Chapter Five

INTERNATIONAL MONETARY SYSTEM

AND KEY INTERNATIONAL FINANCIAL
INSTITUTIONS

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 What is Money ?
 A current medium of exchange in the form of
coins and banknotes.
 Any good that is widely accepted in exchange of
goods and services as well as payment of debts.

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 Three Functions of Money
1. Medium of Exchange:-
Exchange money used for buying
and selling goods and services.

2. Unit of Account:-
Account common standard for
measuring relative value of goods and services.

3. Store of Value:-
Value convenient way to store wealth.

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 INTERNATIONAL MONETARY SYSTEM

 This chapter examines the evolution of the

international monetary system and how it influenced
macroeconomic policy.
 International monetary systems are sets of
internationally agreed rules, conventions and
supporting institutions.
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 That facilitate international trade, cross border
investment and generally there allocation of capital
between nation states.
 IMS refers to the system prevailing in world
foreign exchange market through which
international trade and capital movement are
financed and exchange rates are determined

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Features that IMS Should Possess

 Efficient and unrestricted flow of international

trade and investment
 Stability in foreign exchange aspects

 Promoting balance of payments adjustments to

prevent disruptions associated.

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 Cont.…
 Providing countries with sufficient liquidity to
finance temporary balance of payments deficit.
 Should at least try avoid adding further uncertainty

 Allowing member countries to pursue independent

and fiscal policy

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 Requirement of good international
monetary system
• Adjustment : a good system must be able to adjust
imbalance in balance of payments quickly and at a
relatively lower cost.
• Stability and Confidence:
Confidence the system must be able
to keep exchange rate relatively fixed and people
must have confidence in the stability.
• Liquidity : the system must be able to provide
enough reserve assets for a nation to correct its
balance of payments deficits.
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 The Evolution / stages of an
International Monetary System

• 1. Bimetallism: before 1875

• 2. Classical gold standard: 1875 – 1914

• 3. Interwar period : 1915 – 1944

• 4. Bretton woods system: 1945 – 1972

• 5. The flexible exchange regime: 1973 – present

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 1. 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 god or
silver contents.
• Gresham’s Law implied that it would be the least
valuable
Chapter
metal that would tend to circulate.
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 Gresham’s Law
• Gresham’s Law is an economic principle that sates:
“ if coins containing metal of different value have
the same value as legal tender, the coins composed
of the cheaper metal will be payment, while those
made of more expensive metal will be
hoarded/Saved or exported and thus tend to
disappear from circulation”.
• It is commonly stated as “Bad” ( abundant) money
derives out “Good” (scarce) money.

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 Classical gold standard: 1875 – 1914
The gold standard had its origin in the use of gold
coins as a medium of exchange, unit of account, and
store of value.
 Gold alone was assured of unrestricted coinage.
 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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 Rules of the System
 Each country defined the value of its currency in
terms of gold
 Exchange rate between any two currencies was
calculated as X currency per ounce of gold /
Y currency per ounce of gold.
 These exchange rates were set by arbitrage
depending on the transportation costs of gold.
 Central banks are restricted in not being able to
issue more currency than gold reserves.
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 Exchange rate Determination
Example: if the dollar is pegged to gold at US $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
Highly stable exchange rates under the classical
gold standard provided an environment that was
favorable to international trade and investment.
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 Interwar period : 1915 – 1944
• Exchange rates fluctuated as countries widely used
“predatory’’ depreciation 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 “ flow
the rules of the game’’
• The world economy characterized by tremendous
instability and eventually economic breakdown,
what is known as the Great Depreciation (1930-
39)
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International Economics Disintegration
 Many countries suffered during the great
depreciation
 Major economic harm was done by restrictions on
international trade and payments.
 These beggar the neighbor policies provoked
foreign retaliation and led to the disintegration of
the world economy.
 All countries’ situations could have been bettered
through international cooperation.
 Bretton
Chapter Woods agreement
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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 post war
international monetary system
 The goal was exchange rate stability with out the
gold standard.
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 This Resulted in
• The creation of the IMF and the World Bank
(International Monetary Institutions)
1. IMF : maintain order in monetary system
2.World Bank : promote general economic
development
 They play a major role in the social and economic
development of countries with emerging economies.
 This includes advising, funding, and assisting on
development projects to: reduce global poverty and
improve living conditions and standards
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International Monetary Fund (IMF)
• In July 1944, 44 representing countries met in
Bretton Woods, New Hampshire to set up a
system of fixed exchange rates.
• All currencies had fixed exchange rates against
the U.S. dollar and an unvarying dollar price of
gold ($35 an ounce).
• It intended to provide lending to countries with
current account deficits.

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• Goals and Structure of the IMF
The IMF agreement tried to incorporate
sufficient flexibility to allow countries to attain
external balance without sacrificing internal
objectives or fixed exchange rates.
Two major features of the IMF Articles of
Agreement helped promote this flexibility in
external adjustment:
 IMF lending facilities
 Adjustable parities
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 The Current System: Managed
Float / Hybrid System
• In a free-floating exchange rate system, exchange
rates are determined by demand and supply.
• Exchange rates are determined by demand and
supply in a managed float system, but
governments intervene as buyers or sellers of
currencies in an effort to influence exchange
rates.

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• In simple terms, a managed floating exchange rate
is a system where currencies fluctuate daily but the
regulatory authorities, including the government
and the Reserve bank, may step in to control and
stabilize the value of the currency
• If these bodies do not step in, there is bound to be
an ‘economic shock’ to the country.
• A managed floating exchange rate is occasionally
called a ‘dirty float’ as opposed to a ‘clean float’
where central banks do not intervene.
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 International Capital Flows and
Multinational Corporations
• International capital flows are the transfer of
financial assets, such as cash, stocks, or bonds,
across international borders.
• International capital flows are the financial side
of International trade.

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• Net capital outflows
= S –I
= net outflow of “loanable funds”
= net purchases of foreign assets
the country’s purchases of foreign assets
minus foreign purchases of domestic assets

• When S > I, country is a net lender

• When S < I, country is a net borrower

• ( S = Private saving(Y-C-T) + Public saving(T-G)
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 Multinational Corporation (MNC)
 Is any corporation that is registered and operates
in more than one country at a time.
 Generally the corporation has its headquarters in
one country and operates wholly or partially
owned subsidiaries in other countries.
 Its subsidiaries report to the corporation's central
headquarters.

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Characteristics of a Multinational
Corporation
 Global business presence
 Business conducted in various languages
 A complicated business model and structure
 Direct investments in foreign countries
 Jobs created in foreign countries
 Seeks improved efficiencies, lower production
costs, larger market share
 Pays taxes in countries in which it operates
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 The Concept of Dutch Disease
• Dutch disease is a concept that describes an
economic phenomenon where the rapid
development of one sector of the economy
(particularly natural resources) precipitates a
decline in other sectors.
• In both the rapid development of one sector of
the economy and the decline of other sectors lead
to the substantial appreciation of the domestic
currency

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 Dutch disease is a paradoxical situation where
good news for one sector of the economy, such as
the discovery of natural resources, results in a
negative impact on the country’s overall economy.

 How to Avoid Dutch Disease?

 Reading Assignment

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Chapter
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