Evolution of the

International Monetary System

• Bimetallism: Before 1875
• Classical Gold Standard: 1875-1914
• Interwar Period: 1915-1944
• Bretton Woods System: 1945-1972
• The Flexible Exchange Rate Regime: 1973-
Present

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 Bimetallism: Before 1875
• A “double standard” in the sense that both gold
and silver were used as money.
• Some countries were on the gold standard, some
on the silver standard, some on both.
• Both gold and silver were used as international
means of payment and the exchange rates
among currencies were determined by either
their gold or silver contents.
• Gresham’s Law implied that it would be the least
valuable metal that would tend to circulate.
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 Classical Gold Standard:
1875-1914
• During this period in most major countries:
– Gold alone was assured of unrestricted coinage
– There was two-way convertibility between gold and
national currencies at a stable ratio.
– Gold could be freely exported or imported.
• The exchange rate between two country’s
currencies would be determined by their
relative gold contents.
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 Classical Gold Standard:
1875-1914
For example, if the dollar is pegged to gold at
U.S.$30 = 1 ounce of gold, and the British
pound is pegged to gold at £6 = 1 ounce of gold,
it must be the case that the exchange rate is
determined by the relative gold contents:

$30 = £6
$5 = £1
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 Classical Gold Standard:
1875-1914
• Highly stable exchange rates under the classical
gold standard provided an environment that
was conducive to international trade and
investment.
• Misalignment of exchange rates and
international imbalances of payment were
automatically corrected by the price-specie-flow
mechanism.
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 Classical Gold Standard:
1875-1914
• There are shortcomings:
– The supply of newly minted gold is so restricted that
the growth of world trade and investment can be
hampered for the lack of sufficient monetary
reserves.
– Even if the world returned to a gold standard, any
national government could abandon the standard.

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 Interwar Period: 1915-1944
• Exchange rates fluctuated as countries widely
used “predatory” depreciations of their
currencies as a means of gaining advantage in
the world export market.
• Attempts were made to restore the gold
standard, but participants lacked the political
will to “follow the rules of the game”.
• The result for international trade and
investment was profoundly detrimental.
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 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.
• The goal was exchange rate stability without the
gold standard.
• The result was the creation of the IMF and the
World Bank.
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 Bretton Woods System:
1945-1972
• Under the Bretton Woods system, the U.S.
dollar was pegged to gold at $35 per ounce and
other currencies were pegged to the U.S. dollar.
• Each country was responsible for maintaining
its exchange rate within ±1% of the adopted par
value by buying or selling foreign reserves as
necessary.
• The Bretton Woods system was a dollar-based
gold exchange standard.
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The Flexible Exchange Rate Regime: 1973-
Present.
• 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.
• Gold was abandoned as an international reserve
asset.
• Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.
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 Current Exchange Rate Arrangements
• Free Float
– The largest number of countries, about 48, allow market forces
to determine their currency’s value.
• Managed Float
– About 25 countries combine government intervention with
market forces to set exchange rates.
• Pegged to another currency
– Such as the U.S. dollar or euro (through franc or mark).
• No national currency
– Some countries do not bother printing their own, they just use
the U.S. dollar. For example, Ecuador has recently dollarized.
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 European Monetary System
• Eleven European countries maintain exchange
rates among their currencies within narrow
bands, and jointly float against outside
currencies.
• Objectives:
– To establish a zone of monetary stability in Europe.
– To coordinate exchange rate policies vis-à-vis non-
European currencies.
– To pave the way for the European Monetary Union.
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 The Euro
• What is the euro?
• When will the new European currency become
a reality?
• What value do various national currencies have
in euro?

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 What Is the Euro?
• The euro is the single currency of the European
Monetary Union which was adopted by 11
Member States on 1 January 1999.
• These member states are: Belgium, Germany,
Spain, France, Ireland, Italy, Luxemburg,
Finland, Austria, Portugal and the Netherlands.

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EURO CONVERSION RATES
1 Euro is Equal to:
40.3399 BEF Belgian franc
1.95583 DEM German mark
166.386 ESP Spanish peseta
6.55957 FRF French franc
.787564 IEP Irish punt
1936.27 ITL Italian lira
40.3399 LUF Luxembourg franc
2.20371 NLG Dutch gilder
13.7603 ATS Austrian schilling
200.482 PTE Portuguese escudo
5.94573 FIM Finnish markka
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What is the subdivision of the euro?
• During the transitional period up to 31
December 2001, the national currencies of the
member states (Lira, Deutsche Mark, Peseta,
Franc. . . ) will be "non-decimal" subdivisions of
the euro.
• The euro itself is divided into 100 cents.

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What is the official sign of the euro?
 The sign for the new single currency looks like an
“E” with two clearly marked, horizontal parallel
lines across it.

It was inspired by the Greek letter epsilon, in reference to the cradle of European
civilization and to the first letter of the word 'Europe'.

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 What are the different denominations of
the euro notes and coins ?
• There will be 7 euro notes and 8 euro coins.
• The notes will be: 500, 200, 100, 50, 20, 10, and
5 euro.
• The coins will be: 2 euro, 1 euro, 50 euro cent,
20 euro cent, 10, euro cent, 5 euro cent, 2 euro
cent, and 1 euro cent.

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 How will the euro affect contracts
denominated in national currency?
• All insurance and other legal contracts will continue in
force with the substitution of amounts denominated in
national currencies with their equivalents in euro.
• Euro values will be calculated according to the fixed
conversion rates with the national currency unit adopted
on 1 January 1999.
• Generally, the conversion to the euro will take place on 1
January 2002, unless both parties to the contract agree
to do so beforehand.

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 The Mexican Peso Crisis
• On 20 December, 1994, the Mexican
government announced a plan to devalue the
peso against the dollar by 14 percent.
• This decision changed currency trader’s
expectations about the future value of the peso.
• They stampeded for the exits.
• In their rush to get out the peso fell by as much
as 40 percent.

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 The Mexican Peso Crisis
• The Mexican Peso crisis is unique in that it
represents the first serious international
financial crisis touched off by cross-border
flight of portfolio capital.
• Two lessons emerge:
– It is essential to have a multinational safety net in
place to safeguard the world financial system from
such crises.
– An influx of foreign capital can lead to an
overvaluation in the first place.
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 The Asian Currency Crisis
• The Asian currency crisis turned out to be far
more serious than the Mexican peso crisis 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.
• The region experienced a deep, widespread
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 Currency Crisis Explanations
• In theory, a currency’s value mirrors the fundamental
strength of its underlying economy, relative to other
economies. In the long run.
• In the short run, currency trader’s expectations play a
much more important role.
• In today’s environment, traders and lenders, using the
most modern communications, act by fight-or-flight
instincts. For example, if they expect others are about to
sell Brazilian reals for U.S. dollars, they want to “get to
the exits first”.
• Thus, fears of depreciation become self-fulfilling
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 Fixed versus Flexible
Exchange Rate Regimes
• Arguments in favor of flexible exchange rates:
– Easier external adjustments.
– National policy autonomy.
• Arguments against flexible exchange rates:
– Exchange rate uncertainty may hamper
international trade.
– No safeguards to prevent crises.

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 Balance of Payments Accounting
• The Balance of Payments is the statistical
record of a country’s international transactions
over a certain period of time presented in the
form of double-entry bookkeeping.

N.B. when we say “a country’s balance of

payments” we are referring to the transactions
of its citizens and government.

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 Balance of Payments Example
• Suppose that Maplewood Bicycle in
Maplewood Missouri, USA imports
$100,000 worth of bicycle frames from
Mercian Bicycles in Darby England.
• There will exist a $100,000 credit recorded
by Mercian that offsets a $100,000 debit at
Maplewood’s bank account.
• This will lead to a rise in the supply of
dollars and the demand for British pounds.
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 Balance of Payments Accounts
• The balance of payments accounts are those
that record all transactions between the
residents of a country and residents of all
foreign nations.
• They are composed of the following:
– The Current Account
– The Capital Account
– Statistical Discrepancy
– The Official Reserves Account
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 The Current Account
• Includes all imports and exports of goods and
services.
• Includes one-sided transfers of foreign serve.
• If the debits exceed the credits, then a country
is running a trade deficit.

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 The Capital Account
• The capital account measures the difference
between U.S. sales of assets to foreigners and
U.S. purchases of foreign assets.
• The U.S. enjoys about a $150,000,000,000 capital
account surplus—absent of U.S. borrowing from
foreigners, this “finances” our trade deficit.
• The capital account is composed of Foreign
Direct Investment (FDI), portfolio investments
and other investments.
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 Statistical Discrepancy
• There’s going to be some omissions and
misrecorded transactions—so we use a “plug”
figure to get things to balance.
• Exhibit 3.1 shows a discrepancy of $96.76
billion in 1997.

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 The Official Reserves Account
• Official reserves assets include gold, foreign
currencies, SDRs, reserve positions in the IMF.

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 The Balance of Payments Identity
BCA + BKA + BRA = 0
where
BCA = balance on current account
BKA = balance on capital account
BRA = balance on the reserves account

Under a pure flexible exchange rate regime,

BCA + BKA = 0
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 U.S. Balance of Payments Data
  Credits Debits
Current Account    
1 Exports $1,167.61  
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)
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 U.S. Balance of Payments Data
  Credits Debits
Current Account     In 1997, the U.S.
1 Exports $1,167.61   imported more than it
exported, thus running
2 Imports   ($1,295.53) a current account
3 Unilateral Transfers $6.13 ($45.01) deficit of $166.8
  Balance on Current Account ($166.80) billion.
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)
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 U.S. Balance of Payments Data
During the same year,
  Credits Debits
the U.S. attracted net
Current Account    
investment of $264.58
1 Exports $1,167.61  
billion—clearly the rest
2 Imports   ($1,295.53) of the world found the
3 Unilateral Transfers $6.13 ($45.01)
U.S. to be a good place
Balance on Current Account to invest.
  ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)
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 U.S. Balance of Payments Data
  Credits Debits
Current Account     Under a pure flexible
1 Exports $1,167.61   exchange rate regime,
2 Imports   ($1,295.53)
these numbers would
balance each other
3 Unilateral Transfers $6.13 ($45.01) out.
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)
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 U.S. Balance of Payments Data
  Credits Debits
Current Account     In the real world,
1 Exports $1,167.61   there is a statistical
2 Imports   ($1,295.53)
discrepancy.

3 Unilateral Transfers $6.13 ($45.01)

  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)
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 U.S. Balance of Payments Data
  Credits Debits
Current Account     Including that, the
1 Exports $1,167.61   balance of payments
2 Imports   ($1,295.53)
identity should hold:

3 Unilateral Transfers $6.13 ($45.01) BCA + BKA = - BRA

  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)
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($166.80) + $264.58 + ($96.76) = $1.02= –($1.02)
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 Balance of Payments and the Exchange
Rate
  Credits Debits
Current Account    
1 Exports $1,167.61   P S

2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2) D
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
Q
  Overall Balance $1.02  
Official Reserve Account Exchange rate $
($1.02)
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 Balance of Payments and the Exchange
Rate
  Credits Debits
Current Account    
1 Exports $1,167.61   P S

2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2) D
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
Q
  Overall Balance $1.02  
Official Reserve Account Exchange rate $
($1.02)
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As U.S. citizens import,Copyright
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 Balance of Payments and the Exchange
Rate
  Credits Debits
Current Account    
1 Exports $1,167.61   P S

2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2) D
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
Q
  Overall Balance $1.02  
Official Reserve Account Exchange rate $
($1.02)
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As U.S. citizens export,Copyright
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 Balance of Payments and the Exchange
Rate
  Credits Debits
Current Account    
1 Exports $1,167.61   P S
S1
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2) D
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
Q
  Overall Balance $1.02  
Official Reserve Account Exchange rate $
($1.02)
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 Balance of Payments Trends
• Since 1982 the U.S. has experienced
continuous deficits on the current account and
continuous surpluses on the capital account.
• During the same period, Japan has
experienced the opposite.

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 Balance of Payments Trends
U.S. Balance of Payments Trends

200
Balance of Payments ($b)

150
100
50
Current Account
0
Capital Account
-50
-100
-150
-200
Year
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 Balance of Payments Trends
Japan's Balance of Payments Trend

150
Balance of Payments ($b)

100

50
Current Account
0
Capital Account
-50

-100

-150
Year
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 Balance of Payments Trends
• Germany traditionally had current account
surpluses.
• Since 1991 Germany has been experiencing
current account deficits.
• This is largely due to German reunification and
the resultant need to absorb more output
domestically to rebuild the former East Germany.
• What matters is the nature and causes of the
disequilibrium.
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 Balance of Payments Trends
Germany's Balance of Payments Trend

80
Balance of Payments ($b)

60
40
20
Current Account
0
Capital Account
-20
-40
-60
-80
Year
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End Chapter Three

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