Chapter 2

The International
Monetary System
The International Monetary System

Theincreasedvolatilityofexchange
ratesisoneofthemaineconomic
developmentsofthepast40years.
Policiesforforecastingandreactingto
exchangeratefluctuationsarestill
evolving.
Althoughvolatileexchangerates
increaserisk,theyalsocreateprofit
opportunitiesforfirmsandinvestors.
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The International Monetary System

Theinternationalmonetarysystemisthe
structurewithinwhichforeignexchangerates
aredetermined,internationaltradeandcapital
flowsareaccommodated,andthebalanceof
paymentsadjustmentsmade.
Alloftheinstruments,institutions,and
agreementsthatlinktogethertheworlds
currency,moneymarkets,securities,real
estate,andcommoditymarketsarealso
encompassedwithinthatterm.

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Currency Terminology

ForeignCurrencyExchangeRatethe
priceofonecountryscurrencyinunits
ofanothercurrencyofcommodity.
Canbefixedorfloating

SpotExchangeRatethequotedprice
forforeignexchangetobedeliveredat
once,orintwodaysforinterbank
transactions.

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Currency Terminology

ForwardRatethequotedpriceforforeignexchange
tobedeliveredataspecifieddateinthefuture.
Canbeguaranteedwithaforwardexchange
contract
ForwardPremiumorDiscountthepercentage
differencebetweenthespotandforwardexchangerate.
CalculatedasSpot Forward x 360 x 100
Forward n

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Currency Terminology

DevaluationofaCurrencyreferstoadropin
foreignexchangevalueofacurrencythatis
peggedtogoldoranothercurrency.
Theoppositeisrevaluation
Weakening,deterioration,ordepreciationofa
Currencyreferstoadropintheforeign
exchangevalueofafloatingcurrency.
Theoppositeisstrengtheningorappreciation

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Currency Terminology

SoftorWeakdescribesacurrencythatis
expectedtodevalueordepreciaterelativeto
majorcurrencies.
Alsoreferstocurrenciesbeingartificiallysustained
bytheirgovernments
HardorStrongdescribesacurrencythatis
expectedtorevalueorappreciaterelativeto
majortradingcurrencies.
Eurocurrenciesaredomesticcurrenciesofone
countryondepositinabankinasecondcountry.

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History of the International
Monetary System
TheGoldStandard(18761913)
Goldhasbeenamediumofexchangesince3000BC
Rulesofthegameweresimple,eachcountryset
therateatwhichitscurrencyunitcouldbeconverted
toaweightofgold
Currencyexchangerateswereineffectfixed
Expansionarymonetarypolicywaslimitedtoa
governmentssupplyofgold
WasineffectuntiltheoutbreakofWWIasthefree
movementofgoldwasinterrupted

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History of the International
Monetary System
TheInterWarYears&WWII(19141944)
Duringthisperiod,currencieswereallowedto
fluctuateoverafairlywiderangeintermsofgold
andeachother
Increasingfluctuationsincurrencyvaluesbecame
realizedasspeculatorssoldshortweakcurrencies
TheUSadoptedamodifiedgoldstandardin1934
DuringWWIIanditschaoticaftermaththeUS
dollarwastheonlymajortradingcurrencythat
continuedtobeconvertible
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History of the International
Monetary System
BrettonWoodsandtheInternationalMonetary
Fund(IMF)(1944)
AsWWIIdrewtoaclose,theAlliedPowersmetat
BrettonWoods,NewHampshiretocreateapost
warinternationalmonetarysystem
TheBrettonWoodsAgreementestablishedaUS
dollarbasedinternationalmonetarysystemand
createdtwonewinstitutionstheInternational
MonetaryFund(IMF)andtheWorldBank

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History of the International
Monetary System
TheInternationalMonetaryFundisakey
institutioninthenewinternationalmonetary
systemandwascreatedto:
Helpcountriesdefendtheircurrenciesagainstcyclical,
seasonal,orrandomoccurrences
Assistcountrieshavingstructuraltradeproblemsifthey
promisetotakeadequatestepstocorrecttheseproblems
TheInternationalBankforReconstructionand
Development(WorldBank)helpedfundpostwar
reconstructionandhassincethensupportedgeneral
economicdevelopment

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History of the International
Monetary System
FixedExchangeRates(19451973)
ThecurrencyarrangementnegotiatedatBrettonWoodsand
monitoredbytheIMFworkedfairlywellduringthepost
WWIIeraofreconstructionandgrowthinworldtrade
However,widelydivergingmonetaryandfiscalpolicies,
differentialratesofinflationandvariouscurrencyshocks
resultedinthesystemsdemise
TheUSdollarbecamethemainreservecurrencyheldby
centralbanks,resultinginaconsistentandgrowingbalanceof
paymentsdeficitwhichrequiredaheavycapitaloutflowof
dollarstofinancethesedeficitsandmeetthegrowingdemand
fordollarsfrominvestorsandbusinesses

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History of the International
Monetary System
Eventually,theheavyoverhangofdollarsheldbyforeigners
resultedinalackofconfidenceintheabilityoftheUStomet
itscommitmenttoconvertdollarstogold
ThelackofconfidenceforcedPresidentRichardNixonto
suspendofficialpurchasesorsalesofgoldbytheUSTreasury
onAugust15,1971
Thisresultedinsubsequentdevaluationsofthedollar
Mostcurrencieswereallowedtofloattolevelsdeterminedby
marketforcesasofMarch,1973

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History of the International
Monetary System
AnEclecticCurrencyArrangement
(1973Present)
SinceMarch1973,exchangerateshave
becomemuchmorevolatileandless
predictablethantheywereduringthe
fixedperiod
Therehavebeennumerous,significant
worldcurrencyeventsoverthepast30years

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The IMFs Exchange Rate
Regime Classifications
TheInternationalMonetaryFund
classifiesallexchangerateregimesinto
eightspecificcategories.Thereareeight
categoriesthatspanthespectrumof
exchangerateregimesfromrigidlyfixed
toindependentlyfloating.

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Fixed Versus Flexible
Exchange Rates
Anationschoiceastowhichcurrencyregime
tofollowreflectsnationalprioritiesaboutall
facetsoftheeconomy,includinginflation,
unemployment,interestratelevels,trade
balances,andeconomicgrowth.
Thechoicebetweenfixedandflexiblerates
maychangeovertimeasprioritieschange.

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Fixed Versus Flexible
Exchange Rates
Countrieswouldpreferafixedrateregimefor
thefollowingreasons:
stabilityininternationalprices
inherentantiinflationarynatureoffixedprices
However,afixedrateregimehasthefollowing
problems:
Needforcentralbankstomaintainlargequantities
ofhardcurrenciesandgoldtodefendthefixedrate
Fixedratescanbemaintainedatratesthatare
inconsistentwitheconomicfundamentals

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Attributes of the Ideal Currency

Possessesthreeattributes,oftenreferred
toastheImpossibleTrinity:
Exchangeratestability
Fullfinancialintegration
Monetaryindependence

Theforcesofeconomicstonotallowthe
simultaneousachievementofallthree

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Emerging Markets
and Regime Choices
Acurrencyboardexistswhenacountryscentralbank
commitstobackitsmonetarybaseitsmoneysupply
entirelywithforeignreservesatalltimes.
Thismeansthataunitofdomesticcurrencycannotbe
introducedintotheeconomywithoutanadditionalunit
offoreignexchangereservesbeingobtainedfirst.
Argentinamovedfromamanagedexchangerateto
acurrencyboardin1991
In2002,thecountryendedthecurrencyboardasa
resultofsubstantialeconomicandpoliticalturmoil

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Emerging Markets
and Regime Choices
DollarizationistheuseoftheUSdollarasthe
officialcurrencyofthecountry.
Oneattractionofdollarizationisthatsound
monetaryandexchangeratepoliciesnolonger
dependontheintelligenceanddisciplineof
domesticpolicymakers.
Panamahasusedthedollarasitsofficialcurrency
since1907
EcuadorreplaceditsdomesticcurrencywiththeUS
dollarinSeptember,2000

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The Euro:
Birth of a European Currency
InDecember1991,themembersofthe
EuropeanUnionmetatMaastricht,the
Netherlandstofinalizeatreatythat
changedEuropescurrencyfuture.
Thistreatysetoutatimetableandaplan
toreplaceallindividualECUcurrencies
withasinglecurrencycalledtheeuro.

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The Euro:
Birth of a European Currency
TopreparefortheEMU,aconvergencecriteria
waslaidoutwherebyeachmembercountrywas
responsibleformanagingthefollowingtoa
specificlevel:
Nominalinflationrates
Longterminterestrates
Fiscaldeficits
Governmentdebt
Inaddition,astrongcentralbank,calledthe
EuropeanCentralBank(ECB),wasestablishedin
Frankfurt,Germany.

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Effects of the Euro

Theeuroaffectsmarketsinthreeways:
CheapertransactionscostsintheEuroZone
Currencyrisksandcostsrelatedto
uncertaintyarereduced
Allconsumersandbusinessesbothinside
andoutsidetheEuroZoneenjoyprice
transparencyandincreasedpricebased
competition

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Achieving Monetary Unification

Iftheeuroistobesuccessful,itmusthavea
solideconomicfoundation.
Theprimarydriverofacurrencysvalueisits
abilitytomaintainitspurchasingpower.
Thesinglelargestthreattomaintaining
purchasingpowerisinflation,sothejobofthe
EUhasbeentopreventinflationaryforces
fromunderminingtheeuro.

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Exchange Rate Regimes:
The Future
Allexchangerateregimesmustdealwiththetradeoff
betweenrulesanddiscretion(vertical),aswellasbetween
cooperationandindependence(horizontal).
ThepreWWIGoldStandardrequiredadherencetorules
andallowedindependence.
TheBrettonWoodsagreement(andtoacertainextentthe
EMS)alsorequiredadherencetorulesinadditionto
cooperation.
Thepresentsystemischaracterizedbynorules,with
varyingdegreesofcooperation.
Manybelievethatanewinternationalmonetarysystem
couldsucceedonlyifitcombinedcooperationamong
nationswithindividualdiscretiontopursuedomesticsocial,
economic,andfinancialgoals.
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