Chapter 10

The International Monetary System

Introduction The institutional arrangements that countries adopt to govern exchange rates are known as the international monetary system When a country allows the foreign exchange market to determine the relative value of a currency, a floating exchange rate system exists When a country fixes the value of its currency relative to a reference currency, a pegged exchange rate system exists When a country tried to hold the value of its currency within some range of a reference currency, dirty float exists Countries that adopt a fixed exchange rate system fix their currencies against each other Prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

Classroom Performance SystemA ________ exchange rate system exists when the foreign exchange market determines the relative value of a currency. a) Fixed b) Floating c) Pegged d) Market

10.1 The Gold Standard The gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value Payment for imports was made in gold or silver Later, as trade grew, payment was made in paper currency which was linked to gold at a fixed rate

10.1.1 Mechanics Of The Gold Standard Pegging currencies to gold and guaranteeing convertibility is known as the gold standard In the 1880s, most of the world’s trading nations followed the gold standard Under the gold standard one U.S. dollar was defined as equivalent to 23.22 grains of"fine (pure) gold The amount of a currency needed to purchase one ounce of gold was called the gold par value

10.1.2 Strength Of The Gold Standard The great strength of the gold standard was that it contained a powerful mechanism for achieving balance-oftrade equilibrium (when the income a country’s residents earn from its exports is equal to the money its residents pay for imports) by all countries

Classroom Performance SystemWhat type of exchange rates system was the gold standard? a) Fixed b) Floating c) Pegged d) Market

10.1.3 The Period Between The Wars: 1918-1939 The gold standard worked fairly well from the 1870s until the start of World War I in 1914 During the war, many governments financed their war expenditures by printing money, and in doing so, created inflation People lost confidence in the system and started to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility By 1939, the gold standard was dead

10.2 The Bretton Woods System In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system that would facilitate postwar economic growth Under the new agreement: a fixed exchange rate system was established all currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold

devaluations could not to be used for competitive purposes a country could not devalue its currency by more than 10% without IMF approval

The Bretton Woods SystemThe Bretton Woods agreement also established two multinational institutions: the International Monetary Fund (IMF) to maintain order in the international monetary system the World Bank to promote general economic development

10.2.1 The Role Of The IMF The IMF was charged with executing the main goal of the Bretton Woods agreement - avoiding a repetition of the chaos that occurred between the wars through a combination of discipline and flexibility Discipline mean that: the need to maintain a fixed exchange rate put a brake on competitive devaluations and brought stability to the world trade environment a fixed exchange rate regime imposed monetary discipline on countries, thereby curtailing price inflation

The Role Of The IMFFlexibility meant that: while monetary discipline was a central objective of the agreement, a rigid policy of fixed exchange rates would be too inflexible the IMF was ready to lend foreign currencies to members to tide them over during short periods of balance-ofpayments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment

10.2.2 The Role Of The World BankThe World Bank is also called the International Bank for Reconstruction and Development (IBRD) There are two ways to borrow from the World Bank: 1. under the IBRD scheme, money is raised through bond sales in the international capital market borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses. 2. through the International Development Agency, an arm of the bank created in 1960 IDA loans go only to the poorest countries

10.3 The Collapse Of The Fixed Exchange Rate System Bretton Woods worked well until the late 1960s It collapsed when huge increases in welfare programs and the Vietnam War were financed by increasing the money supply and causing significant inflation Other countries increased the value of their currencies relative to the dollar in response to speculation the dollar would be devalued However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point

10.4 The Floating Exchange Rate Regime In 1976, following the collapse of Bretton Woods, IMF members formalized a new exchange rate system at a meeting in Jamaica The rules that were agreed on then, are still in place today

10.4.1 The Jamaica AgreementUnder the Jamaican agreement: floating rates were declared acceptable gold was abandoned as a reserve asset total annual IMF quotas - the amount member countries contribute to the IMF - were increased to$41 billion