INTERNATIONAL MONETARY SYSTEM

Specie commodity standard:

In early days prior to evolution of international monetary system, trade payments were settled
through barter, but there were many inconveniences and so to overcome those difficulties, traders
began using metal, especially gold or silver for settling payments.
Metal took the form of coin which had the stamp of sovereign on the basis of weight and
fineness giving birth to the specie commodity standard. Coins were full bodied coins meaning
that their value was equal to the value of metal contained therein.
With lapse of time lower value metal was mixed with the coin with the result the value of metal
came to be lower than the face value of coin. Debased coins were largely used as medium of
exchange. Full bodied coins mainly used for store of value and for melting and selling them as
gold and silver. The debased coin had led to bimetallic standard.
Gold standard 1876-1913:
It is originated in England in 17th century. The form of gold standard was not the same in all the
countries adopting it. In UK and USA gold coins were minted and ban k notes were also
exchanged for gold on demand. The price of gold was fixed under law. It was the price at which
gold could be bought and sold. It is the purest form of gold standard and was known as gold
specie standard.
A modified version of gold standard was known as gold bullion standard. It had all advantages of
gold standard without any compulsion to maintain gold coinage. Individual bank notes were not
convertible to gold directly and for conversion, gold bars were purchased at fixed rates.
Gold exchange standard was more economical form of gold standard where neither gold coinage
was required nor purchase of gold bars exists. A county on gold exchange standard linked its
currency to the currency of a country on the gold specie standards. If a country on the gold
exchange standard held pound as its reserves, its currency was convertible into pounds and the
pound was convertible into gold.
Essential features of gold standard:
The government adopting it fixed the value of currency in terms of specific weight and fineness
of gold and guaranteed a two way convertibility
Export and import of gold were allowed so that it could flow freely among the gold standard
countries

The central bank acting as the apex monetary institution held gold reserves in direct relationship
with the currency it had issued
The government allowed unrestricted minting of gold and melting of gold coins at the option of
the holder
Since fixed weight of gold had formed the basis for a unit of the currency and since free flow of
gold was allowed among the countries gold standard possess automatic mechanism for domestic
price stability, fixed exchange rates and adjustment in balance of payments.
Decline of gold standard:
One of the problems is price specie (gold) mechanism which requires the nations to keep above
the balance of payments and foreign exchange considerations above domestic policy goals which
is not realistic.
Gold is scarce commodity and gold volume could not grow fast enough to allow adequate
amounts of money to be created to finance the growth of world trade.
Inter war years 1914-1944:
Gold standard as IMS worked well until world war I. War had interrupted trade flows and
disturbed the stability of exchange rates for currencies of major countries. There was a
widespread fluctuation in currencies in terms of gold during war. The role of Great Britain as
world major creditor nation also came to end and US began to assume the role of leading creditor
nation.
Countries had made attempts to recover from war and stabilize their economies to return to gold
standard. The key currency involved in the attempt to restore the international gold standard was
the pound sterling which returned to gold in 1925. This was a great mistake since UK had
experienced considerably more inflation than US because UK had liquidated most of its foreign
investment in financing the war. The result was increased unemployment and economic
stagnation in Britain.
Pounds overvaluation was not only the major problem of restored gold standard. Other problems
included the failure of US to act responsibly, the undervaluation of French franc and general
decrease in the willingness and ability of nations to rely on the gold standard adjustment
mechanism.
In 1934 US returned to modified gold standard and US$ was devalued. The modified gold
standard was known as gold exchange standard. Under this standard the US traded gold only

with foreign central banks not with private citizens. From 1934 till the end of world war II,
exchange rates were theoretically determined by each currencys value in terms of gold. World
war II also resulted in many of worlds major currencies losing their convertibility. The only
major currency that continued to remain convertible was the dollar.
Thus 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 stock market crash also resulted in the
collapse of many banks.
The Bretton woods system 1945-1972:
The depression of 1930s followed by another war had vastly diminished commercial trade, the
international exchange of currencies and cross border lending and borrowing. Revival of the
system was necessary and the reconstruction of the post war financial system began with the
Bretton woods agreement from the international monetary and financial conference of the united
and associated nations in July 1944 at Bretton woods, New Hampshire.
There was a general agreement that restoring gold standard was out of question. Governments
needed access to credits in convertible currencies if they were to stabilize exchange rates and
governments should make major adjustments in exchange rates only after consultation with other
countries. But opinions were divided. British wanted a reduced role for the gold, more exchange
rate flexibility than that had existed with gold standard, large pool of lendable resources at the
disposal of a proposed international monetary organization and acceptance of principle that the
burden of correcting payment disequilibria should be shared by both surplus countries and deficit
countries. Americans favored a major role of gold, highly stable exchange rates, a small pool of
lendable resources and principle that the burden of adjustment of payment imbalances should fall
primarily on deficit countries.
Recommendations in Bretton wood:
1. Each nation should be at liberty to use macro- economic policies for full employment.
2. Free floating exchange rates could not work. Their ineffectiveness had been demonstrated
during the 1920s and 1930s. But the extremes of both permanently fixed and 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 a dollar based IMS and created two new institutions The International
Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World
Bank). The basic role of IMF would be help countries with BOP and exchange rate problems
while the World Bank would help countries with post war reconstruction and general economic
development.
Propositions of Bretton wood system:
1. The stable exchange rates under the gold standard before world war I were desirable but
there were certain conditions to make adjustments in exchange rates necessary
2. Performance of fluctuating exchange rates had been unsatisfactory and
3. The complex network of government controls during 1931-1945 deterred the expansion
of world trade and investment.
The Bretton wood agreement placed major emphasis on the stability of exchange rates by
adopting the concept of fixed but adjustable rates. The keystones of the system were:
1. No provision was made for the US to change the value of gold at $35 per ounce
2. Each country was obligated to define its monetary unit in terms of gold or dollars. While
other currencies were required to exchange their currencies for gold, US % remained
convertible into gold at $35 per ounce.
3. Each country established par rates of exchange between its currency and the currencies of
all other countries.
4. Each currency was permitted to fluctuate within plus or minus 1% of par value by buying
or selling foreign exchange and gold as needed.
5. If a currency became too weak to maintain its par value, it was allowed to devalue up to
10% without formal approval by IMF
6. Countries would have to make payment of gold and currency to IMF in order to become a
member. Subscription quotas were assigned according to a members size and resources.
Payment of quota normally was 25% in gold and 75% in members own currency.
Break down of Bretton wood system:
The system has worked without major changes till 1971. During the period the fixed exchange
rates were maintained by official intervention in foreign exchange markets. International trade
expanded at a faster rate than world output and currencies of many nations particularly those of
developed countries become convertible.
The system suffered from a number of inherent structural problems. There was much imbalance
in the roles and responsibilities of the surplus and deficits nations. Countries with persistent
deficits in their BOP had under-go tight and stringent economic policy measures if they wanted

to take help of IMF and stop the drain on their reserves. However countries with surplus
positions in their BOP were not bound by such immediate compulsions.
The basic problem here was the rigid approach adopted by IMF to BOP disequilibria situation.
The controversy mainly centers around the conditionality issue which refers to a set of rules and
policies that a member country is required to pursue as a prerequisite to using IMFs resources.
These policies mainly try and ensure that the use of resources by concerned members is
appropriate and temporary. The IMF distinguishes between two levels of conditionality low
conditionality where a member needs funds only for a short period and high conditionality where
a member country wants a large access to the funds resources. This involves formulation of a
formal financial program containing specific measures designed to eliminate the countrys BOP
disequilibrium. Use of IMFs resources requires IMFs willingness that the stabilization
programmed is adequate for the achievement of its objectives and an understanding by the
member to implement it.
The Smithsonian Agreement:
From August to December 1971 most of the major currencies were permitted to fluctuate. The
US$ fell in value against a number of major currencies. Several countries imposed some trade
and exchange controls causing major concern. It was felt that such measures would limit
international commerce. In order to solve the problem the worlds leading trading countries
called the Group of ten produced Smithsonian Agreement on December 18 1971. The agreement
established a new set of parity rates.
Although US$ was not convertible into gold, it was till defined in terms of gold. The other nine
currencies were defined in terms of either gold or dollar. The US agreed to devalue the dollar
from $35 per ounce of gold to $38 in return for promises from other members to up value their
currencies relative to the dollar by specific amounts.
In order to maintain market exchange rates relatively close to central rtes without constant
government intervention currencies permitted to fluctuate over a wider band of margin of 2.25%
and it could fluctuate by as much as 9% against any currency except the dollar.
Proponents of Smithsonian Agreement argued that a wider band would allow countries to retain
(i) discipline that they would expect from the fixed exchange rate system and (ii) greater freedom
and a smoother adjustment process of flexible exchange rates.
Flexible exchange rates Regime 1973- present:
The flexible exchange rate regime that followed the demise of the Bretton Woods system was
ratified after the fact in January 1976 when the IMF members met in Jamaica and agreed to a

new set of rules for the international monetary system. The key elements of the Jamaica
Agreement include:
1. Flexible exchange rates were declared acceptable to the IMP members, and central banks were
allowed to intervene in the exchange markets to iron out unwarranted volatilities.
2. Gold was officially abandoned (i.e., demonetized) as an international reserve asset. Half of the
IMF's gold holdings were returned to the members and the other half were sold, with the
proceeds to be used to help poor nations.
3. Non-oil-exporting countries and less-developed countries were given greater access to IMF
funds.
The IMF continued to provide assistance to countries facing balance-of-payments and exchange
rate difficulties. The IMF, however, extended assistance and loans to the member countries on
the condition that those countries follow the IMP's macroeconomic policy prescriptions. This
"conditionality," which often involves deflationary macroeconomic policies and elimination of
various subsidy programs, provoked resentment among the people of developing countries
receiving the IMP's balance-of-payments loans.
As can be expected, exchange rates have become substantially more volatile since March 1973
than they were under the Bretton Woods system.
In September 1985, the so-called G-5 countries (France, Japan, Germany, the U.K., and the
United States) met at the Plaza Hotel in New York and reached what became known as the Plaza
Accord. They agreed that it would be desirable for the dollar to depreciate against most major
currencies to solve the U.S. trade deficit problem and expressed their willingness to intervene in
the exchange market to realize this objective.
As the dollar continued its decline, the governments of the major industrial countries began to
worry that the dollar may fall too far. To address the problem of exchange rate volatility and
other related issues, the G-7 economic summit meeting was convened in Paris in 1987.6 The
meeting produced the Louvre Accord, according to which:
1. The G-7 countries would cooperate to achieve greater exchange rate stability.
2. The G-7 countries agreed to more closely consult and coordinate their macroeconomic
policies.

The Louvre Accord marked the inception of the managed-float system under which the G-7
countries would jointly intervene in the exchange market to correct over- or undervaluation of
currencies.