sell an ounce ofgold for 4.247 pounds sterling, thereby establishing the pound pervalue or official price in terms of gold. The United States agreedto buy or sell an ounce of gold to a par value of $20.67. The twocurrencies could be freely exchanged for the stated amount ofgold making 4.247 = 1 ounce of gold = $20.67. This implied a fixedexchanging rate between the pound and the dollar of 1= $4.867,or $20.67/ 4.247.

Representative money and the Gold Standard protect citizens from hyperinflation andother abuses of monetary policy, as were seen in some countries during the GreatDepression. However, they were not without their problems and critics, and so werepartially abandoned via the international adoption of the Bretton Woods System. Thatsystem eventually collapsed in 1971, at which time all nations had switched to full fiatmoney4.

1 Del Mar,A History of Money in Ancient Countries(New York: Burt Franklin, 1968), p.71.2 I. Drummond, The Gold Standard and the International Monetary System 1900-1939 (London:

McMillan Education Group, 1987), pp.10-11.3

http://en.wikipedia.org/wiki/Gold_standard 4 In which paper notes are backed only by the traders' "full faith and credit" in the government, inparticular by its acceptability for payments of debts to the government (usually taxes).


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The Gold Standard variously specified how the gold backing would be implemented,including the amount of specie per currency unit. The currency itself is just paper and sohas no innate value, but is accepted by traders because it can be redeemed any time forthe equivalent specie. A US silver certificate, for example, could be redeemed for anactual piece of silver5.

Difficulty: Transacting in gold was expensive. For example, suppose JardineMatheson, a Hong Kong trading company, sold 100,000 worth of tea to Twining &Company, a London distributor of fine teas. If it wanted to be paid in gold by Twining &Company upon delivery of the tea, Jardine Matheson had to bear the costs ofloading the gold into the cargo hold of a ship, guarding it against theft,transporting it, and insuring it against possible disasters. Moreover, because of theslowness of sailing ships, Jardine Matheson would be unable to earn interest onthe 100,000 payment while the gold was in transit from London to Hong-Kong. Onthe other hand, if Jardine Matheson was willing to he paid in British pounds, Twiningcould draft a check to Jardine Matheson and give it to the firms London agent. TheLondon agent could then either immediately deposit the check in JardineMatheson's interest-bearing London bank account or transfer the funds telegraphof the firm's account at its Hong Kong bank.

Starling-Based Gold Standard: From 1821 until the end of 1918, the most importantcurrency in international commerce was the British pound sterling because of the UnitedKingdoms large territory6 due to dominant economic and military power. So, most of thepeople relayed on pound that time. As a result international monetary system during thisperiod is also called starling-based gold standard7. Because of the international trustLondon became a dominant international center in the 19th century, a position it still

holds8.

2. The Collapse of Gold Standard

World War I: During World War 1, the sterling-based gold standard unraveled. With theoutbreak of war, normal commercial transactions between the Allies (France, Russia, andthe United Kingdom) and the Central Powers (Austria-Hungary, Germany, and theOttoman Empire) ceased. The economic pressures of war caused country after countryto suspend their pledges to buy or sell gold at their currencies' par values.

Post-War Conferences & Re-adaptation of Gold Standard:After the war, conferencesat Brussels (1920) and Genoa (1922) yielded genera agreements among the majoreconomic powers to return to the prewar gold standard. Most countries, including theUnited States, the United Kingdom, and France, readopted the gold standard in the 1920s

5 http://en.wikipedia.org/wiki/Gold_standard 6 United Kingdoms territory that time was consisted of Canada, Australia, New Zealand, Hong

Kong, Singapore, India, Pakistan, Bangladesh, Kenya, Zimbabwe, South Africa, Gibraltar,Bermuda, and Belize.

7 At the turn of the century, the French franc & the German mark were used in addition to

sterling for setting private international transactions.8 B. Cohen, The Future of Sterling as an international Currency (London: McMillan, 1971), pp.60-61.


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despite the high levels of inflation, unemployment, and political instability that werewracking Europe.9

Implementation of Floating Rate System By Bank of England: The standard of goldstandard was doomed by economic stresses triggered by the worldwide Great

Depression. The Bank of England, the United Kingdom's central bank, was unable tomaintain its new pledges under the gold standard. On September 21, 1931, it allowed thepound to float, meaning that the pound's value would be determined by the forces ofsupply and demand and the Bank of England would no longer guarantee to redeemBritish paper currency for gold at par value10.

Competitive Devaluation of Currencies & Increased Tariff Rate: After the UnitedKingdom abandoned the gold standard, a "sterling area emerged as some countries,primarily members of the British Commonwealth, pegged their currencies to thepound and relied on sterling balances held in London as their internationalreserves.11 Other countries tied the value of their currencies to the U.S. dollar or theFrench franc. Some countries (United States, France, United Kingdom, Belgium, Latvia,the Netherlands, Switzerland & Italy) were deliberately & artificially devaluating theirofficial value of currencies to make their goods cheaper in the internationalmarkets, which is stimulating its exports and reducing its imports. But, none weregetting the benefit due to competitive devaluation at almost same percentage that iseach currency's value relative to the other remains the same. Most countries also raisedthe tariffs they imposed on imported goods in the hope of protecting domestic jobs inimport-competing industries. Nations adversely affected by trade barriers of any kindare quite likely to impose retaliatory or reciprocal tariffs12.

Effect of beggar-thy-neighbor policies (World War II): As more and more countriesadopted beggar-thy-neighbor policies like devaluation of currencies and increasing thetariff rate on imported goods, international trade contracted that hurt employment ineach country's export industries. More ominously, this international economic conflictwas soon replaced by international military conflict that was the outbreak of World WarII in 1939.

3. The Bretton Woods Era

Post-War Situation: World War II created inflation, unemployment and an instablepolitical situation. Every country was struggling to rebuild their war-torn economy.

Bretton Woods Conference: Not to repeat the mistakes that had caused World War II,to promote worldwide peace & prosperity and to construct the postwar internationalmonetary system representatives of 44 countries met at a resort in Bretton Woods, NewHampshire in 1944.

9 I. Drummond, The Gold Standard and the International Monetary System 1900-1939 (London:McMillan Education Group, 1987), p.31

10

Ibid., pp.40.11 B. Cohen, The Future of Sterling as an international Currency (London: McMillan, 1971), p.68.12 http://www.csusm.edu/politicalscience/golich/money-module/


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Decisions & Outcome of the Bretton Woods Conference: The Bretton WoodsConference has presented the world two historic agreements. These are as follows:

A. Agreement of conferees to renew the gold standard on a modified basis.B. Agreement to create two new international organizations to assist the rebuilding

of the world economy and the international monetary system. These are-a. International Bank for Reconstruction and Development (IBRD)b. International Monetary Fund (IMF)

a. The International Bank for Reconstruction and Development (IBRD)

The International Bank for Reconstruction and Development (IBRD) is the official nameof the World Bank. Established in 1945, the World Bank's initial goal was to help financereconstruction of the war-torn European economics. With the assistance of theMarshall Plan, the World Bank accomplished this task by the mid-1950s. The Bankthen adopted a new missionto build the economies of the world's developing

countries. As its mission has expanded over time, the World Bank created three affiliatedorganizations:

a. International Development Association (IDA)b. International Finance Corporation (IFC)c. Multilateral Investment Guarantee Agency (MIGA)

Together with the World Bank, these constitute the World Bank Group. The World Bank

is currently owned by the 185 member countries. The World Banks activities are

focused on the reduction of global poverty, focusing on the achievement of the

Millennium Development Goals (MDGs), goals calling for the elimination of poverty and

the implementation of sustainable development. United States is the banks largest

shareholder.

International Bank forReconstruction and

Development (IBRD)

InternationalDevelopment

Association (IDA)

Offers soft loans

International FinanceCorporation (IFC)

Promotes private

sector development

MultilateralInvestment Guarantee

Agency (MIGA)

Provides political risk

insurance


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b. International Monetary Fund (IMF)

International Monetary Fund (IMF) was created to monitor andcontrol the functioning of the international monetary system. It is aninternational organization that oversees the global financial system

by observing exchange rates and balance of payments, as well asoffering financial and technical assistance. Its objectives are asfollows:

i. To promote international monetary cooperation.ii. To facilitate the expansion and balanced growth of international trade.

iii. To promote exchange stability, to maintain orderly exchange arrangementsamong members, and to avoid competitive exchange depreciation.

iv. To assist in the establishment of a multilateral system of payments.v. To give confidence to members by making the general resources of the Fund

temporarily available to them and to correct maladjustments in their balancesof payments.

vi. To shorten the duration and lessen the degree of disequilibrium in theinteractional balances of payments of members.

At first 29 countries signed its Articles of Agreement of IMF. But now it has 186

Members. Its Headquarters are at Washington, D.C., USA. Current Managing Director is

Dominique Strauss-Kahn. Its Central Bank of Base borrowing rate 5.50%.

A Dollar-Based Gold Standard: The IMF and the World Bank provided the institutionalframework for the postwar international monetary system. All countries agreed to pegthe value of their currencies to gold. However, only the United States pledged to redeem

its currency for gold at the request of a foreign central bank. Thus the U.S. dollarbecame the key-stone of the Bretton Woods system.

In the early postwar years, only the U.S. and Canadian dollars were convertiblecurrencies, that is, ones that could be freely exchanged for other currencies withoutlegal restrictions. Countries had faith in the U.S. economy and so were willing to acceptU.S. dollars to settle their transactions. As the British pound sterling had been in thenineteenth century, the U.S. dollar became the preferred vehicle for settling mostinternational transactions. The effect of the Bretton Woods conference was thus toestablish a U.S. dollar-based gold standard.

Under the Bretton Woods Agreement each country pledged to maintain the value of itscurrency within 1% of its par value. If the market value of its currency fell outside thatrange, a country was obligated to intervene in the foreign-exchange market to bring thevalue back within 1% of par value. This stability in exchange rates benefitedinternational businesses, since the Bretton Woods system generally provided anassurance that the value of each currency would remain stable.

Bretton Woods System as Adjustable Peg : The Bretton Woods system is oftendescribed as using an adjustable peg because currencies were pegged to gold but thepegs themselves could be altered under certain conditions. The arrangement of Bretton

Woods System worked well as long as pessimism about a countrys economy was


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temporary. But, if a country suffered from structural macroeconomic problems, majordifficulties could arise.

4. The End of the Bretton Woods System

Shortcoming of Dollar-Based Gold Standard Under Bretton Woods System & Triffin

Paradox: The British and French central banks were a precursor to a run on the mostimportant bank in the Bretton Woods systemthe U.S. Federal Reserve Bank. Ironically,the reliance of the Bretton Woods system on the dollar ultimately led to the system'sundoing. Because the supply of gold did not expand in the short run, the only source ofthe liquidity needed to expand international trade was the U.S. dollar. Under the BrettonWoods system, the expansion of international liquidity depended on foreigners'willingness to continually increase their holdings of dollars. Foreigners were perfectlyhappy to hold dollars as long as they trusted the integrity of the U.S. currency, and duringthe 1950s and 1960s the number of dollars held by foreigners rose steadily.

As foreign dollar holdings increased, however, people began to question the ability of theUnited States to live up to its Bretton Woods obligation. This led to the Triffin paradox,named after Robert Triffin13, who first identified the problem. The paradox arose becauseforeigners needed to increase their holdings of dollars to finance expansion ofinternational trade. But the more dollars they owned, the less faith they had in the abilityof the United States to redeem those dollars for gold. The less faith foreigners had in theUnited States, the more they wanted to rid themselves of dollars and get gold in return.But if they did this, international trade and the international monetary system mightcollapse because the United States didn't have enough gold to redeem all the dollars held

by foreigners. The shortcomings are listed below in brief-Limited gold.Liquidity problem.Foreigners behavior of continuous increasing in dollar holding.Foreigners less faith on United States.

Agreement to Create Special Drawing Rights (SDRs): To inject more liquidity into theinternational monetary system while reducing the demands placed on the dollar as areserve currency, IMF members created the special drawing rights in 1967. SDR is acredit granted by the IMF that can be used to settle official transactions among centralbanks. Thus SDRs are sometimes called "paper gold".

As of 1993, approximately 21.4 billion SDRs, representing about 2% of the world'stotal reserves, had been distributed to IMF members in proportion to their IMFquotas. The value of an SDR is a function of the current value of five different currenciesfrom which it is comprised. They include the U.S. dollar, the Japanese yen, the UnitedKingdom pound sterling, and the respective euro values of Germany and France. AnSDR's value is currently calculated daily as a weighted average of the market value offive major currencies (U.S. dollar, German mark, French franc, Japanese yen, and

13 A Belgian-born Yale University economist


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pound sterling) with the weights revised every five years14. As of May 1995, the SDRwas worth $1.54 in U.S. dollars.

Outcome of Creating SDRs: SDRs solved the liquidity problem for the internationalmonetary system, but if failed to solve the problem related to the glut of dollars held

by foreigners & faith. By mid 1971, the Bretton Woods system was tottering, thevictim of fears about the dollar's instability. In the first seven months of 1971, theUnited States sold one third of its gold reserves15. It became clear to the marketplace thatthe United States did not have sufficient gold on hand to meet the demands of those whostill wanted to exchange their dollars for gold.

Official Ending of Bretton Woods System: The Bretton Woods system officially endedwhen in a dramatic address on August 15, 1971, President Richard M. Nixon announcedthat the United States would no longer redeem gold at $35 per ounce.

5. Post Bretton Woods System & the Floating Rate Era

After President Nixon's speech, most foreign currencies began to float, their values beingdetermined by supply and demand in the foreign-exchange market. The value of the U.S.dollar fell relative to most of the world's major currencies. But the nations of the worldwere not yet ready to abandon the fixed exchange-rate system.

At the Smithsonian Conference, held in Washington, D.C. in December 1971, centralbank representatives from the Group of Ten16 agreed to restore the fixed exchange-ratesystem but with restructured rates of exchange between the major trading currencies.

The U.S. dollar was devalued to $38 per ounce but remained inconvertible into gold, andthe par values of strong currencies such as the yen were revalued upward. Currencieswere allowed to fluctuate around their new par values by =2.25%, which replaced thenarrower 1.00% range authorized by the Bretton Woods Agreement.

Recent changes in international monetary policy17:

US$ 100 Trillion estimated total world assets, including real estate. US$ 30 Trillion worldwide liquidity held by pension funds which traditionally

invest in long term assets: formerly gold, today government bonds.

US$ 15-18 Trillion cash, mainly in Japan.

US$ 3-4 Trillion "hot money" in offshore trusts.

14 International Monetary Fund, 1990 Annual Report, p.133.15The European Financial Common Market (Luxembourg: Office for Official Publications of the

European Communities, 1989), pp. 43ff.; The European Community in the nineties(Washington, D.C.: EC Delegation to the United States, 1992), pp.12ff.; Directorate-General forEconomic and Financial Affairs, European Economy, No. 44 (October 1990), p. 42.

16 Group of Ten means the group consists of following countries who have worlds top most GDPshares: United States, Japan, Germany, France, Italy, United Kingdom, Canada, Netherlands,

Belgium & Sweden.17 http://www.gold-eagle.com

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14242911 History of International Monetary System