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UNIT 1. INTERNATIONAL MONETARY SYSTEM

Economic and financial transactions among different

countries require some sort of arrangement that couldfacilitate settlement of payments. Institutional framework within which international payments are made,movements of capital are accommodated, and exchangerates among currencies are determined. Thesearrangements form the subject matter of the internationalmonetary system.

The international monetary system we find todayis the result of a century-long evolution going back to thedays of the gold standard and even earlier when costlymetals were used for making payments

Evolution of the International Monetary System:

Bimetallism: Before 1875 Gold Standard System: 1875-1914

Interwar Period: 1915-1944

Bretton Woods System: 1945-1972

The Flexible Exchange Rate Regime: 1973-Present

BIMETALLISM: BEFORE 1875

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Gresham’s Law implied that it would be the leastvaluable metal that would tend to circulate.

GOLD STANDARD SYSTEM: 1875-1914 :

“Gold constitutes treasure, and he who possesses it has all he needsin this world”. Columbus

During this period in most major countries:

• Gold alone was assured of unrestricted coinage

• There was two-way convertibility between goldand national currencies at a stable ratio.

• Gold could be freely exported or imported.

The exchange rate between two country’scurrencies would be determined by their relative goldcontents.

For example, if the dollar is pegged to gold at U.S. $30 = 1ounce of gold (28.34 grams of gold), and the British pound

is pegged to gold at £6 = 1 ounce of gold, it must be thecase that the exchange rate is determined by the relativegold contents:$30 = 1 ounce of gold = £6

$30 = £6$5 = £1

Highly stable exchange rates under the classical

gold standard provided an environment that wasconducive to international trade and investment.

Shortcomings of Gold Standard System:

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The supply of newly minted gold is sorestricted that the growth of world trade andinvestment can be hampered for the lack of 

sufficient monetary reserves. Even if the world returned to a gold

standard, any national government could abandonthe standard.

INTERWAR PERIOD: 1915-1944 

Exchange rates fluctuated as countries widelyused “predatory” depreciations of their currencies as ameans of gaining advantage in the world exportmarket.

Attempts were made to restore the gold standard, but participants lacked the political will to “follow therules of the game”.

The result for international trade and investmentwas profoundly detrimental.

Economic nationalism (protectionism), economic and political instabilities, bank failures, panicky flights of capital across borders, 1929 Great Depression, allreasons required a new system.

BRETTON WOODS SYSTEM: 1945-1972

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• Bretton Woods had provisions for reevaluating par if deviations persist.

• The US dollar was the only currency directly

exchangeable for gold. Therefore, most internationaltransactions occurred in US dollars and gold.• The Bretton Woods system was a dollar-based gold

exchange standard.

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Collapse of the Bretton Woods Agreement:

However, by the late 1960s, there was a dollar oversupplyin the world economy. This turnaround was due to the US balance of payments deficit, which in turn was caused byexpansionary fiscal policy. The spending of the USgovernment increased for three reasons:

(i) The war in Vietnam;(ii)

Welfare expenditure; and(iii) The space race with the USSR (send humans tothe moon by the end of the 1960s).

As the world economy grew, more international money(dollar) was demanded. To supply that, the US had to run a

Pegged at $35/ounce.

Germanmark British

 poundFrenchfranc

U.S. dollar 

Gold

Par Value

P  a r   V   a l  u  e  

   P  a  r 

   V  a   l  u

  e

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 balance-of-payments deficit (how else can the rest of theworld get more dollars?) But if the US continued to run aBOP deficit, it would loose credibility as a sound currency

country. That was the fundamental dilemma.The amount of gold that the US had would soon be muchless than the amount of dollars held by other countries. Thismeant that the US could not guarantee conversion of international dollars into gold, if all foreign central bankstried to cash in.

In the end, the US opted to run a BOP deficit, which led tothe loss of credibility and the collapse of the BrettonWoods system.

THE FLEXIBLE EXCHANGE RATE REGIME: 1973-

 PRESENT.

January 1976 IMF members met in Jamaica andcame out Jamaica Agreement which is:

1. Flexible exchange rates were declared acceptable tothe IMF members. Central banks were allowed tointervene in the exchange rate markets to iron outunwarranted volatilities.

2. Gold was abandoned as an international reserveasset.

3. Non-oil-exporting countries and less-developedcountries were given greater access to IMF funds.