BSA CORE 6

INTERNATIONAL BUSINESS AND TRADE

MODULE 5 (MONDAY)
MONETARY SYSTEM IN INTERNATIONAL ARENA

Learning Objectives
1. Explain the international impact of domestic monetary and fiscal policies.
2. Understand the importance of international policy coordination.
The International Monetary System
 The international monetary system can be seen as a network effecting
international payments through institutions, rules, and regulations. In order to
fulfill its role effectively, an international monetary system should possess certain
characteristics:
• A time element regarding the elimination of balance of payments
disequilibrium among countries, that is countries must be allowed
sufficient time to adjust without severe recessions or high inflation but, at
the same time, should not be allowed to avoid adjustment at the expense
of other countries.
• The choice of the unit of account, that is the agreed measure of the value
of currencies.
• International cooperation with respect to adjustment methods, concerted
intervention, and reserve assets.
• Promotion of free international trade so that productive resources are
optimally allocated.
The Gold Standard
 The gold standard is the only example in history when exchange rates were truly
fixed.
• It was a system whereby the values of currencies were fixed relative to the
value of gold, which was used as a unit of account and the main reserve
asset.
• Each country participating in the gold standard fixed the value of its
currency relative to gold and maintained gold reserves.
• The difference between the quantity demanded and supplied of a
country’s currency was determined by the purchase or sale of gold so that
the value of the currency in terms of gold remained fixed.
• The amount of purchase or sale depended on the balance of payments
deficit or surplus, respectively.

Source: Katsioloudes, Marios & Hadjidakis, Spyros. 2007. International Business: A Global Perspective.
Elsevier Inc.
  A country with a balance of payments surplus would sell its currency (i.e., buy
gold) in order to hold the revaluation (appreciation) of its currency.
• Because the domestic money supply was based on gold, the inflow of gold
would increase the money supply and lower interest rates.
• Lower interest rates would provoke capital outflows while the resulting
expansionary monetary policy would increase income and cause domestic
inflation, which encouraged imports and discouraged exports.
• All these forces would work toward the elimination of the balance of
payments surplus.

 On the other hand, a balance of payments deficit would necessitate the purchase
of the home currency (i.e., sale of gold) in order to keep the exchange rate from
falling.
o The resulting money supply contraction would dampen domestic demand
and output, decrease imports, and bring about a rise in interest rates.
o As a result, the balance of payments deficit would be eliminated.

 Since the money supply was directly tied to gold, the government could not
pursue an independent monetary policy in order to achieve domestic goals.
 The gold standard was suspended in 1914, just before World War I.
 It was reintroduced in the 1920s and finally collapsed following the financial
chaos of the Great Depression and World War II.
The Bretton Woods System
 Following the collapse of the gold standard, the Great Depression, and the years
before and during World War II, massive unemployment and severe recessions
induced many countries to resort to protectionism, that is insulating domestic
industries from foreign competition while interest rates were used as a purely
domestic monetary policy instrument.
o When the war ended, the Allies met at Bretton Woods, New Hampshire, in
1944 in an attempt to establish a stable international monetary system that
would restore international trade.
o The resulting agreement led to the adoption of fixed, but adjustable,
exchange rates based on the free convertibility of the US dollar to gold
and the establishment of the International Monetary Fund (IMF).18 It was
clearly an attempt to create a “new order.”

 The Bretton Woods was essentially an agreement for a return to fixed exchange
rates.
 The agreement also provided for the establishment of the IMF to oversee and
manage the new international economic order and tackle two main problems:
Source: Katsioloudes, Marios & Hadjidakis, Spyros. 2007. International Business: A Global Perspective.
Elsevier Inc.
 o financing of temporary balance of payments deficits (or dealing with
surpluses)
o correction of fundamental disequilibrium.

 The Fund provided a stabilization fund from which a country with temporary
balance of payments difficulties could obtain short-term loans.
o The correction of fundamental disequilibrium required structural changes
in the domestic economy and for this reason the World Bank was also
established for providing long-term financing.

 The system was based on mutual agreement about the actions of countries when
experiencing balance of payments deficits or surpluses.
o The United States agreed to buy and sell gold to maintain the $35 per
ounce price established in 1933.
o Currencies were to be freely convertible to other currencies.

 The monetary authorities of the signatory nations would maintain an exchange

rate within a band of ±1 percent of the agreed central parity.
o If the value of a currency fell below the lower intervention point, the central
bank had to purchase the domestic currency by selling foreign exchange
reserves.
o The main reserve asset was gold but, in practice, countries bought or sold
dollars.
o To ensure the adequacy of reserves, a country could obtain a short-term
loan from the stabilization fund in order to deal with short-run adjustments.

 Adjustment was to be achieved by domestic expenditure-switching policies but

provision was made for changes in the exchange rate in cases of fundamental
imbalances.
o The IMF had to authorize a one-time change in the exchange rate by more
than 10 percent.
o A distinction was also made between trade and capital movements.
o Restrictions on payments of goods were not allowed whereas countries
could resort to foreign exchange controls or other policies inhibiting the
free inflow or outflow of capital.

Source: Katsioloudes, Marios & Hadjidakis, Spyros. 2007. International Business: A Global Perspective.
Elsevier Inc.