International Monetary

System and the

Balance of Payments
Week 4
Abdul Halim, BSM, MBA
INTERNATIONAL MONETARY
TERMINOLOGY
To conduct international business or international trade, a well-organized
and internationally accepted system must exist to settle the financial
transactions that arise out of trade payments. Moreover, this system has to
be in step with the nature of the financial transactions that occur in
international business and trade and must be flexible enough to
accommodate the constant changes in the patterns, directions, volumes,
and nature of the financial flows.
HARD CURRENCIES
Currencies of certain countries have a fairly wide acceptance for the
settlement of international obligations and are used as a medium in
international transactions. These currencies are known as hard currencies.
The U.S. dollar, British pound, Japanese yen, and euro are examples of hard
currencies.
SOFT CURRENCIES
Soft currencies, on the other hand, are not widely accepted as a medium
for settling international financial transactions. Usually there is no free
market or foreign exchange for them. Thus, they are not easy to acquire,
and disposal is even more difficult. Many soft currencies are subject to
restrictions by monetary or governmental authorities on their transfer in
and out of their countries. Examples of soft currencies are the Zimbabwe
dollar, North Korean won, and Cuban peso.
CONVERTIBILITY
Linked to the notion of hard and soft currencies is the concept of
convertibility, whereby one currency can be freely converted into another
currency.
EXCHANGE RATE
When the currency of any one country is used as a medium of settlement
for an international transaction, its value has to be fixed vis--vis the
currency of the other country, either directly or in terms of a third currency.
This fixing of a price or value of one currency in terms of another currency
is known as the determination of the exchange rate.
APPRECIATION
When the value of a currency is revised or changes upward, it is said to
have appreciated.1 Appreciation of a currency implies that it has become
more expensive in terms of other currencies (that is, more units of other
currencies will be needed to purchase the same amount of this currency, or
fewer units of the appreciated currency will buy the same amount of the
other currency).
DEPRECIATION
When the price of a currency is changed downward, it is said to have
undergone depreciation. A currency, upon depreciation, becomes less
expensive in terms of another currency. Fewer units of the other currency
can be purchased with the same amount of the currency after its
devaluation. Alternatively, more units of the depreciated currency are
needed to purchase the same amount of foreign currency.
A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY
SYSTEM

The first form of an international monetary system emerged toward the

latter half of the nineteenth century. In 1865 four European countries
founded the Latin Monetary Union. Its monetary system rested on the use
of bimetallic currencies that had international acceptability within member
countries of the union. Bimetallism (using gold and silver) was the basis on
which the values of the different currencies were determined.
THE GOLD STANDARD
The gold standard, which replaced the bimetallic standard as a system with
wide international acceptance, lasted from its introduction in 1880 until the
outbreak of World War I in 1914. The central feature of the gold standard
was that exchange rates of different countries were fixed, and the parities,
or values, were set in relation to gold. Thus, gold served as the common
basis for the determination of individual currency values.
Each country adhering to the gold standard specified that one unit of its
currency would be equal to a certain amount of gold. Thus, if country As
currency equaled two units of gold and country Bs currency equaled four
units of gold, the exchange rate of country As currency against country Bs
currency would be one to two.
THE GOLD SPECIE STANDARD
The gold specie standard was a pure gold standard. The primary role of
gold was as an internationally accepted means of settlement through an
arrangement of corresponding debits and credits between different nations.
At the same time, gold was in the form of coins, the primary means of
settling domestic transactions. Therefore, the gold specie standard required
that gold should be available through the monetary authorities in unlimited
quantities at fixed prices.
THE GOLD BULLION STANDARD

Under the gold bullion standard, the direct link between gold and actual
currency that a country could issue was eliminated. Currency could be in
the form of either gold or paper, but the issuing authority of the currency
would give a standing guarantee to redeem the currency it had issued in
gold on demand at the announced price, which would be fixed.
THE INTERWAR YEARS (19181939)
At the end of World War I, the IMS was in a state of disarray. Most currencies
had undergone wide fluctuations, and the economies of several European
countries were severely damaged by the war. Several attempts were made,
primarily motivated by Great Britain, to return to the gold standard in the
years immediately following the end of World War I.
While Great Britain tried to maintain a strong currency, redeemable in gold,
several other countries, eager to improve their international competitive
position, began a rush of currency devaluations without any formal
agreement with other countries on what a desirable and internationally
acceptable value of their currencies should be vis--vis other currencies.
The United States, having become the worlds leading economic power as
well as the major creditor, added to the general monetary difficulties by
continuing to maintain a relatively undervalued exchange rate, despite
having huge balance of payments surpluses.3 Moreover, by acquiring
substantial quantities of gold, which it financed by its balance of payment
surpluses, the United States exerted further pressure on the economically
beleaguered nations of Europe.
THE BRETTON WOODS SYSTEM
(19441973)
in 1943 the United States and Great Britain took the initiative toward
creating a stable and internationally acceptable monetary system. The
Bretton Woods Agreement adopted a gold exchange standard, primarily
along the proposals made by the U.S. delegation, which was led by Harry
Dexter White. The gold exchange standard got its basic logic from the gold
standard because it sought to bring gold back into a position of
international monetary preeminence and, at the same time, to revive the
system of fixed exchange rates.
THE INTERNATIONAL
MONETARY FUND
The Bretton Woods Conference created the International Monetary Fund to
administer the exchange rate arrangements and to secure orderly
monetary conditions. More specifically, the five aims of the IMF, as laid out
in its articles, are to achieve the following:
1. Promote international cooperation through consultation and
collaboration by member countries on international monetary issues
2. Facilitate the expansion and balanced growth of international trade
3. Promote exchange-rate stability and orderly exchange-rate
arrangements
4. Foster a multilateral system of international payments and seek
elimination of exchange restrictions that hinder the growth of world
trade
5. Try to reduce both the duration and the magnitude of imbalances in
international payments by making its resources available (with adequate
safeguards)
MEMBERSHIP
Initially the IMF had 44 member countries and now has 184. Growth in
membership was particularly rapid in the 1960s, as newly independent
nations of Asia and Africa became members. Membership in the fund is
based on subscription to its resources in the form of a quota. A members
quota, being equal to its subscription to the fund, determines the members
voting power, as well as, to a considerable extent, its access to the funds
resources.
DIFFICULTIES IN THE BRETTON
WOODS SYSTEM
Because the U.S. dollar was a key international reserve currency under the
Bretton Woods system, the deficit in the U.S. balance of payments was
essential if the liquidity requirements of the IMS were to be fully met. If the
U.S. dollar deficits grew larger and larger, however, the holders of dollars
would tend to lose confidence in the currency as a reserve and in the
capacity of the United States to honor its obligations.
The economist Robert Triffin noted this problem in relying too heavily on
the U.S. dollar. The Triffin paradox states that the more that foreigners
relied on the U.S. dollar to expand trade, the less confidence they had in
the United States being able to honor its commitment of redeeming dollars
for gold.
THE FLOATING-RATE ERA:
1973 TO THE PRESENT
PURE FLOATING RATES
Under the pure-floating-rate arrangement, the exchange rate of a countrys
currency is determined entirely by such market considerations as demand
and supply. The government or the monetary authorities make no efforts to
either fix or manipulate the exchange rate. Although many industrialized
countries officially state that they follow a policy of floating for their
exchange rates, most of them do intervene to influence the direction of the
movement of their exchange rates.
MANAGED, OR DIRTY,
FLOATING RATES
An important feature of the managed-float system is the necessity for the
central bank or the monetary authorities to maintain a certain level of
foreign exchange reserves. Foreign exchange reserves are needed because
the authorities are required to buy or sell foreign currencies in the market
to influence exchange-rate movements.
PEGGING
Under a pegging arrangement, a country links the value of its currency to
that of another currency, usually that of its major trading partner. Pegging
to a particular currency implies that the value of the pegged currency
moves along with the currency to It does fluctuate, however, against all
other currencies to the same extent as the currency to which it is pegged
(for example, the currency of the Republic of Gabon, the CFA franc, has
been pegged to the euro since 1999).
CRAWLING PEGS
Under a crawling-peg arrangement, a country makes small periodic
changes in the value of its currency with the intent to move it to a
particular value over a period of time. The system, however, can be taken
advantage of by currency speculators, who can make substantial profits by
buying or selling the currency just before its revaluation or devaluation.
DIFFICULTIES IN THE
FLOATING-RATE ERA
Exchange rates in the floating-rate era have been marked by violent
fluctuations that have been prompted by a variety of factors. There were
periodic crises in the international monetary system, which were reflected
in the extreme fluctuations of exchange rates.
The continuous trade deficits, however, and policies that encouraged
capital outflows, caused confidence in the dollar to weaken, leading to a
sharp fall in its price in 1978. Further, this decline of confidence in the
dollar was exacerbated by the difficulties the United States faced in Iran
because of its revolution, as well as the problems created by the second oil
crisis, of 1979, when the OPEC countries indulged in yet another round of
dramatic price increases.