THE INTERNATIONAL MONETARY SYSTEM

1. Definition
 International monetary systems are sets of internationally agreed rules,
conventions and supporting institutions i.e. banks that facilitate
international trade, cross border investment and generally the
reallocation of capital between nation states.
 They provide means of payment acceptable between buyers and sellers of
different nationality, including deferred payment.
 To operate successfully, they need to inspire confidence, to provide
sufficient liquidity for fluctuating levels of trade and to provide means by
which global imbalances can be corrected.

2. The international monetary system history

Throughout history, precious (valuable) metals such as gold and silver have
been used for trade, termed bullion, and since early history the coins of
various issuers – generally kingdoms and empires – have been traded.

a. Gold standard
 Prior to 1914, major countries of the world operated on what is known as
the classical gold standard, sometimes known as the First age of
Globalization in which gold was used to settle national trade balances in a
pegged exchange rate system.
 World War I broke the standard, which leads to a period of floating
exchange rates.
 In 1925, a gold exchange standard was instituted in which the US and UK
held only gold reserves while other nations held gold, US dollars, or pound
as reserves.
 Reserves are used by central banks to manage their balance of payments
and foreign exchange positions.
 The system lasted on 1931, at which time England withdrew under the
pressure from demands on its reserves as a result of an unrealistically
pound value. To maintain the competiveness of their products on world
markets, most other countries followed England in devaluing their
currencies relative to gold.
 In 1930, a global depression occurred being fueled by the breakdown of
the international monetary system and by the protectionist trade policies
that followed.
 Currency speculation during this period was out of control, causing wild
fluctuations in exchange rates. There was no way to hedge risk, because
there was not an established forward exchange market at the time.

b. Bretton Woods
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 In 1994, Bretton Woods’s conference created the IMF and World Bank; it
also created a fixed or pegged exchange rate system that lasted for 25
years. Under the Bretton woods system, the price of an ounce of gold was
set in US$35 per ounce.
 Each nation agreed to maintain a fixed or pegged exchange rate for its
currency in terms of the dollars or gold. Under this form of gold exchange
standard only US dollars were convertible into gold at the official par
value of US$35 per ounce. Other member nations were not required to
exchange their currency for gold, but pledged to intervene in the foreign
exchange market if their currency moved more than one percent from the
official rate.
 The Bretton Woods system worked passably well until the late 1960s.
Devaluations were common as the market periodically imposed its own
values on the world’s currencies, but by-and-large the system facilitated
cross –border trade and economic development.
 During the 1960s, the US inflation rose as the US government borrowed
money to finance the war in Vietnam. High US inflation caused the market
price of gold rise above the US$35 per ounce and the market value of the
dollar to fall below the official rate relative to foreign currencies. A run on
the US dollar followed as speculators rushed to buy gold with dollars at
the price of US$35 per ounce. In 1971, the Bretton Woods gold standard
proved failure, at that time many currencies were already started floating.

c. Exchange rates after the fail of Bretton Woods

 After the collapse of the Bretton woods, several attempts were made to
revive a gold exchange standard. The first of these in 1971, the
Smithsonian agreement, in Washington D.C., this agreement devalued the
dollar to US$38 per ounce of gold and revalued other currencies relative
to dollar. A 4.5 percent band was established to promote monetary
stability.
 In 1972, members of the European Economic Community (EEC) – the
predecessor to European Union established the pegged system known as
“the snake within the tunnel” or “the snake.” The term snake refers to the
fact that the pegged currencies floated as a group against non-EEC
currencies. The tunnel refers to the band allowed around the central
currency rate in the system.
 Both the Smithsonian agreement and the snake proved unworkable in the
presence of continued exchange rate volatility. Countries were frequently
forced to either devalue their currency or fall out of these pegged systems
until an agreement could be reached on a new target price. The
realignments were the rule of the day. In 1972, the bank of England
allowed the pound to float against other currencies. In 1973, the US
government devalued the dollar from US$38 per ounce to US$42.22 per
ounce of gold.

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 In 1976, the IMF convened a monetary summit in Jamaica to reach some
consensus on the monetary system. Under the Jamaica agreement,
floating exchange rates were declared acceptable, officially
acknowledging the system already in place and legitimizing the basis for
the floating rate still used by many countries today.

3. Exchange rate regime (systems)

 An exchange-rate regime is the way an authority manages its currency in
relation to other currencies and the foreign exchange market.
 Central banks around the world are the entities that create the different
national currencies used in each country.
 Exchange rate systems are classified according to the role a central bank
plays in the foreign exchange markets.
 There are two extreme, or pure, systems: the flexible exchange rate
system and the fixed exchange rate system.

a. Floating exchange rate system

 Floating exchange rate system means that the exchange rate is allowed
to fluctuate according to the market forces without the intervention of the
Central bank or the government.
 In these systems, there are no official bounds on currency value. Floating
rates are the most common exchange rate regime today. For example,
the dollar, euro, yen, and British pound all are floating currencies.
 In floating exchange rate system, when the value of the currency goes up
as compared to other currency it is known as appreciation.
 The appreciation of a country's currency refers to an increase in the value
of that country's currency.
 For example, the CAD/EUR rate, if the Canadian dollar appreciates relative
to the euro, the exchange rate falls - it takes fewer Canadian dollars to
purchase 1 euro (1 EUR=1.5 CAD → 1 EUR=1.4 CAD).
 When the Canadian dollar appreciates relative to the Euro, the Canadian
dollar becomes less competitive. This will lead to larger imports of
European goods and services, and lower exports of Canadian goods and
services.
 In floating exchange rate system, when the value of currency falls as
compared to other currency it is known as depreciation.
 The depreciation of a country's currency refers to a decrease in the value
of that country's currency.
 For instance, if the Canadian dollar depreciates relative to the euro, the
exchange rate (the Canadian dollar price of euros) rises - it takes more
Canadian dollars to purchase 1 euro (1 EUR=1.5CAD → 1 EUR=1.7CAD).
 When the Canadian dollar depreciates relative to the Euro, the Canadian
dollar becomes more competitive because the price of Canadian goods
when exchanged to Euro will be cheaper leading to a larger Canadian
export.
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 On the other hand, European countries that denominate its goods and
services in Euros will have lost competitiveness to the Canadian dollar.
The price of European products denominated in Euros will thus become
more expensive in Canada.

 How currency appreciates

Any currency appreciates whenever its demand increases i.e. its value in
the world market increases. The increase in demand can occur in these 3
ways:

1. When a country’s exports are high, its currency’s demand increases for
transactional purposes.
2. Whenever Central Bank increases the interest rates, the demand for
that currency increases as people will try to exchange other currency
for that one to deposit it into the banks and get higher returns.
3. Whenever the employment and per capita income in a country
increases, the demand for goods and services increases and thus the
demand for that country’s currency in local market.

Note: Higher inflation rate will make the currency uncompetitive in the
international market. The exports will fall resulting in decreased demand for
the currency and hence lower value.

b. Fixed exchange-rate system

 The second pure exchange rate system is the fixed exchange rate
system. Under this system, the central bank fixes the price of the foreign
currency in terms of the domestic currency.
 Moreover, at this fixed price, the central bank is willing to buy and sell
(potentially) unlimited amount of foreign currency.
 In order to fix the price of a foreign currency in terms of the domestic
currency, a central bank needs two things.
i. The central bank needs a large stock of the foreign currency (reserves)
to supply to the market whenever there is a tendency for the market
price of the foreign currency to increase,
ii. The central bank also needs a large stock of the domestic currency to
buy the foreign currency whenever there is a tendency for the market
price of the foreign currency to go down.
 Therefore, in a fixed exchange rate system a central bank is ready to buy
and sell its domestic currency at a fixed price in terms of foreign currency.
 Devaluation is when the price of the currency is officially decreased in a
fixed exchange rate system.
 Revaluation is the official increase in the price of the currency within a
fixed exchange rate system.

c. Managed Float
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 In practice, the flexible exchange rate system, has not been one of clean
(i.e. no central bank intervention) floating.
 Instead, the exchange rate system of choice has been a managed, or
dirty, float. This system is an intermediate arrangement that combines
features of the free floating and fixed systems.
 The exchange rate is managed, but allowed to fluctuate over some limited
interval. That is, while the exchange rate is allowed to change, the Central
Bank allows only limited fluctuations.
 Under a managed exchange rate system, policy influences the exchange
rate. We will call the act of buying and selling foreign currency by a
central bank intervention.
 Under managed floating, central banks intervene to buy and sell foreign
currencies in attempts to influence exchange rates. Official reserve
transactions are not equal to zero under managed floating.

d. Dual Exchange Rate System

 In some countries, the government sets exchange rates, like in a fixed
exchange rate system. But, the government will sell foreign exchange at
the official rate only for some types of transactions (in general, officially
recognized foreign imports). For all the other transactions, a black market
is created. For example, in 1993, China had an official rate of 5.7 yuans
(CNY) per US$, while the black market rate was 10 CNY/US$.
 A variation of the dual exchange rate system is the multiple exchange
rate system. Under this system, the government sets different exchange
rates for different official transactions.
 Usually, certain imported goods classified as essential to an economy -for
example, oil, wheat, etc- have a lower exchange rate. Other imported
goods –for example, luxury goods- have a higher, discouraging exchange
rate. All other transactions are done at the black market rate.

e. Pegged Exchange Rate System

 Some countries use a variation of the pure fixed exchange rate system:
the value of their domestic currency is pegged to a foreign currency, or to
some unit of account.
 Under a pegged exchange rate system, the value of the domestic
currency is fixed in terms of a selected unit of account (or foreign
currency). The domestic currency moves in line with the unit of account to
which is pegged against other currencies.
 Sometimes the exchange rate against the unit of account is allowed to
fluctuate only within narrow limits.
 Some central banks use a variation of the pegged exchange rate system
called crawling-peg.
 Under a crawling-peg, a central bank periodically changes the pegged
exchange rate through a system of mini-devaluations in response to
supply and demand pressures.
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 Pegged floating currencies are pegged to some band or value, either fixed
or periodically adjusted. Pegged floats are:
i. Crawling bands
The rate is allowed to fluctuate in a band around a central value, which
is adjusted periodically. This is done at a preannounced rate or in a
controlled way following economic indicators.
ii. Crawling pegs
The rate itself is fixed, and adjusted as above.
iii.Pegged with horizontal bands
The rate is allowed to fluctuate in a fixed band (bigger than 1%)
around a central rate.

f. Dollarization
 Dollarization occurs when the inhabitants of a country use foreign
currency in parallel to or instead of the domestic currency.
 The term is not only applied to usage of the United States dollar, but
generally to the use of any foreign currency as the national currency.

4. Different Policy Tools: A Comparison of Fixed and Flexible

Exchange Rate Regimes
 The policy arguments for flexible exchange rates are centered on
monetary policy. Under a fixed exchange rate system, the money
supply is endogenous (i.e. without external cause) and, thus, the central
bank has no power to alter interest rates. Under a flexible exchange rate
regime, however, a central bank can pursue independent monetary
policies to stimulate the economy. For example, an extensive monetary
policy tends to reduce interest rates. Under perfect capital mobility, this
reduction in interest rate will create capital outflows, thus, depreciating
the value of the domestic currency. The depreciation of the domestic
currency increases foreign demand for domestic products and, as a result,
domestic, output increases.
 On the other hand, the policy arguments for fixed exchange rates rest on
fiscal policy. Under a fixed exchange rate regime, a fiscal expansion
under conditions of capital mobility might be effective in raising
equilibrium output. For example, a fiscal expansion tends to increase both
interest rates and the level of output. The higher interest rate, under
perfect capital mobility, will attract capital inflows into the country,
reducing the domestic interest rate. Under flexible exchange rates, by
contrast, a fiscal expansion does not affect equilibrium output. The fiscal
expansion tends to increase output and interest rates. The increase in
interest rates produces an offsetting appreciation of the domestic
currency and an increase in imports and a decrease in exports, thereby
reducing output. That is, fiscal policies, under flexible exchange rates,
shift the composition of domestic demand toward foreign goods away
from domestic goods.
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 The above arguments show that the choice between the two regimes
involves a trade-off. Each of the two alternatives has only one
independent policy tool for internal purposes. A government under fixed
exchange rates can attempt to expand domestic output using fiscal
policies. On the other hand, a government under flexible exchange rates
can attempt to use monetary policies to affect domestic output.

5. Central Bank Intervention

 In a managed float, central banks buy and sell foreign currency with the
purpose of changing the value of their domestic currency to different level
than what the free market would set. In the case of an appreciating
domestic currency, central banks usually buy foreign currency, raising the
price of the foreign currency in terms of the domestic currency.
 Example below illustrates the opposite intervention, where the domestic
central bank sells foreign currency (and buys domestic currency!).
Suppose that due to an increase demand for Swiss goods, the demand for
CHF switches from D0 to D1. Thus, the equilibrium changes from A to B.
The US$ depreciates against the CHF, moving the exchange rate from
0.74 US$/CHF to 0.80 US$/CHF. The Federal Reserve decides to intervene
to stop the depreciation and bring the value of the CHF back to US$ 0.74.
The Federal Reserve sells CHF (usually, CHF bonds), moving the supply of
CHF from S0 to S1

Central Bank Intervention to Halt Depreciation of Domestic

Currency

S0 reserve sold
St
US$/CHF
B S1
S1 = 0.80
A C
S0 = 0.74

D1
D0
Quantity of CHF

 As a final result, the equilibrium changes to C, where the US$ appreciates

back to the 0.74 US$/CHF level. As Example shows, the Federal Reserve
sold an amount of CHF equal to AC, receiving an equivalent amount in
US$. This is needed to support the 0.74 US$/CHF exchange rate.
Central Bank Intervention: Exchange of Cash Flows

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 CHF
Fed Reserve Fx Market

(Bank)
US$

 Usually, central banks do not have enough foreign reserves in stock to

effectively affect exchange rates. To this purpose, central banks have
reciprocal currency (swap) arrangements. For example, the Federal
Reserve of the U.S. has established with the Swiss National Bank a swap
arrangement of up to USD 4,000 million that may be drawn upon when
needed. Any large central bank intervention in the FX market involves
either the Federal Reserve or a foreign bank drawing from the swap
facility currency balances, which are repaid at a later date.

6. Central Bank Intervention: Sterilization

 When a central bank buys foreign currency, it gives domestic currency to
the FX sellers, thereby increasing the domestic money supply. On the
hand, when a central bank sells foreign currency, the domestic money
supply shrinks. Central bank intervention affects money markets. Thus,
interest rates will be affected by central bank intervention in the FX
market. In example below, we present the effects of the central bank
intervention, ceteris paribus, on money markets. That is, shows the
money supply (MS) shrinking from MS0 to MS1. As a result, interest rates, i,
increase from 5% to 5.20%.
Central Bank Sells CHF and Decreases Money Supply
Ms1
i
Ms0
B
i1 = 0.052
A
i0 = 0.050

L0

Quantity of money

 Many central banks want to have an independent monetary policy.

Therefore, central banks need to take some offsetting actions to avoid the
indirect effects of intervention in the FX market.

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 Sterilization refers to the actions taken by a central bank to neutralize the
effects of international reserve flows in money markets. For example, take
the case of above, where the Federal Reserve sells CHF to halt the
appreciation of the CHF against the US$. To neutralize the increase in
interest rates –above--, the Federal Reserve uses an open market
operation (OMO). Through the OMO, the Federal Reserve buys Treasury
Bills in the U.S. to increase money supply.

Central Bank: Open Market Operation (OMO) to increase Money

Supply

US$
Fed Reserve Fx Market

(Bank)
T-Bill

 If the Federal Reserve coordinates both operations perfectly, the U.S.

money supply will not be affected by the central bank intervention. This
kind of intervention is called sterilized intervention.
 The Federal Reserve uses an OMO to counteract the effect of FX
intervention in Money Markets.

US Money Market OMO

Ms1
iUS$
Ms0
B
i1 = 0.052
A
i0 = 0.050

L0

Quantity of money (in US)

 The Federal Reserve buys T-Bills to increase the U.S. MS. The effect of
both coordinated operations (sterilized intervention) results in the
following net exchange of cash flows:

CHF
Fed Reserve Fx Market
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(Bank)
 T-Bill

 As a result, the CHF depreciates (St goes to 0.74 US$/CHF) and US money
markets are unaffected (US interest rates stay at go back to i 0 = 0.050).

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