Chapter 2

The
International
Monetary System
 Learning Objectives

• Learn how the international monetary system has

evolved from the days of the gold standard to
today’s eclectic currency arrangement
• Analyze the characteristics of an ideal currency
• Explain the currency regime choices faced by
emerging market countries
• Examine how the euro, a single currency for the
European Union, was created

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 History of the International
Monetary System

• Exhibit 2.1 summarizes exchange rate regimes

since 1860
• The Gold Standard, 1876-1913
– Countries set par value for their currency in terms of gold
– Exchange rates were in effect “fixed”
– Gold reserves were needed to back a currency’s value
– The gold standard worked until the outbreak of WWI,
which interrupted trade flows and free movement of gold

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 Exhibit 2.1 The Evolution of
Capital Mobility

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 History of the International
Monetary System
• The Inter-War years and WWII, 1914-1944
– During this period currencies were allowed to fluctuate in
terms of gold and each other
– Increasing fluctuations in currency values became
realized as speculators sold short weak currencies
– In 1934, the U.S. dollar was devalued to $35/oz from
$20.67/oz
– During WWII and its chaotic aftermath the US dollar was
the only major trading currency that continued to be
convertible

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 History of the International
Monetary System

• Bretton Woods and the IMF, 1944

– Allied Powers met in Bretton Woods, NH and created a
post-war international monetary system
– The agreement established a US dollar based monetary
system and created the IMF and World Bank
– 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)

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 History of the International
Monetary System
– Therefore, each country established its exchange rate vis-
à-vis the USD and then calculated the gold par value of
their currency
– 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 and up to a 10% devaluation was allowed without
formal approval from the IMF

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 History of the International
Monetary System

– The Special Drawing Right (SDR)

• Created by the IMF to supplement existing foreign
exchange reserves
• Used as unit of account
• Base against which some countries peg their currency
• Defined initially in terms of fixed quantity of gold
• Currently, it is the weighted average value of
currencies of 5 IMF members having the largest
exports
• Individual countries hold SDRs as deposits at the IMF
and settle IMF transactions through SDR transfers

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 History of the International
Monetary System

• Fixed exchange rates, 1945-1973

– Bretton Woods and IMF worked well post WWII, but
diverging fiscal and monetary policies and external
shocks caused the system’s demise
• The US dollar remained the key to the web of exchange
rates
– Heavy capital outflows of dollars became required to
meet investors’ and deficit needs and eventually created
a lack of confidence in the US’ ability to convert dollars to
gold

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 History of the International
Monetary System
– This lack of confidence forced President Nixon to suspend
official purchases or sales of gold on Aug. 15, 1971
– Exchange rates of most leading countries were allowed to
float in relation to the US dollar
– A year and a half later, the dollar came under attack
again and lost 10% of its value
– By early 1973 a fixed rate system no longer seemed
feasible and the dollar, along with the other major
currencies was allowed to float

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 History of the International
Monetary System

• Floating Era, 1973-1997

– Exchange rates became much more volatile and less
predictable they were during the “fixed” period
– Several emerging market currency crises
– EMS restructuring (1992) and introduction of the Euro
(1999)
– The volatility of the U.S. dollar exchange rate index is
illustrated in Exhibit 2.2
– Key world currency events are summarized in Exhibit 2.3

• Emerging Era, 1997-Present

– Growth in emerging market economies and currencies

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 Exhibit 2.2 The BIS Exchange Rate
Index of the Dollar

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 Exhibit 2.3 World Currency
Events 1971 – 2014 (cont.)

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 Exhibit 2.3 World Currency
Events 1971 – 2014 (cont.)

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 Exhibit 2.3 World Currency
Events 1971 – 2014

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 IMF Classification of Currency
Regimes
• Exhibit 2.4 presents the IMF’s regime classification
methodology in effect since January 2009
• Category 1: Hard Pegs
– Countries that have given up their own sovereignty over
monetary policy
– E.g. dollarization or currency boards
• Category 2: Soft Pegs
– AKA fixed exchange rates, with five subcategories of
classification
• Category 3: Floating Arrangements
– Mostly market driven, these may be free floating or floating with
occasional government intervention
• Category 4: Residual
– The remains of currency arrangements that don’t well fit the
previous categorizations

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 Exhibit 2.4 IMF Exchange Rate
Classifications (cont.)

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 Exhibit 2.4 IMF Exchange Rate
Classifications

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 Exhibit 2.5 Taxonomy of Exchange
Rate Regimes

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 Fixed versus Flexible Exchange Rates

• A nation’s choice as to which currency regime to

follow reflects national priorities about all facets
of the economy, including:
– inflation,
– unemployment,
– interest rate levels,
– trade balances, and
– economic growth.
• The choice between fixed and flexible rates may
change over time as priorities change.

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 Fixed versus Flexible Exchange Rates

• Fixed rate regime pros:

– stability in international prices
– inherent anti-inflationary nature of fixed prices

• Fixed rate regime cons:

– Need for central banks to maintain large quantities of
hard currencies and gold to defend the fixed rate
– Fixed rates can be maintained at rates that are
inconsistent with economic fundamentals

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 Fixed versus Flexible Exchange Rates

• The “ideal currency” possesses three attributes, often

referred to as The Impossible Trinity:
– Exchange rate stability
– Full financial integration
– Monetary independence
• The forces of economics do not allow the simultaneous
achievement of all three
• Exhibit 2.6 illustrates how pursuit of one element of the
trinity must result in giving up one of the other elements

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 Exhibit 2.6 The Impossible
Trinity

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 A Single Currency for Europe:
The Euro
• In December 1991, the members of the European
Union met at Maastricht, the Netherlands, to
finalize a treaty that changed Europe’s currency
future.
• This treaty set out a timetable and a plan to replace
all individual EMS currencies with a single currency
called the euro.

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 A Single Currency for Europe:
The Euro

• To prepare for the EMU, a convergence criteria was

laid out whereby each member country was
responsible for managing the following to a specific
level:
– Nominal inflation rates
– Long-term interest rates
– Fiscal deficits
– Government debt
• In addition, a strong central bank, called the
European Central Bank (ECB), was established in
Frankfurt, Germany.

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 A Single Currency for Europe:
The Euro
• EMU initiated by 11 members in 1999 and with 28
member states by 2014.
• The euro affects markets in three ways:
– Cheaper transactions costs in the eurozone
– Currency risks and costs related to uncertainty are reduced
– Price transparency and increased price-based competition

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 Emerging Markets & Regime
Choices

• Currency Boards – exist when a country’s central

bank commits to back its monetary base, money
supply, entirely with foreign reserves at all times

• This means that a unit of the domestic currency

cannot be introduced into the economy without an
additional unit of foreign exchange reserves being
obtained first
• Example is Argentina between 1991 and 2002 when it fixed
the Argentinean Peso to the US Dollar

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 Emerging Markets & Regime
Choices
• Dollarization is the use of the USD as the official currency of
the country
• Arguments for include
– No currency volatility and currency crises
– Greater economic integration with dollar based markets
• Arguments against include
– Loss of monetary policy
– Loss of power of seignorage
– The central bank of the country no longer can serve as
lender of last resort
• Examples include Panama circa 1907 and Ecuador circa 2000

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 Exhibit 2.8 Ecuadorian Sucre/US Dollar
Exchange Rate, 1998-2000

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 Exhibit 2.9 Regime Choices for
Emerging Markets

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 Globalizing the Chinese
Renminbi
• The Chinese renminbi (RMB) or yuan (CNY) is becoming a
true international currency
• Yuan, unit of account; renminbi, physical currency
• Since 2005 has a managed float regime and has gradually
revalued against the US dollar
• The RMB has a two-market structure, onshore and offshore
(mainly Hong Kong)
• Degrees of internationalization:
1. Readily accessible for trade
2. Used for international investments
3. Used as reserve currency (Triffin Paradox)

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 Exhibit 2.10 The Gradual
Revaluation of the RMB

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 Exhibit 2.11 Structure of the Chinese
Renminbi Market

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 Exchange Rate Regimes:
What Lies Ahead?
• Exchange rate regimes tradeoffs: rules vs.
discretion and cooperation vs. independence
• The pre WWI Gold Standard: rules and
independence
• The Bretton Woods agreement (and to a certain
extent the EMS): rules and cooperation
• The present system: no rules with varying degrees
of cooperation
• International monetary systems could only succeed
if it combined cooperation with individual discretion

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 Exhibit 2.12 Exchange Rate
Regimes Trade-offs

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 Summary of Learning Objectives

• The international monetary system has evolved

from the days of the gold standard to today’s
eclectic currency arrangement
– Gold Standard (1876 – 1913)
– Inter-war period (1914 – 1944)
– Bretton Woods (1944)
– Fixed exchange rates (1945-1973)
– Elimination of dollar convertibility into gold (1971)
– Floating Era (1973-1997)
– Emerging Era (1997-Present)

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 Summary of Learning Objectives

• If the ideal currency existed in today’s world, it

would have three attributes: a fixed value,
convertibility, and independent monetary policy
• Emerging market countries must often choose
between two extreme exchange rate regimes,
either free-floating or fixed regime such as a
currency board or dollarization

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 Summary of Learning Objectives

• The members of the EU are also members of the EMS.

– Members of this group have formed an island of fixed
exchange rates amongst themselves in a sea of floating
currencies
– They rely heavily on trade among themselves, so day-to-
day benefits are great
• The euro affects markets in three ways
– Countries within the zone enjoy cheaper transaction costs
– Currency risks and costs related to exchange rate
uncertainty are reduced,
– All consumers and businesses enjoy price transparency
and increased price-based competition

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