Faculty of Business

International
Finance
IBF301 – FPT UNIVERSIT Y
CHAPTER 2
International Monetary System
Content
1. Evolution of the International Monetary System

2. The Current Exchange Rate Arrangements

3. European Monetary System

4. The Euro and the European Monetary Union

5. The Asian Currency Crisis

6. Fixed versus Flexible Exchange Rate Regimes

Chapter Objective:
1. This chapter examines the international monetary system, which defines the overall financial
environment in which multinational corporations and international investors operate.

2. In this chapter, we will review the history of the international monetary system and
contemplate its future prospects.

3. In addition, we will compare and contrast the alternative exchange rate systems, that is, fixed
versus flexible exchange rates.
1. Evolution of the
International Monetary
System
IBF301 – CHAPTER 2
International Monetary System
International Monetary System: Institutional
framework within which international
payments are made, movements of capital
are accommodated, and exchange rates
among currencies are determined.

A complex whole of agreements, rules,

institutions, mechanisms, and policies
regarding exchange rates, international
payments, and the flow of capital.
Evolution of the International
Monetary System
The international monetary system went through several distinct stages of
evolution. These stages are summarized as follows:

Before 1875 1915-1944 1973-Present

Bimetallism Interwar Period The Flexible Exchange
Rate Regime

1875-1914 1945-1972
Classical Gold Bretton Woods
Standard System
Bimetallism: Before 1875
Bimetallism was a “double standard” in the sense that free coinage was
maintained for both gold and silver
Countries on the bimetallic standard often experienced the well-known
phenomenon referred to as Gresham’s law
◦ Gresham’s law dictates that, under the bimetallic standard, the abundant metal was used as money
while the scarce metal was driven out of circulation, because the ratio of the two metals was
officially fixed

For example, when gold from newly discovered mines in California and Australia poured into the
market in the 1850s, the value of gold became depressed, causing overvaluation of gold under the
French official ratio, which equated a gold franc to a silver franc 15½ times as heavy. As a result, the
franc effectively became a gold currency.

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Classical Gold Standard: 1875-1914
First full-fledged gold standard, a monetary system in which currencies are
defined in terms of their gold content, was established in 1821 in Great
Britain
◦ Majority of countries moved away from gold in 1914 when World War I began

Under the gold standard, the exchange rate between any two currencies will
be determined by the gold contents

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Classical Gold Standard: An
Example
Suppose the pound (£) is pegged to gold at six pounds (£6) per ounce,
whereas one ounce of gold is worth 12 francs (₣)
◦ £6 = 1 oz. gold
◦ ₣12 = 1 oz. gold

Deducing from the information given above, £6 must equal ₣12

◦ 6/12 reduces to 1/2; therefore £1 = ₣2

Exchange rate between the pound and the franc should then be two francs
per pound
Classical Gold Standard:
Adjustment Mechanism
Price-specie-flow mechanism was an automatic correction of payment
imbalanced between countries operating under the gold standard
◦ Based on the fact that domestic money stock rises or falls as the country experiences
inflows or outflows of gold

Key shortcomings of the gold standard:

◦ Supply of newly minted gold is so restricted that the growth of world trade and
investment can be seriously hampered for lack of sufficient monetary reserves
◦ No mechanism to compel each major country to abide by the rules of the game
Price-Specie-Flow Mechanism
Suppose Great Britain exported more to France than France imported from
Great Britain.
This cannot persist under a gold standard.
◦ Net export of goods from Great Britain to France will be accompanied by a net flow of
gold from France to Great Britain.
◦ This flow of gold will lead to a lower price level in France and, at the same time, a
higher price level in Britain.

The resultant change in relative price levels will slow exports from Great Britain
and encourage exports from France.

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Price-Specie-Flow Mechanism
Higher prices cause
export to decrease and
imports to increase

If Export is
bigger than
import

+ Balance
of Trade

Prices will
go up

Money
Supply will
Increase

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Bretton Woods System:
1945–1972
IBF301 – CHAPTER 2
 Bretton Woods System:1945-1972
❑ Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire.
❑ The purpose was to design a postwar international monetary system.
❑ Described as a dollar-based gold-exchange standard.
❑ Triffin paradox explains the collapse of this system in the early 1970s
Reserve-currency country should run a balance of payments deficit, but this
can decrease confidence in the reserve currency and lead to the downfall of
the system

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The Design of the Gold-Exchange System
German
British mark French
pound franc
Par
Value

U.S. dollar

Pegged at $35/oz.
Gold
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 Special Drawing Rights (SDR)
The SDR, which is a basket currency comprising major individual currencies, was allotted to the
members of the IMF, who could then use it for transactions among themselves or with the IMF.
The SDR was greatly simplified to
comprise only five major
currencies: U.S. dollar, German The Chinese yuan
mark, Japanese yen, British was added to the
1970 pound, and French franc. 1999 SDR basket

Initially, the SDR was designed to be

the weighted average of 16 1981 With the advent of the euro
in 1999, the SDR became
2016
currencies of those countries whose
shares in world exports were more composed of just four major
than 1 percent. The percentage currencies: the U.S. dollar,
share of each currency in the SDR the euro, the British pound,
was about the same as the and the Japanese yen.
country’s share in world exports.
The Flexible Exchange
Rate Regime: 1973–
Present
IBF301 – CHAPTER 2
The Flexible Exchange Rate
Regime: 1973–Present
The flexible exchange rate regime that followed the demise of the Bretton Woods system was
ratified after the fact in January 1976 when the IMF members met in Jamaica and agreed to
a new set of rules for the international monetary system.

The key elements of the Jamaica Agreement include

1. Flexible exchange rates were declared acceptable to the IMF members.
Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted
volatilities.

2. Gold was abandoned as an international reserve asset.

3. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.
The Flexible Exchange Rate
Regime: 1973–Present
EXHIBIT 2.3 The Trade-Weighted Value of the U.S. Dollar since 1964
2. The Current
Exchange Rate
Arrangements
IBF301 – CHAPTER 2
Current Exchange Rate Arrangements
According to IMF annual report (2018), the IMF classifies exchange rate arrangements into 10 separate
regimes:
1. No separate legal tender:
2. Currency board:
3. Conventional fixed pegs:
4. Stabilized arrangement:
5. Crawling peg:
6. Crawl-like arrangement:
7. Pegged exchange rate within horizontal banks
8. Other managed arrangement:
9. Floating:
10. Free floating:
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Current Exchange Rate Arrangements
According to IMF annual report (2018), the IMF classifies exchange rate arrangements into 10
separate regimes:
1. No separate legal tender: The currency of another country circulates as the sole legal tender.
Examples include Ecuador, El Salvador, Panama using the US dollar.
2. Currency board: Legislative commitment to exchange domestic currency for a specified foreign
currecy at a fixed exchange rate. Examples include Hong Kong, Bulgaria, and Brunei.
3. Conventional fixed pegs: the country formally (de jure) pegs its currency at a fixed rate to
another currency or a basket of currencies, where the basket is formed, for example, from the
currencies of major trading or financial partners and weights reflect the geographic distribution
of trade, services, or capital flows. Examples includes Jordan, Saudi Arabia, and Morocco.
4. Stabilized arrangement: a spot market exchange rate that remains within a margin of 2 percent
for 6 months or more and is not floating. Examples are Cambodia, Singapore, and Lebanon.

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Current Exchange Rate Arrangements
5. Crawling peg: The currency is adjusted in small amounts at a fixed rate or in response to
changes in selected quantitative indicators, such as past inflation differentials vis-à-vis
major trading partners or differentials between the inflation target and expected
inflation in major trading partners. Examples are Honduras and Nicaragua.
6. Crawl-like arrangement: The exchange rate must remain within a narrow margin of 2
percent relative to a statistically identified trend for six months or more (with the
exception of a specified number of outliers), and the exchange rate arrangement cannot
be considered as floating. Ethiopia, China, and Croatia are examples.
7. Pegged exchange rate within horizontal banks: The value of the currency is maintained
within certain margins of fluctuation of at least ±1 percent around a fixed central rate,
or the margin between the maximum and minimum value of the exchange rate exceeds
2 percent. Tonga is the only example.

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Current Exchange Rate Arrangements
8. Other managed arrangement: This category is a residual, and is used when the exchange rate
arrangement does not meet the criteria for any of the other categories. Arrangements
characterized by frequent shifts in policies may fall into this category. Examples are Algeria,
Nigeria, and Malaysia.
9. Floating: A floating exchange rate is largely market determined, without an ascertainable or
predictable path for the rate. In particular, an exchange rate that satisfies the statistical criteria
for a stabilized or a crawl-like arrangement will be classified as such unless it is clear that the
stability of the exchange rate is not the result of official actions. Examples include Brazil, Korea,
Turkey, and India.
10. Free floating: if intervention occurs only exceptionally and aims to address disorderly market
conditions and if the authorities have provided information or data confirming that intervention
has been limited to at most three instances in the previous six months, each lasting no more
than three business days. Examples are Canada, Mexico, Japan, the U.K., United States, and
euro zone.
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3. European Monetary
System
IBF301 – CHAPTER 2
European Monetary System
European countries maintain exchange rates among their currencies within narrow
bands (+- 1.125 although Smithsonian Agreement requires 2.25), and jointly float
against outside currencies.

Objectives:
◦ To establish a “zone of monetary stability” in Europe.
◦ To coordinate exchange rate policies vis-à-vis (in comparition
with) non-European currencies.
◦ To pave the way for the eventual European Monetary Union.

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EMS main instruments: ECU
The European Currency Unit (ECU) is a “basket”
currency constructed as a weighted average of the
currencies of member countries of the European
Union (EU).

The weights are based on each currency’s relative

GNP and share in intra-EU trade.

The ECU serves as the accounting unit of the EMS

and plays an important role in the workings of the
exchange rate mechanism.
EMS main instruments: ERM
The Exchange Rate Mechanism (ERM) refers to the
procedure by which EMS member countries
collectively manage their exchange rates.

The ERM is based on a “parity grid” system, which is

a system of par values among ERM currencies.

The par values in the parity grid are computed by

first defining the par values of EMS currencies in
terms of the ECU.
4. The Euro and the
European Monetary
Union
IBF301 – CHAPTER 2
Brief history of the Euro
Monetary policy for euro zone countries is now conducted by the European
Central Bank (ECB)
◦ Primary objective is to maintain price stability
◦ Independence is legally guaranteed

Eurosystem is made up of ECB and central banks of euro-zone countries;

tasks include:
1. Defining and implementing common monetary policy of the Union
2. Conducting foreign exchange operations
3. Holding and managing official foreign reserves of euro member states
Brief history of the Euro
Benefits and Costs of Monetary
Union
Key benefits
◦ Reduced transaction costs
◦ Elimination of exchange rate uncertainty
◦ Enhanced efficiency and competitiveness of the European economy
◦ Conditions conducive to the development of continental capital markets with depth and
liquidity comparable to those of the U.S.
◦ Political cooperation and peace in Europe

Main cost
◦ Loss of national monetary and exchange rate policy independence
5. The Asian Currency
Crisis
IBF301 – CHAPTER 2
The Asian Currency Crisis (1997)
Far more serious than the crises of the EMS and Mexican peso in terms of the
extent of the contagion and the severity of the resultant economic and social
costs
◦ Many firms with foreign currency bonds were forced into bankruptcy

Led to an unprecedentedly deep, widespread, and long-lasting recession in

East Asia, a region that has enjoyed the most rapidly growing economy in the
world over the last few decades

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Origins of the Asian Currency Crisis
As capital markets were opened, large inflows of private capital resulted in a
credit boom in the Asian countries
Fixed or stable exchange rates also encouraged unhedged financial
transactions and excessive risk-taking by both borrowers and lenders
The real exchange rate rose, which led to a slowdown in export growth.
Also, Japan’s long-lasting recession (and yen depreciation) hurt neighboring
countries

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Origins of the Asian Currency Crisis
(continued)
If the Asian currencies had been allowed to depreciate in real terms (which
was not possible due to the fixed exchange rates), the sudden and
catastrophic changes in exchange rates observed in 1997 might have been
avoided
Eventually, something had to give—it was the Thai bhat
◦ Sudden collapse of the bhat touched off a panicky flight of capital from other Asian
countries

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Asian Currency Crisis
EXHIBIT 2.10 (page 45) –
Asian Currency Crisis
Lessons from Asian Currency
Crisis
A fixed, but adjustable, exchange rate is problematic in the face of
integrated international financial markets
◦ Invites speculative attack at the time of financial vulnerability
◦ Incompatible trinity suggests it is very difficult, if not impossible, to have all
three conditions:
1. A fixed exchange rate
2. Free international flows of capital
3. Independent monetary policy
6. Fixed versus Flexible
Exchange Rate Regimes
IBF301 – CHAPTER 2
Fixed versus Flexible Exchange Rate
Regimes
Which Exchange Rate Regime is better?
Arguments in favor of flexible exchange rates:
◦ Easier external adjustments.
◦ National policy autonomy (independence).

Arguments against flexible exchange rates:

◦ Exchange rate uncertainty may hamper international trade.
◦ No safeguards to prevent crises.

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“Good” international monetary
system
A “good” (or ideal) international monetary system should provide:
(i) liquidity: should be able to provide the world economy with sufficient monetary reserves
to support the growth of international trade and investment.
(ii) adjustment: provide an effective mechanism that restores the balance-of-payments
equilibrium whenever it is disturbed;
(iii) confidence: offer a safeguard to prevent crises of confidence in the system that result in
panicked flights from one reserve asset to another

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Practice
IBF301 – CHAPTER 2
Summary
IBF301 – CHAPTER 2
Summary
1. The international monetary system can be defined as the institutional framework within which
international payments are made, the movements of capital are accommodated, and exchange
rates among currencies are determined.

2. The international monetary system went through five stages of evolution: (a) bimetallism, (b)
classical gold standard, (c) interwar period, (d) Bretton Woods system, and (e) flexible exchange
rate regime.

3. The classical gold standard spanned 1875 to 1914. Under the gold standard, the exchange rate
between two currencies is determined by the gold contents of the currencies. Balance-of-
payments disequilibrium is automatically corrected through the price-specie-flow mechanism. The
gold standard still has ardent supporters who believe that it provides an effective hedge against
price inflation. Under the gold standard, however, the world economy can be subject to
deflationary pressure due to the limited supply of monetary gold.
Summary
4. To prevent the recurrence of economic nationalism with no clear “rules of the game” witnessed during the
interwar period, representatives of 44 nations met at Bretton Woods, New Hampshire, in 1944 and adopted a new
international monetary system. Under the Bretton Woods system, each country established a par value in relation to
the U.S. dollar, which was fully convertible to gold. Countries used foreign exchanges, especially the U.S. dollar, as
well as gold as international means of payments. The Bretton Woods system was designed to maintain stable
exchange rates and economize on gold. The Bretton Woods system eventually collapsed in 1973 mainly because of
U.S. domestic inflation and the persistent balance-of-payments deficits.
5. The flexible exchange rate regime that replaced the Bretton Woods system was ratified by the Jamaica
Agreement. Following a spectacular rise and fall of the U.S. dollar in the 1980s, major industrial countries agreed to
cooperate to achieve greater exchange rate stability. The Louvre Accord of 1987 marked the inception of the
managed-float system under which the G-7 countries would jointly intervene in the foreign exchange market to
correct over- or undervaluation of currencies.
6. In 1979, the EEC countries launched the European Monetary System (EMS) to establish a “zone of monetary
stability” in Europe. The two main instruments of the EMS are the European Currency Unit (ECU) and the Exchange
Rate Mechanism (ERM). The ECU is a basket currency comprising the currencies of the EMS members and serves as
the accounting unit of the EMS. The ERM refers to the procedure by which EMS members collectively manage their
exchange rates. The ERM is based on a parity grid that the member countries are required to maintain.
Summary
7. On January 1, 1999, 11 European countries, including France and Germany, adopted a common currency called
the euro. Greece adopted the euro in 2001. Subsequently, five other countries—Cyprus, Malta, Slovakia, Slovenia,
and Estonia—adopted the euro. The advent of a single European currency, which may eventually rival the U.S. dollar
as a global vehicle currency, will have major implications for the European as well as world economy. Euro-zone
countries will benefit from reduced transaction costs and the elimination of exchange rate uncertainty. The advent of
the euro will also help develop continentwide capital markets where companies can raise capital at favorable rates.
8. Under the European Monetary Union (EMU), the common monetary policy for the euro-zone countries is
formulated by the European Central Bank (ECB) located in Frankfurt. The ECB is legally mandated to maintain price
stability in Europe. Together with the ECB, the national central banks of the euro-zone countries form the Euro
system, which is responsible for defining and implementing the common monetary policy for the EMU.
9. While the core EMU members, including France and Germany, apparently prefer the fixed exchange rate regime,
other major countries such as the United States and Japan are willing to live with flexible exchange rates. Under the
flexible exchange rate regime, governments can retain policy independence because the external balance will be
achieved by the exchange rate adjustments rather than by policy intervention. Exchange rate uncertainty, however,
can potentially hamper international trade and investment. The choice between the alternative exchange rate
regimes is likely to involve a trade-off between national policy autonomy and international economic integration..
Thank you for your attention!

END OF CHAPTER