Chapter 11
The International Monetary
System
LERARNING OBJECTIVES
•Historical development of the modern global monetary system.
Role of world bank and the IMF in the international monetary system.
•Know differences between a fixed and floating exchange rate system.
•Know what exchange rate regimes are used in the world today and why
countries adopt different exchange rate regimes.
•Understand the debate surrounding the role of the IMF in the
management of financial crises.
What Is The International
Monetary System?
The international monetary system refers to the
institutional arrangements that countries adopt to govern
exchange rates
A floating exchange rate system exists when a country
allows the foreign exchange market to determine the relative
value of a currency
the U.S. dollar, the EU euro, the Japanese yen, and the British pound
all float freely against each other
their values are determined by market forces and fluctuate day to day
Exchange Rate Regimes in the
International Financial System
Fixed exchange rate regime
◦ Value of a currency is pegged relative to the value of one other currency (anchor
currency)
Pegged exchange rate system
exists when a country fixes the value of its currency relative to a reference currency
◦ many Gulf states peg their currencies to the U.S. dollar
Floating exchange rate regime
◦ Value of a currency is allowed to fluctuate against all other currencies
Managed float regime (dirty float)
◦ Attempt to influence exchange rates by buying and selling currencies
◦ A dirty float exists when a country tries to hold the value of its currency within
some range of a reference currency such as the U.S. dollar (e.g. China pegs the
yuan to a basket of other currencies)
Exchange Rate Regimes in
the International Financial
System
Gold standard
◦ Fixed exchange rates
◦ No control over monetary policy
◦ Influenced heavily by production of gold and
gold discoveries
Bretton Woods System
◦ Fixed exchange rates using U.S. dollar as reserve currency
◦ The fixed exchange rates were maintained by intervention of central banks
◦ International Monetary Fund (IMF)
Exchange Rate Regimes in
the International Financial
System
Bretton Woods System (cont’d)
◦ World Bank
◦ General Agreement on Tariffs and Trade (GATT)
◦ World Trade Organization
European Monetary System
◦ Exchange rate mechanism
How the Bretton Woods
System Worked
Exchange rates adjusted only when experiencing a
“fundamental disequilibrium” (large persistent deficits in
balance of payments)
Loans from IMF to cover loss in international reserves
IMF encouraged contractionary monetary policies
Devaluation only if IMF loans were not sufficient
No tools for surplus countries
U.S. could not devalue currency
How a Fixed Exchange Rate
Regime Works
When the domestic currency is overvalued, the central bank
must:
◦ Purchase domestic currency to keep the exchange rate fixed (it loses
international reserves), or
◦ Conduct a devaluation
When the domestic currency is undervalued, the central
bank must:
◦ Sell domestic currency to keep the exchange rate fixed (it gains
international reserves), or
◦ Conduct a revaluation
Figure 2 Intervention in the Foreign Exchange Market
Under a Fixed Exchange Rate Regime
Application: How Did China Accumulate $4
Trillion of International Reserves?
By 2014, China had accumulated $4 trillion in international reserves.
The Chinese central bank engaged in massive purchases of U.S. dollar
assets to maintain the fixed relationship between RMB and the U.S.
dollar.
The undervaluation of RMB has caused Chinese goods abroad so cheap
that many countries (like the U.S.) have threatened to erect trade
barriers.
Managed Float
Hybrid of fixed and flexible
Small daily changes in response to market
Interventions to prevent large fluctuations
Rates fluctuate in response to market forces but are not solely determined by
them
Appreciation hurts exporters and employment
Depreciation hurts imports and stimulates inflation
Special drawing rights as substitute for gold
Are Capital Controls A Good
Ideas? Disadvantages of Capital
Controls
Controls on capital outflows:
◦ Seldom effective and may increase capital flight
◦ Weaken confidence in government
◦ Lead to corruption
◦ Lose opportunity to reform the financial system
Controls on capital inflows:
◦ Lead to a lending boom and excessive risk taking by financial intermediaries
Capital Controls
Controls on inflows (cont’d):
◦ Controls may block funds for productions uses
◦ Produce substantial distortion and misallocation
(Households and businesses need to find a way to get around these barriers)
◦ Lead to corruption
Strong case for improving bank regulation
and supervision
The Role of the IMF
Fixed exchange rates stopped competitive devaluations and brought
stability to the world trade environment
Fixed exchange rates imposed monetary discipline on countries,
limiting price inflation
In cases of fundamental disequilibrium, devaluations were permitted
IMF lent foreign currencies to members during short periods of
balance-of-payments deficit, when a rapid tightening of monetary or
fiscal policy would hurt domestic employment
International Considerations
and Monetary Policy
Balance of payment considerations:
◦ Current account deficits in the U.S. suggest that American businesses may be
losing ability to compete because the dollar is too strong.
◦ U.S. deficits mean surpluses in other countries large increases in their
international reserve holdings world inflation.
International Considerations
and Monetary Policy
Exchange rate considerations:
A contractionary monetary policy will raise the domestic interest rate
and strengthen the currency.
An expansionary monetary policy will lower interest rates and weaken
currency.
Exchange Rate Since 1973
Since 1973, exchange rates is less predictable because
1971 and 1979 oil crises
The loss of confidence in the dollar after U.S. inflation in 1977-78
the rise in the dollar between 1980 and 1985 The partial collapse of
the European Monetary System (EMS) in 1992
The 1997 Asian currency crisis
The decline in the dollar from 2001 to 2009
Which one is better- Fixed or Floating
Floating exchange rates provide
Monetary policy autonomy
removing the obligation to maintain exchange rate parity restores monetary control to
a government
Automatic trade balance adjustments
under Bretton Woods, if a country developed a permanent deficit in its
balance of trade that could not be corrected by domestic policy, the IMF would have
to agree to a currency devaluation. BUT
Fixed exchange rate system Provides monetary discipline
ensures that governments do not expand their money supplies at inflationary rates
Minimizes speculation and s uncertainty and promotes growth of international trade
and investment
Pegged Exchange System
Pegged exchange rate system pegs the value of its currency to that of
another major currency
popular among the world’s smaller nations
imposes monetary discipline and leads to low inflation
adopting a pegged exchange rate regime can moderate inflationary pressures
in a country
Currency Boards
A monetary authority that makes decisions about the valuation of a
nation's currency
A strong commitment to the fixed exchange rate and a solution to lack
of transparency and commitment to target
Domestic currency is backed 100% by a foreign currency
Note issuing authority establishes a fixed exchange rate and stands
ready to exchange currency at this rate
Currency Boards
Money supply can expand only when foreign currency is exchanged for
domestic currency.
Stronger commitment by central bank
Loss of independent monetary policy and increased exposure to shock
from anchor country
Loss of ability to create money and act as lender of last resort
Role of IMF
A currency crisis
occurs when a speculative attack on the exchange value of a currency results in
a sharp depreciation in the value of the currency, or forces authorities to expend
large volumes of international currency reserves and sharply increase interest
rates in order to defend prevailing exchange rates
A banking crisis refers to a situation in which a loss of confidence in the
banking system leads to a run on the banks, as individuals and companies
withdraw their deposits
A foreign debt crisis is a situation in which a country cannot service its foreign
debt obligations, whether private sector or government debt Greece and
Ireland 2010
