CHAPTER 11

THE GLOBAL MONETARY SYSTEM

International Monetary
System
 The International Monetary System is:
 The structure within which foreign exchange rates are
determined, international trade and capital flows are
accommodated and balance of payments adjustments are
made.
 The institutional arrangements that countries adopt to
govern exchange rates of currencies used as money and
monitor values to insure stability in currency value.
 All of the institutions, instruments and agreements which
link together the money markets, world currencies, real
estate, commodity and futures markets, etc. are a part of
the International Monetary System.
TERMS
 Fixed exchange rate system: value of the
currency is fixed by the government and related to
another currency or range of currencies. It
remains the same and is changed only under
specific circumstances by the government.
 Role of Central Bank:
 Must keep reserves of both foreign and domestic currency
on hand to buy or sell to the foreign exchange market in
order to preserve fixed exchange rate. If the domestic
currency drops below the established fixed value, the
central bank will increase the price of the domestic
currency by trading in foreign currency reserves to buy
domestic currency.
 If the domestic currency rises above the established fixed
value, the central bank will decrease the price of domestic
currency by trading it in for foreign currency.
 Has a monetary policy that centers around managing the
money supply.
WHY A FIXED RATE?
 Monetary discipline required.
 Destabilizing speculation less likely to impact
fixed rates.
 Uncertainty in foreign exchange rates is
limited; fixed rates are better for International
Trade & Investment.
 Trade balance adjustments managed by the
government.
TERMS
 Floating rate system: value of currency in relation to
another currency is not determined by the government,
but by the free market where it “floats”. Exchange rates
between two currencies are thus influenced by market
factors, such as inflation, interest rates, etc. and
equilibrium is reached through market forces. Foreign
exchange market determines the relative value of a
currency.
 Dollar, Euro, Yen and Pound “float” against each other.

 Role of the Central Bank:

 Allows the mechanism of supply and demand in the foreign
exchange market to equalize the exchange rate;
 Has an independent monetary policy that is not guided
solely by exchange rate concerns.
WHY A FLOATING RATE?
 Trade balance adjustments made automatically
through the foreign exchange market as a function
of supply and demand.
 Adjustments to the foreign exchange rate are made
in smaller, continuous movements, rather than
occasional actions taken by the Central Bank.
 Greater ability to absorb shocks in the market, such
as the oil crisis.
 Monetary policy is not limited by necessity to
maintain exchange rate parity; government is free
to use monetary policy to address other issues.
$MONEY, MONEY, MONEY$
 Goods and Services have two types of value:
 Use value (what something is)
 Exchange value (what something is worth)
 Use value + exchange value = commodity
 Money: a commodity single out as a universal
equivalent; a standard measure of the value of all
commodities; the representation token which
mediates the relationship between commodities.
$MONEY, MONEY, MONEY$
 Money have certain
characteristics:
 Portability
 Divisibility
 Convertibility
 Durability
History of Profit and Money
 Early civilizations: exchange between
societies of whatever was needed/wanted.
 Major Empires through early feudalism:
local forms of money (salt, grains, silver,
cattle, etc); money is a vehicle through
which goods are exchanged. Exchange is
for survival.
 Late feudal through City-States (14th-16th
centuries): rise of mercantilism and trade;
profit is made in spices, silks, quest for
gold and metals; gold and silver are media
of exchange; balance of trade is favorable
History of Profit and Money
 Industrialism (17th-19th centuries): paper
money as currency is created; profit is
made on production; trade deficits are
acceptable.
 Modern and post-modern (20-21st
centuries): profit is made on capital;
fictitious wealth, rise of paramoney (credit
cards, checks, etc.); trade deficits are
acceptable. Value of money is no longer a
face value reflection of use + worth. The
globalized world is fueled by multiple
currencies, of which many determine their
value in the foreign exchange market.
The Gold Standard-1800’s
 In1800’s, major trading nations adopt the gold standard. The
development of free trade led to need for a more formalized
system for settling international balances.
 The gold standard is a monetary standard that pegs currencies
to gold; currencies are guaranteed by being convertible to gold.
 This was a fixed rate, based on a determination made by each
government about how much one ounce of gold would be worth
in local currency. Each country had its own value. The value of
two currencies could be determined by comparing the value of
each individual currency in terms of gold.
 The amount of currency needed to purchase one ounce of gold
is the gold par value. e.g.
One ounce of gold was worth: US$20.67; £4.25.
 How do you determine the exchange rate between U.S. dollars
and English pounds?

$20.67/ounce of gold = $4.87 per GBP (English

pound sterling)
GBP4.25
The Gold Standard
 Each country had to maintain adequate
reserves of gold to back the currency in
circulation.
 Because it was linked to gold, the gold
standard had the effect of limiting the rate at
which an individual country could expand its
money supply.
 Gold was considered an automatic
mechanism to help all countries achieve
balance-of-payment equilibrium.
Between the Wars 1914-
1939
 During WWI, gold standard abandoned because of world
war.
 Post WWI, war heavy expenditures affected the value of
dollars against gold.
 1919-1929: many countries back on the gold standard.
 1929-1933: no fixed standards because of the Depression
era.
 1934:US raised dollars to gold from $20.67 to $35 per
ounce, causing devaluation of dollar to other currencies
(more dollars needed to buy gold). Other countries followed
suit and devalued their currencies.
 1939: Gold Standard suspended due to start of WWII.
Key Date: Bretton Woods,
1944
 In 1944, 44 countries met in New Hampshire
 Countries agreed to peg their currencies to
US$ which was convertible to gold at
$35/oz.
 Agreed not to engage in competitive
devaluations for trade purposes and defend
their currencies.
 Weak currencies could be devalued up to
10% w/o approval.
 IMF and World Bank created.
International Monetary Fund
 The International Monetary Fund (IMF) Articles of
Agreement were heavily influenced by the worldwide
financial collapse, competitive devaluations, trade wars, high
unemployment, hyperinflation in Germany and elsewhere,
and general economic disintegration that occurred between
the two world wars
 Created to police monetary system by ensuring maintenance
of the fixed-exchange rate
 Promote int’l monetary cooperation and facilitate growth of
int’l trade The aim of the IMF was to try to avoid a repetition
of that chaos through a combination of discipline and
flexibility.
IMF: MAIN DUTIES TODAY
 Surveillance of exchange rate policies (No
longer fixed rate exchange)
 Financial assistance (including credits and
loans)
 Technical assistance (expertise in
fiscal/monetary policy)
WORLD BANK
 International Bank for Reconstruction and
Development (IBRD)
 Purpose: To fund Europe’s reconstruction and
help 3d world countries.
 Overshadowed by Marshall Plan, World Bank
mission turns to ‘development’
 Lending money raised by WB bond sales
 Agriculture
 Education
 Population control
 Urban development
1945-73: FIXED EXCHANGE
RATES: US $ IS Main Reserve
 1945-1973: Fixed exchange rates Countries
continued to peg their currencies to US$ which was
convertible to gold at $35/oz .
 U.S. dollar was the main reserve currency held by
central banks and was the key to the web of exchange
rates.
 The system of fixed exchange rates established at
Bretton Woods worked well until the late 1960’s:
 The US dollar served as the reference point for all
other currencies
 Any pressure to devalue the dollar would cause
problems through out the world
1970’s: MONETARY SYSTEM UNDER PRESSURE:
COLLAPSE OF THE FIXED EXCHANGE RATE
 Pressure to devalue dollar led to collapse
 President Johnson financed both the Great Society and
Vietnam by printing money
 High inflation and high spending on imports
 August 8, 1971, Nixon announces dollar no longer
convertible into gold.
 Countries agreed to revalue their currencies against the
dollar
 March 19, 1972, Japan and most of Europe floated their
currencies
 In 1973, Bretton Woods fails when key currency (dollar)
is under speculative attack
1976: FLOATING EXCHANGE
RATE REGIME
 Jamaica Agreement - 1976
 Currencies will be allowed to Float
 Currencies are no longer fixed to the dollar
 Gold abandoned as reserve asset
 IMF quotas increased
 IMF continues role of helping countries cope with
macroeconomic and exchange rate problems..
 From this point on, the monetary system is an eclectic
or “mixed bag” of methods which range from free
float to a pegged system that is similar to fixed rates.
TODAY’S REGIME: ECLECTIC
IMF MEMBER REGIME CHOICES, 2004

p. 380
6th ed.
TODAY’S REGIME: ECLECTIC
TODAY’S REGIME: ECLECTIC
TODAY’S REGIME: ECLECTIC
TODAY’S REGIME: ECLECTIC
International Monetary System
Evolution
EARLY INDUSTRIAL/ WWI- POST WWII
PAPER MONEY WWII (1945-73)

Main World IMF countries

Many forms of Trading Partners On and off Adopt fixed rate
money Adopt the Gold The Tied to the
Standard Gold Standard U.S. $ (which is
backed by gold

Mixed system with

Major currencies
1973 - NOW being floated;
Other currencies-
various systems
FLOATING EXCHANGE RATE
REGIME SINCE 1973
 Since 1973, the world economy has suffered
through numerous financial crises in various
countries.
 The post 1973 period is characterized by more volatility.
 Oil crisis -1971
 Loss of confidence in the dollar - 1977-78
 Oil crisis – 1979, OPEC increases price of oil
 Unexpected rise in the dollar - 1980-85
 Rapid fall of the dollar - 1985-87 and 1993-95
 Partial collapse of European Monetary System - 1992
 Asian currency crisis - 1997
FINANCIAL CRISES in the POST-
BRETTON WOODS ERA
 A number of financial crisis have occurred in the past twenty five
years, causing major shocks to the global economy and often
needing help from the IMF. These three types of financial crises
impacting the world monetary system are:
 Currency crisis
 when a speculative attack on a currency’s exchange value
results in a sharp depreciation of the currency’s value or
forces authorities to defend the currency
 Banking crisis
 Loss of confidence in the banking system leading to a run
on the banks, capital flight occurs.
 Foreign debt crisis
 When a country cannot service its foreign debt obligations
Anatomy of CURRENCY CRISES
 Common causes of currency crises:
 High inflation
 Widening current account deficit
 Excessive expansion of domestic borrowing
 Asset price inflation (e.g. increases in stock prices or
prices or real property)
 Fundamental flaws in governmental policy: actions of the
Government can be too little, too late, or ineffective in
dealing with currency crises.
Anatomy of CURRENCY CRISES
Government action: example of too little, too late--
 Governments defend home currency that is
devaluating by using the foreign currency held in
their reserves to buy back its home currency in
order to strengthen it.
 This can cause drain foreign reserves to
dangerously low levels so that foreign debts
cannot be serviced.
 This causes other problems, especially a loss of
confidence, which prompts investors to sell their
holdings of the home currency; capital flight and
panic can follow.
WHAT HAPPENS WHEN THERE IS
FINANCIAL CRISIS IN A COUNTRY?
In a globalized world, countries are highly interdependent
and therefore are impacted by financial crisis in a specific
country.

When there is crisis in one country and that country’s

money loses its value (devaluates), financial panic can
occur that lead to similar devaluations at about the same
time by other, often nearby countries. This is known as
CONTAGION.
If countries cannot stop the devaluation themselves
the may ask for help from the IMF.
MEXICO CRISIS: 1995
 Peso pegged to U.S. dollar.
 Mexican producer prices rise by 45% without corresponding
exchange rate adjustment. Changes in prices
 Significant increase in public and private sector debt
 Growing trade deficit ($17 billion) Import more than export
 Investments continued ($64B between 1990 -1994)
 Speculators began selling pesos. Government responds by selling
dollars to buy pesos but it lacked foreign currency reserves to
defend it. Impact on supply and demand
 Foreign investors panic and sell peso denominated assets.
 Government devalues the peso which drops
from Ps 3.46/US$ to Ps5.50/US$.
 Collapse of the peso leads to contagion, “tequila” effect in Central
and South America.
MEXICO CRISIS: 1995
 IMF stepped in and did the following:
 $18 billion dollar loan, supplemented by a loan from
the U.S. government.
 Demanded that the Mexican government tighten
controls and reduce public spending drastically.
 Helped to renegotiate loans which Mexican
government was unable to service.
MEXICO CRISIS:
Impact on Wal-Mart
 Wal-Mart had 63 stores stocked with
goods imported from the U.S.
 The drop in the peso meant that imports
from the U.S. cost more.
 Sales dropped by 16% because Mexican
consumers did not spend as much because
of recession.
 Wal-Mart suspended its plans to build 25
more stores.
ASIAN CRISIS
 Background:
 Unprecedented growth in 70’s and 80’s
 Industrial policies of governments hinge upon export of labor-
intensive, low-cost manufactured goods.
 Liberalization of banking occurs and financial sector develops
(“emerging market funds”).
 Above liberalization fuels investment boom in commercial and
residential property and industrial assets.
 Governments implement policies that bring about huge
infrastructure projects.
 Government encourages investors to put money into certain projects
to meet “national goals” (Korea, Indonesia)
 As a result of the above, wages increase so citizens have more
disposable income. Changes in Income
ASIAN CRISIS
 Results:
 Quality of investments declines.
 Economic forecasts based on expansion are unrealistic.
 Excess capacity in factories is created (e.g. semi-conductors in
Korea).
 Residential and commercial property stands idle but
developers must continue to service debt secured to build
projects (e.g. Thailand).
 Demand for imports increases dramatically because of increase
in individual disposable income and because of increase in
capital equipment and materials needed for construction of
factories and residential and commercial property. Result is
outflow of foreign currency and trade deficit.

Import more than export

ASIAN CRISIS
 Consequences:
 Currencies come under attack.
 Investors start converting local currency into
dollars and leaving the country.
 Increased demand for dollars and increase in
supply of local currency continues to devalue
local currencies even more.
Impact on supply and demand
 Governments try to defend them
unsuccessfully.
 Stock markets weaken or plunge.
ASIAN CRISIS
 Repercussions:
 Prices in factories and real estate holdings drop and
facilities are underutilized.
 Investors have heavy debts to service (especially in
dollar-denominated debt) and defaults begin to occur.
 Huge current account deficit (balance of trade) is
created.
 Investor confidence drops and portfolio investors flee
(CAPITAL FLIGHT).
ASIAN CRISIS
 Asia countries must ask for help from IMF.
 Thailand is the first, followed by Indonesia, and finally
Korea.
 Example of Thailand
 Thailand:
 Unable to defend the baht, it announces it will allow it
to float freely. The baht which had been pegged for 13
years at the exchange rate of $1 = Bt25 drops to $1 =
Bt55.
 Thailand cannot finance international trade or service its
debts anymore
ASIAN CRISIS
 IMF gives 17.2 billion in loans in Thailand with
following conditions for the Thai government:
 Taxes must be raised.
 Public spending must be cut.
 Certain state-owned businesses must be privatized.
 Interests rates must be raised.
 Similar programs are developed for Indonesia and
Korea.
 IMF loans Indonesia $37 billion.
 IMF loans Korea $20 billion.
ASIAN CRISIS
 Problems in Asian Market Economies:
 Cronyism
 Too much money, dependence on speculative
capital inflows
 Lack of transparency in the financial sector.
 Currencies tied to strengthening dollar
 Increasing current account deficits
 Weakness in the Japanese economy
 Too much, too fast
CRITIQUE OF IMF POLICIES
 Inappropriate policies:
 “One size fits all’
 Moral hazard:
 People behave recklessly when they know they will
be saved if things go wrong--
 Foreign lending banks could fail
 Foreign lending banks have paid price for rash
lending
 Lack of Accountability
 IMF has grown too powerful
IMPLICATIONS FOR BUSINES
 Currency management is essential.
 Business strategy must have provision for
complications of the international monetary system
 Faced with uncertainty about the future value of currencies,
firms should utilize the forward exchange market to insure
against exchange rate risk
 Firms should pursue strategies that will increase the
company’s strategic flexibility in the face of unpredictable
exchange rate movements — that is, to pursue strategies that
reduce the economic exposure of the firm
 Governments have tremendous power and influence which
they can wield in the international monetary system.
 Corporate-government relations are essential.