The International
Monetary System
Ing. Tomáš Heryán, Ph.D.
International Business Finance
FIU/NKIFA
Questions and Applications
???What is the financial system???
???What is the difference between financial system and
international financial system???
The International Monetary System (International Business Finance – presentation 01)
Definition of Financial System (Repetition)
• Financial system is system that allows transfer money between savers and
borrowers
• Functions
• to channel funds from lenders to borrowers
• to create a payment and clearing mechanism
The International Monetary System (International Business Finance – presentation 01)
Questions and Applications
???
When government of Greece experienced problems in meeting
its debt obligation in 2010, some investors became concerned
that the crisis would spread to other European countries.
Explain why integrated European financial markets might
allow a debt crisis in one European country to spread to other
countries in Europe.
???
The International Monetary System (International Business Finance – presentation 01)
• Complex system of international arrangements, rules, institutions, policies
in regard to exchange rates, international payments and capital flows
• Institutional framework within which
– International payments are made
– Movements of capital are accommodated
– Exchange rates are determined
• International monetary system has evolved over time as international
trade/business/finance have changed, technology has improved and political
systems have changed
Definition of the International Monetary System
The International Monetary System (International Business Finance – presentation 01)
Questions and Applications
???What is the money???
???Why the money came into existence???
The International Monetary System (International Business Finance – presentation 01)
Definition of the Money
• Money is any good that is widely accepted for the purposes of the exchange and in
the repayments of debts
• Functions
• medium of exchange
• money is used to intermediate the exchange of goods and services
• it solves the problem of the double coincidence of wants
• unit of account
• money measures the market value of goods, services, and other transactions
• it decreases number of prices (in barter: 4 types of goods = 6 prices, 100 types of goods =
495 prices)
• store of value
• money is a way to keep some of our wealth in a readily spendable form for future needs
The International Monetary System (International Business Finance – presentation 01)
• Bimetallism (before 1850s – 1870)
• Classic Gold Standard (1870s – 1914)
• Interwar period (1918 – 1939)
• Bretton Woods system (1945 – 1972)
• System of floating exchange rates (1972 – present)
Evolution of the International Monetary System
The International Monetary System (International Business Finance – presentation 01)
• A „double standard“ in which both gold and silver were used as money
– United States, the Netherlands, France
• Period of different arrangements
– United Kingdom on gold standard since 1821
– German states, Austro-Hungarian Empire, Scandinavia, Russia, and the Far East operated
silver standards
• Exchange rates among currencies determined by either their gold or silver
contents
– Problems when relative price of metals differs from official mint parity
Bimetallism
The International Monetary System (International Business Finance – presentation 01)
• During the 1800s the industrial revolution brought about a vast increase in
the production of goods and widened the basis of world trade
• At that time, trading countries believed that a necessary condition to
facilitate world trade was a stable exchange rate system
– Stable exchange rates were seen as necessary for encouraging and settling commercial
transactions across borders (both by companies and by governments)
– So by the second half of the 19th century, most countries had adopted the gold standard
exchange rate regime
Gold Standard until 1914
The International Monetary System (International Business Finance – presentation 01)
• Replacement of bimetallism with gold
standard in Great Britain (1816)
• Unpromising political circumstances
in Europe
• Chain reaction in the area of
establishing gold standard
– Strong interest of every country to
implement the same international
monetary system as their most important
economic and financial partners have
implemented
Way towards Gold Standard
Country Year
Great Britain 1816
Germany 1871
Sweden, Norway and Denmark 1873
France, Belgium, Switzerland, Italy and
Greece
1874
Netherlands 1875
Uruguay 1876
USA 1879
Austria 1892
Chile 1895
Japan 1897
Russia 1898
Dominican Republic 1901
Panama 1904
Mexico 1905
The International Monetary System (International Business Finance – presentation 01)
• Countries set par value for their currency in terms of gold
• Determination of exchange rates in the gold standard was simple
– Example: US$ gold rate was $20.67/oz, the British pound was pegged at £4.2474/oz
– US$/£ rate calculation is $20.67/£4.2472 = $4.8665/£
• Highly stable exchange rates
• During this period in most major countries
– Gold alone was assured of unrestricted coinage
– There was two-way convertibility between gold and national currencies at a stable ratio
– Gold could be freely exported or imported
Basics of Gold Standard
The International Monetary System (International Business Finance – presentation 01)
Example of exchange rate development in Gold Standard
The International Monetary System (International Business Finance – presentation 01)
Exchange rate FRF / USD during the period 1876 - 1914
5,10
5,12
5,14
5,16
5,18
5,20
5,22
5,24
5,26
1876
1878
1880
1883
1885
1888
1890
1892
1895
1897
1900
1902
1905
1907
1909
1912
• Countries had to maintain adequate gold reserves to back its currency’s
value in order for regime to function
• Because of dominance of British during this period, pound sterling also a
medium of exchange
• Environment that was conducive to international trade and investment
• Misalignment of exchange rates and international imbalances of payment
automatically corrected by the price-specie-flow mechanism
• Each country should adjust its domestic money supply in direct relation to
the amount of gold it held
– Increase in gold would increase the domestic money and a reduction in its gold supply
would reduce the money supply
Basics of Gold Standard
The International Monetary System (International Business Finance – presentation 01)
Gold production and relative value of gold and silver
The International Monetary System (International Business Finance – presentation 01)
Questions and Applications
???Imagine 2 countries – United States and France - in the
period of Classical Gold Standard and suppose that the United
States exported more to France than France exported to the
United States. What will be the consequences???
The International Monetary System (International Business Finance – presentation 01)
• Suppose the United States exported more to a foreign country than the
foreign country exported to the United States
• This cannot persist under a gold standard
– Net export of goods from the United States to abroad will be accompanied by a net flow
of gold from abroad to the United States
– This flow of gold will lead to a lower price level in abroad and, at the same time, a higher
price level in the United States
• Resultant change in relative price levels will slow exports from the United
States and encourage exports from abroad
• Country must guarantee complete back-up of domestic currency with gold
• There has to be price and wage flexibility
Price-Specie-Flow Mechanism
The International Monetary System (International Business Finance – presentation 01)
• The „Rules of the Game“ refers to another adjustment process that was
theoretically carried out by central banks
– Selling of domestic assets when gold exits in the country to pay for imports. This
decreased the money supply and increased interest rates, attracting financial capital
inflows to match a current account deficit, reducing gold outflows
– Buying of domestic assets when gold enters the country as income from exports. This
increased the money supply and decreased interest rates, reducing financial capital
inflows to match a current account surplus, reducing gold inflows
• In practice, little incentive for countries with expanding gold reserves to
follow the rules
– Instead, countries often sterilized gold inflows
Rules of the game
The International Monetary System (International Business Finance – presentation 01)
• Long-term stability of price level (average annual inflation in USA)
– 0.1 % (1880 – 1914) vs. 4.2 % (1946 – 1990)
• Short-term instability of price level (ratio of standard error of annual inflation
rates and average annual inflation)
– 17.0 (1880 – 1914) vs. 0.8 (1946 – 1990)
• Higher volatility of real output (variation coefficient of the real output in USA)
– 3.5 (1879 – 1913) vs. 1.5 (1946 – 1990)
• Higher level of unemployment (average rate of unemployment in USA)
– 6.8 % (1879 – 1913) vs. 5.6 % (1946 – 1990)
Results of Gold Standard
The International Monetary System (International Business Finance – presentation 01)
• With the outbreak of World War I, the classical gold standard came to an
end
• Interwar years marked by severe economic instability
• Reparation payments led to episodes of hyperinflation in Europe
– German hyperinflation
– From a level of 262 in January 1919 to 126,160,000,000,000 in December 1923 (factor of
481.5 billion)
– Economic distress eventually promoted rise of Nazism
• Extremely negative effects of the lack of agreement on the functioning of
the international monetary system
Interwar experience
The International Monetary System (International Business Finance – presentation 01)
• United States returned to gold in 1919
• Group of countries (Great Britain, France, Italy, Japan) agreed in 1922 on a
program calling for:
– A general return to the gold standard
– Cooperation among central banks in attaining external and internal objectives
• Great Britain returned to the gold standard at prewar parity in 1925
• „Gold bloc“ countries (e.g. France, Belgium, Switzerland, Czechoslovakia,
Poland) stayed with gold until 1936
Fleeting return to gold
The International Monetary System (International Business Finance – presentation 01)
• Initial collapse in 1929 (stock market crash) followed by bank failures
throughout the world
• Great Britain forced off gold in 1931 when foreign holders of pounds lost
confidence in Britain‘s commitment to maintain its currency value
• United States devalued in 1933
• Major economic harm was done by restrictions on international trade and
payments
• Protectionist and beggar-thy-neighbor policies
– Competitive devaluations of national currencies
– Foreign retaliation and disintegration of the world economy
– International cooperation would have bettered off economic situation of all countries
Great depression
The International Monetary System (International Business Finance – presentation 01)
Industrial production and price changes (1929-1935)
The International Monetary System (International Business Finance – presentation 01)
• Position of Great Britain
– New international currency “bancor”, accepted as equivalent to gold
– International clearing union would guarantee automatic elimination of balance-ofpayments
disequilibria
– Functioning of the system similar to the functioning of the gold standard, but more
flexible
• Position of the United States
– Restoration of the gold exchange standard
– Establishment of a special fund, into which countries would pay their financial quota and
from which they could borrow in times of temporary balance-of-payments difficulties
– Eradication of trade and payment restrictions
Conference in Bretton Woods, July 1944
The International Monetary System (International Business Finance – presentation 01)
• Bretton Woods international monetary system reflected mostly US interests
• Agreement established a US dollar based monetary system and created the
International Monetary Fund and World Bank
• IMF establishment based on a quota and/or drawing rights system of all
member countries
• Under original provisions, all countries fixed their currencies in terms of
gold but were not required to exchange their currencies
• Only the US dollar remained convertible into gold (at $35/oz with central
banks, not individuals)
• Each country established its exchange rate vis-à-vis the US dollar and then
calculated the gold par value of their currency
Outcomes of the Bretton Woods conference
The International Monetary System (International Business Finance – presentation 01)
• Participating countries agreed to try to maintain the currency values within
1% of par by buying or selling foreign or gold reserves
• Devaluation was not to be used as a competitive trade policy, but if a
currency became too weak to defend, up to a 10% devaluation was allowed
without formal approval from the IMF
• Countries let an international organization accept decisions about exchange
rates for the first time in history by signing the IMF statute
• Removal of all restrictions on the current account transactions
Outcomes of the Bretton Woods conference
The International Monetary System (International Business Finance – presentation 01)
Exchange rates during Bretton Woods
The International Monetary System (International Business Finance – presentation 01)
359
359,5
360
360,5
361
361,5
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
JPY Exchange Rate: 1950 - 1970
2,1
2,2
2,3
2,4
2,5
2,6
2,7
2,8
2,9
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
GBP Exchange Rate: 1950 - 1970
• Generally worked well in the 1950s and early 1960s
• Period of „dollar shortage“
– Enormous world demand for American goods in combination with very limited export
possibilities of other countries and their low foreign exchange reserves
• Diverging fiscal and monetary policies and external shocks caused the system’s
demise
• President Lyndon Johnson financed both his “Great Society” programs at home
and the American war in Vietnam
– Large US Federal budget deficit coupled with easy monetary policy reulted in high
inflation in the United States and increase in US spending for cheaper imports
• As a result, the United States balance of payments moves from a surplus into a
deficit
Functioning of the Bretton Woods system
The International Monetary System (International Business Finance – presentation 01)
• From mid of 1960s period of „dollar glut = dollar overhang“
• US trade balance moved into deficit along with improvement in economic growth
and balance-of-payments of Europe and Japan
• Nations with balance-of-payments deficit are under more pressure than
countries with balance-of-payments surplus
• Dollar devaluation impossible because of its specific role in the Bretton Woods
monetary system
• Problem of facilitating international liquidity and problem of confidence
into the system
– Triffin paradox
Functioning of the Bretton Woods system
The International Monetary System (International Business Finance – presentation 01)
• Named after Robert Triffin, a Belgian American economist known for his critique of
the Bretton Woods system
• System rested on U.S. promise to exchange dollars for gold on demand
• Yet for international trade to grow, foreigners needed increase their holdings of the
reserve currency, the US dollar (U.S. current account deficit needed)
• More dollars foreigners held, the less they believed in U.S. promise to exchange
dollars for gold
• Second option was to reduce the current account deficit and slow down the
international trade and economy
Triffin paradox
The International Monetary System (International Business Finance – presentation 01)
Deficits of the U.S. balance of payments (USD billion)
• By 1970, financial markets are reluctant to hold the “overvalued” U.S.
dollar and sell USD in increasing volume
– This puts downward pressure on the exchange rate for dollars
– And upward pressure on the exchange rate for foreign currencies
– Central banks engage in massive intervention in an attempt to hold their Bretton Woods
par values
• As a result, foreign holdings of dollars increase dramatically and eventually
exceed U.S. gold holdings
– By 1971, gold coverage for U.S. dollars had dropped to 22%
– In August 1971, President Nixon suspends dollar convertibility into gold
– In response, more dollars are sold on foreign exchange markets pushing the dollar lower
(and foreign currencies higher)
Functioning of the Bretton Woods system
The International Monetary System (International Business Finance – presentation 01)
• In December 1971, ten major counties meet in Washington, D.C. with the
aim of restoring stability to the international monetary system
• Main aim was to set up stable exchange rates that would ensure balance-ofpayments
equilibrium in major countries
• Essential meeting conclusions
– Key countries agree to revalue their currencies and in essence set new par values against
the US dollar (e.g., yen +17%, mark +13.5%, pound and franc +9%)
– The United States also agree to raise the dollar price of gold from $35 to $38 an ounce
(represents a further devaluation of the dollar).
– It was also agreed that currencies could now fluctuate + or – 2.25% around their new par
values
– The United States discontinue their 10% import tariff
Smithsonian agreements
The International Monetary System (International Business Finance – presentation 01)
• 13 months after the Smithsonian Agreements, the dollar comes under
renewed attack for being overvalued
• On February 12, 1973 the dollar is devalued further to $42 per ounce
• In response to mounting speculative currency flows, foreign exchange
markets are closed on March 1, 1973, and reopen on March 19, 1973
• When foreign exchange markets reopen, major countries (Japan, Canada,
Western Europe) announce that they are “floating” their currencies
• The Bretton Woods fixed exchange rate system effectively ends on this date
• Approximately 3 months later, by June 1973, the dollar has “floated” down
an average of 10% against the major currencies of the world
The end of Bretton Woods system
The International Monetary System (International Business Finance – presentation 01)
• Since March 1973, the major currencies of the world have operated under a
floating exchange rate system
– While central banks of these major countries have occasionally interviewed in support of
their currencies, this intervention has become less over the years
• In addition to the major currencies of the world, a growing number of other
developing country currencies have also moved to a floating rate system
• The post Bretton Woods’period has resulted exchange rates become much
more volatile and, perhaps, less predictable then they were during previous
fixed exchange rate eras
Post Bretton Woods summary
The International Monetary System (International Business Finance – presentation 01)
• OPEC and the oil crisis (1973-1974)
– OPEC raised oil prices four fold which resulted into exchange rate turmoil
– Caused OPEC nations to earn large surplus balance of payments
– Surpluses recycled to debtor nations which set up debt crisis of 1980s
• Jamaica agreement (1976)
– Floating rates were declared acceptable
– Gold was abandoned as a reserve asset
• Dollar crisis (1978-1979)
– U.S. balance of payments difficulties
– Result of inconsistent monetary policy in the United States
– Dollar value falls as confidence shrinks
Post Bretton Woods system (1)
The International Monetary System (International Business Finance – presentation 01)
• Rising dollar (1980-1985)
– U.S. inflation subsides as the Fed raises interest rates
– Rising rates attracts global capital to USA
– As a result the dollar value raises
• Sinking dollar (1985-1987)
– Dollar devaluated slowly downward
– Plaza agreement (1985): G-5 countries agree to depress the dollar further
– Louvre Agreement (1987): G-7 countries agree to support the falling dollar
Post Bretton Woods system (2)
The International Monetary System (International Business Finance – presentation 01)
• Variety of exchange rate regimes
– Selection depends on a country’s preferences and specifics
• Three most important currencies (USD, EUR, JPY)
– Discussions on the role of GBP and CNY
• Evidences on monetary integration with the eurozone as the most advanced
example
• Financial crises as a phenomena of current system
– Crises in Latin America
– Crises in South-East Asia
– Global financial crisis
• Discussions on controls and regulation of international capital flows
Present international monetary system
The International Monetary System (International Business Finance – presentation 01)
THANK YOU FOR YOUR
ATTENTION
J