Sanjay Ghimire

KUSOM
Unit 5

International Monetary System

1
International Monetory System
The international monetary system consists of laws,
rules, institutions, instruments, and procedures, all of
which are involved in the international transfers of
money
The IMS refers to the institutional arrangements that
countries adopt to govern exchange rates
The elements above affect foreign exchange rates,
international trade and capital flows, and balance-of-
payments adjustments.
Thus IMS ensure Liquidity, Adjustment and Stablity of
the international trade

2
Evolution of IMS
Pre 1875 Bimetalism
1875-1914: Classical Gold Standard
1915-1944: Interwar Period
1945-1972: Bretton Woods System
1973-Present: Flexible (Hybrid) System

3
Bimetalism
A double standard in the sense that both
gold and silver were used as money.
Both gold and silver were used as
international means of payment and the
exchange rates among currencies were
determined by either their gold or silver
contents.

4
The classical gold standards
Gold is freely transferable between countries
Countries fix parity price of gold
Essentially a fixed rate system (Suppose the US
announces a willingness to buy gold for $200/oz and
Great Britain announces a willingness to buy gold for
100. Then 1=$2)
They allow arbitrage between two markets
parity price of gold at Central Bank
free market price of gold
single currency the ounce of gold
Balance of Payments deficits settled with gold
5
Interwar Period
Periods of serious chaos such as German
hyperinflation and the use of exchange rates as a
way to gain trade advantage.
Disturbed supply of gold.
Britain and US adopt a kind of gold standard.
6
Bretton Woods System
Allied powers met in Bretton Woods and created a
post-war international monetary system
Established a US dollar based monetary system
and created the IMF and World Bank
U.S.$ was key currency;
valued at $1 - 1/35 oz. of gold.
All currencies linked to that price in a fixed rate
system.
Exchange rates allowed to fluctuate by 1% above or
below initially set rates.
Collapse, 1971
a. U.S. high inflation rate
b. U.S.$ depreciated sharply.

7
Current Exchange rate regimes
Free Float
The largest number of countries, about 48, allow market forces
to determine their currencys value.
Managed Float
About 25 countries combine government intervention with
market forces to set exchange rates.
Pegged to (or horizontal band around) another currency
No national currency (Dollarization)
Some countries do not bother printing their own, they just use
the U.S. dollar. For example, Ecuador, Panama, and El
Salvador have dollarized.
Monetary unification

8
Fixed vs. Flexible Exchange Rate
Arguments in favor of flexible exchange rates:
Easier external adjustments.
National policy autonomy.
Arguments against flexible exchange rates:
Exchange rate uncertainty may hamper international trade.
No safeguards to prevent crises.
Currencies depreciate (or appreciate) to reflect the
equilibrium value in flexible exchange rates
Governments must adjust monetary or fiscal policies
to return exchange rates to equilibrium value in fixed
exchange rate regimes

9
Fixed vs. Flexible Exchange Rate
Suppose the exchange rate is $1.40/ today.
In the next slide, we see that demand for
British pounds far exceed supply at this
exchange rate.
The U.S. experiences trade deficits.
Under a flexible exchange rate regime, the
dollar will simply depreciate to $1.60/, the
price at which supply equals demand and the
trade deficit disappears.

10
Fixed vs. Flexible Exchange Rate
11
11
S D
Q of
Dollar price per
(exchange
rate)
$1.40
Trade deficit
Demand
(D)
Supply
(S)
$1.60
Fixed vs. Flexible Exchange Rate
Instead, suppose the exchange rate is fixed
at $1.40/, and thus the imbalance between
supply and demand cannot be eliminated by
a price change.
The government would have to shift the
demand curve from D to D*
In this example this corresponds to monetary and
fiscal policies intervention.

12
Fixed vs. Flexible Exchange Rate
13
Supply
(S)
Demand
(D)
Demand (D*)
D* = S
Contractionary
policies
(fixed regime)
Q of
D
o
l
l
a
r

p
r
i
c
e

p
e
r

(
e
x
c
h
a
n
g
e

r
a
t
e
)

$1.40
Some terms
Depreciation: Decline in currency value in a
flexible exchange rate regime
Devaluation: Decline in currency value in a
flexible exchange rate regime
Appreciation: Increases in currency value in
a flexible exchange rate regime
Revaluation: Increase in currency value in a
fixed exchange rate regime
14
European Monetary System (EMS)
EMS was created in 1979 by EEC countries to
maintain exchange rates among their currencies
within narrow bands, and jointly float against outside
currencies.
Objectives:
Establish zone of monetary stability
Coordinate exchange rates vis--vis non-EMS countries
Develop plan for eventual European monetary union
Exchange rate management instruments:
European Currency Unit (ECU)
Weighted average of participating currencies
Accounting unit of the EMS
Exchange Rate Mechanism (ERM)
Procedure by which countries collectively manage exchange
rates


15
What Is the Euro ()?
The euro is the single currency of
the EMU which was adopted by 11
Member States on 1 January 1999.
These original member states
were: Belgium, Germany, Spain,
France, Ireland, Italy, Luxemburg,
Finland, Austria, Portugal and the
Netherlands.
Prominent countries initially
missing from Euro :
UK
Greece ?????


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1 Euro is Equal to:

40.3399 BEF

Belgian franc

1.95583 DEM

German mark

166.386 ESP

Spanish
peseta

6.55957 FRF

French franc

.787564 IEP

Irish punt

1936.27 ITL

Italian lira

40.3399 LUF

Luxembourg
franc

2.20371 NLG

Dutch guilder

13.7603 ATS

Austrian
schilling

200.482 PTE

Portuguese
escudo

5.94573 FIM

Finnish
markka

Benefits and Costs of the
Monetary Union
17
Transaction costs reduced
and FX risk eliminated
Creates a Eurozone
goods, people and capital
can move without
restriction
Compete with the U.S.
Approximately equal in
terms of population and
GDP
Price transparency and
competition

Loss of national monetary
and exchange rate policy
independence
Country-specific
asymmetric shocks can
lead to extended
recessions
The Long-Term Impact of the Euro
If the euro proves successful, it will advance
the political integration of Europe in a major
way, eventually making a United States of
Europe feasible.
It is likely that the U.S. dollar will lose its
place as the dominant world currency.
The euro and the U.S. dollar will be the two
major currencies.

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