Chapter 29

The International
Monetary
System: Past,
Present, and
Future
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives
 Identify the key characteristics of an
effective monetary system.
 Describe the historical evolution of the
international monetary system from Bretton
Woods to the present time.
 Explain the purpose of the IMF and
understand its strengths and weaknesses.
 Differentiate among existing alternative
monetary arrangements.
 Compare and contrast several proposals for
reform of the current international
monetary system.

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 Introduction
 International monetary systems
facilitate movements of goods,
services, and assets.
 Historically, international monetary
systems have differed greatly.
 The gold standard (1880 – 1914).
 1920s: considerable exchange rate
flexibility.
 1930s: global economic downturn;
competitive devaluations and high
tariffs limited trade.
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 Bretton Woods: Goals of
the IMF
 To seek stability in exchange rates
 Reconciliation of country adjustments
to payments imbalances with national
autonomy in macroeconomic policy
 To help preserve relatively free trade
and payments in the world economy

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Bretton Woods: IMF Loans
 When a country joins the IMF, it
agrees to pay a quota based on the
size of its economy.
 Member countries can borrow foreign
exchange from the IMF in tranches to
help with BOP deficits.
 Additional loans may come with
“strings attached” – conditions
requiring policy reform or currency
valuation changes.

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 Bretton Woods in
Retrospect: 3 Problems
 The Bretton Woods system worked
well until the 1960s, when problems
began to emerge.
1. Adequacy of reserves (or liquidity)
• As volume of global trade grows, BOP
imbalances will also grow.
• This demands increases in reserves.
• The supply of gold was not keeping pace.

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 Bretton Woods in
Retrospect: 3 Problems
2. Confidence
• Slow growth of gold supplies meant
countries increasingly held foreign
currency reserves (mainly $s and £s).
• Dollar holdings by foreign countries grew
well above U.S. gold holdings, so concern
grew over convertibility.
3. Adjustment
• Certain countries had prolonged BOP
deficits or surpluses.
• These countries were using monetary and
fiscal policies in ways that prevented BOP
adjustments.
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 Gradual Evolution of a New
International Monetary
System
 Early disruptions
• 1967: U.K. devalued the pound by 14%.
• Since the pound was a “key currency”,
this raised serious doubts about the IMFs
exchange rate pegs.
 1968: Central banks stopped gold
transactions with private individuals
and firms.
• Gold now a “two-tier” market – a private
gold market now emerged.
• This reduced the importance of gold in
the international monetary system.
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 Special Drawing Rights
(SDRs)
 In 1970, IMF created a new paper
asset called special drawing rights.
 Countries were allocated SDRs and
could use them as international
reserves to settle BOP deficits.
 If a country holds SDRs, it receives
interest on excess holdings.
 Originally 1 SDR = $1.
 Today SDRs are a weighted average
of the values of dollars, euros, yen,
and pounds.
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 Breaking the Gold-Dollar
Link: the Smithsonian
Agreement
 1971: U.S. stopped trading gold with
foreign central banks.
• This effectively ended the Bretton Woods
System.
 Later in 1971, the major countries met
to work out a new exchange rate
arrangement: the Smithsonian
Agreement.
• Initially, countries were optimistic.
• However, continued currency speculation
caused some countries to devalue or even
float their currencies. 29-10
 The Jamaica Accords

 1976: IMF makes several changes.

• Each member country can choose its own
exchange rate system.
• Official gold price was abolished; IMF sold
off one-third of its holdings.
• SDRs were to become a more important
reserve asset.
• IMF was to maintain surveillance of
global exchange rate behavior and advise
members.

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 The European Monetary
System
 1979: European countries begin to
move towards a monetary union.
 A European currency unit (ecu) was
created, functioning only as a unit of
account.
 Exchange rates were to be kept
within a narrow band of each other.
 The European Monetary Cooperation
Fund was set up as a proto-European
central bank.

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 The European Monetary
System: Maastricht
 1991: European countries agree to
take steps toward the creation of a
monetary union in 1999.
 The European Central Bank (ECB)
would serve as the supra-national
central bank for member countries.
 In 1999, the 11 member countries
fixed their exchange rates in relation
to the euro.
 In 2002, euro notes and coins were
issued.
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 The European Monetary
System: Maastricht
 “Euroland”: Austria, Belgium, Finland,
France, Germany, Ireland, Italy,
Luxembourg, the Netherlands,
Portugal, and Spain
 This system required convergence
criteria:
• Inflation rates could not be too high.
• Long-term government bond interest rates
could not be too high.
• Government budget deficits could not be
too high.
• Government debt must be kept in check.
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 The European Monetary
System: Maastricht
 Convergence requirements presented
major challenges.
 In the end only Greece was denied
admission to the EMU (it later was
admitted).
 Denmark, Sweden, and the U.K.
elected not to join the EMU.
• Giving up sovereignty over monetary
policy and giving up their domestic
currencies were too great a step for
these countries.

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 The European Monetary
System: Early Results
 The transition to the euro went
smoothly and was popular with
citizens.
 Elimination of exchange rate and
lower transactions costs has created
new opportunities and has enhanced
efficiency.
 The euro has helped further financial
integration.
 The euro is the world’s second-most
widely used currency.
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 The European Monetary
System: New Entrants
 European Union has added many new
countries in the past decades.
 Once they meet convergence criteria,
countries can apply to join the EMU.
 Slovenia was admitted in 2007.
 Slovak Republic was admitted in
2009.

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 Since Bretton Woods: A
Summary
 Fluctuations in the exchange rates
among the major currencies have
been very large since the Bretton
Woods system fell apart.
 As a result, international
competitiveness has varied
considerably, with substantial
dislocations in export and import-
competing sectors of countries.

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 Current Exchange Rate
Arrangements
 As of 1978, IMF member countries
have the right to have whatever
exchange rate systems they wish.
 A number of distinct exchange rate
arrangements now exist, ranging from
no flexibility to total flexibility.
 Sometimes this non-uniform
collection of arrangements is called a
“non-system.”

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 Current Exchange Rate
Arrangements
 Arrangements with no separate legal
tender (a country uses the dollar or
some other currency as its own)
• Complete absence of exchange rate
flexibility
• 10 countries have adopted this, e.g.
Micronesia and Panama.
 Currency Boards (currency is fixed in
value against an anchor currency)
• Ms can only increase if anchor currency
holdings increase.
• 13 countries, e.g. Bulgaria and Dominica
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 Current Exchange Rate
Arrangements
 Conventional Pegs (minimal variation
is allowed around a parity value set
against a foreign currency)
• Pegs against the dollar: 36 countries, e.g.
Argentina, Malawi
• Pegs against the euro: 20 countries, e.g.
Denmark, Niger
• Pegs against other currencies: 5
countries, e.g. Lesotho, Bhutan
• Pegs against a composite basket of
currencies: 7 countries, e.g. Libya,
Russian Federation
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 Current Exchange Rate
Arrangements
 Other pegs, including crawling pegs
(greater variation is allowed around a
parity value set against a foreign
currency)
• Horizontal bands: 3 countries, e.g. Syria
• Crawling pegs/crawling bands: 10
countries, e.g. China, Iran
 Managed floats (currency floats with
occasional intervention)
• 44 countries, e.g. Egypt, Uruguay

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 Current Exchange Rate
Arrangements
 Floats (the value of currency is
determined by markets with only rare
intervention)
• 40 countries, e.g. the EU, Mexico, the U.S.

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Experience Under the Current
International Monetary
System
 The international monetary system
for industrialized countries can be
characterized as a managed float.
 What is the consensus about the
operation of that system?

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Experience Under the Current
International Monetary
System
1. The international monetary system
has been characterized by
substantial exchange rate variations.
2. Exchange rate overshooting
(discussed in Chapter 22) has
occurred.
3. Exchange rate variability has had
real effects: nominal rate
fluctuations have not matched PPP
exchange rate variations, so real
exchange rates have fluctuated.
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Experience Under the Current
International Monetary
System
4. The system hasn’t insulated
countries from foreign shocks as
well as was hoped; perhaps because
of intervention.
5. Countries have increased their
holdings of international reserves; a
flexible exchange rate system was
supposed to allow reduction.
• Particular concern: some central banks
(esp. China’s) now have enormous dollar
reserves – selling these would cause a
dramatic decrease in the dollar’s value.
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Experience Under the Current
International Monetary
System
6. There has not been an increase in
inflation because of greater
flexibility of exchange rates (the
“vicious circle” hypothesis of
Chapter 28 hasn’t come to pass).
7. More flexible exchange rates do not
seem to have caused the volume of
trade to shrink.

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Experience Under the Current
International Monetary
System
8. The Asian financial crisis of 1997
was fueled by
• speculative overinvestment,
• inadequate institutional development
and oversight, and
• ease of capital flight from one country to
another.

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 The Global Financial Crisis
and Recession of 2007-?
 The world’s worst recession since
WWII began in 2007 with the onset
of the collapse of the U.S. subprime
market.
 The downturn quickly spread to
other countries.
 In response, governments have
used expansionary fiscal and
monetary policy; IMF has attempted
to help developing countries.
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The Global Financial Crisis
and Recession of 2007-?
 Who’s to blame? Fingers have been
pointed variously at:
• Financial institutions that took
dangerous risks.
• Regulatory agencies that allowed
reckless behavior.
• Large global imbalances, such as the
U.S.’s large and persistent current
account deficits and China’s surpluses.
 At present, the severity and duration
of this recession are unclear.
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 Suggestions for Reform of
the International Monetary
System
 A return to the gold standard
• Long-standing BOP imbalances would
not occur, and exchange rate risks
would be reduced.
• However, this system emphasizes BOP
equilibrium over internal goals such as
full employment.
 A world central bank
• Extreme form: something like the EMU
• Which country would give up its
sovereignty?
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 Suggestions for Reform of
the International Monetary
System
 The target zone proposal
• Major countries would negotiate
targets for real effective exchange
rates; each country would commit to
maintaining this value within a range
around the target.
• It can be difficult to manage real
exchange rates, and some argue that
such a system would interfere with
efficient resource allocation.

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 Suggestions for Reform of
the International Monetary
System
 Controls on capital flows
• If speculative capital flows cause
instability, minimize them perhaps by a
“Tobin tax.”
• But capital flows can increase
economic efficiency, and so
economists typically oppose capital
controls.

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 Suggestions for Reform of
the International Monetary
System
 Greater stability and coordination
of Macroeconomic Policies Across
Countries
• Macro policies for a particular country
can be unstable over time, and
countries’ macro policies are
sometimes at cross-purposes.
• It might therefore be sensible to make
a greater effort to coordinate policies.
• Such coordination might be difficult to
operationalize.
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 The International Monetary
System and the Developing
Countries
 Less developed countries (LDCs)
generally prefer fixed exchange
rate systems, and they wish to
avoid the exchange rate volatility of
the post-Bretton Woods world.
 However, fixed exchange rate
systems require adequate
international reserves, so LDCs
want any reform to address this.

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 The International Monetary
System and the Developing
Countries
 LDCs are also concerned about IMF
“conditionality” – the strings that
are attached to any LDC use of IMF
resources.
 LDCs want an international
monetary system that will generate
more stability.
 LDCs would like a greater voice in
organizations such as the IMF and
the World Bank.
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