Chapter Five

International Monetary System and

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2 Outline
 What is the International Monetary System?
 Criteria for Evaluating an International Monetary System
 The Evolution of an International Monetary System
 The Gold Standard
 The Inter – War Experience
 The Gold Exchange Standard: Bretton Woods System
 The Current System: Managed Float / Hybrid System
 Key International Financial Institutions
 The International Monetary Fund (IMF)
 The World Bank (WB)
 International Capital Flows and Multinational Corporations
 The Concept of Dutch Disease
 Issues on Foreign Aid and International Debt Crises
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3 International Monetary System (IMS)
 International monetary system (which sometimes is
called international monetary order or regime) refers to
the rules, customs, instruments, facilities, and
organizations for effecting international payments.
 For countries to participate effectively in the exchange
of goods, services, and assets, an international
monetary system is needed to facilitate economic
transactions.
 It refers to the set of rules, institutions, and agreements
that govern international trade and financial
transactions. It establishes the framework for exchange
rate systems, balance of payments, and international
financial stability.
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4 Criteria for evaluating an IMS
 Adjustment refers to the process by which the balance of
payment disequilibria can be corrected. A good IMS is
one that minimizes the cost of and the time required for
adjustment.
 Liquidity refers to the amount of international reserve
assets that are available to settle temporary balance of
payments disequilibria. A good IMS is one that provides
adequate international reserves so that nations can correct
balance of payments deficits without deflating their own
economies or being inflationary for the world as a whole.
 Confidence refers to the knowledge that the adjustment
mechanism is working adequately and that international
reserves will retain their absolute and relative values. That
is, it combines both Adjustment and Liquidity.

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5 Evolution of the IMS
1. The Gold Standard (1880 - 1914)
 The gold standard operated from about 1880 to the
outbreak of World War I in 1914.
 The gold standard refers to the monetary system in
which gold acted as a standard of value in the sense
that the country's monetary unit is either made of
gold of specific weight and purity or its value is
defined in terms of certain specified weight of gold of
specific purity.
 In other words, the gold standard is an international
monetary system where the value of each currency
was fixed in terms of gold.

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6 Cont’d…
 The gold standard was a fixed exchange rate system
in which gold was the only international reserve
asset.
 Under the gold standard, each nation defined the gold
content of its currency and passively stood ready to
buy or sell any amount of gold at that price.
 Because many currencies, including the dollar, the
British pound sterling, and the French franc, were
simultaneously tied to gold for extended periods, these
currencies could also be exchanged among themselves
at a fixed rate.
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7 Cont’d…
 For example, if 1£ = 100 grains of gold and if $1 is 25
grains of gold, then the exchange rate, $/£ = 4. In other
words, 4 dollars are needed to purchase on pound sterling.
 Since the gold content in one unit of each currency was
fixed, exchange rates were also fixed. This was called
the mint parity (the value ratio of two currencies based on
the amount of gold (or another precious metal) contained
in their respective coins under a gold standard).
 The exchange rate could then fluctuate above and below
the mint parity (i.e., within the gold points) because of
the cost of shipping, insurance, packing, and interest
charges on transit from one country to another.
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8 Cont’d…
2. The Interwar Experience (1918 - 1939)
 This period was characterized by hyperinflation to
finance the war, the great depression, financial
instability, adoption of trade protection and autarky,
and beggar my neighbor policies.
 With the outbreak of World War I in 1914, the
classical gold standard came to an end.
 The period between 1919 and 1924 was characterized
by wildly fluctuating exchange rates. This led to a
desire to return to the stability of the gold standard.

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9 Cont’d…
 Starting in 1925, an attempt was made by Britain and
other nations to reestablish the gold standard (the
United States had already returned to the gold standard
in 1919).
 This attempt failed with the deepening of the Great
Depression in 1931.
 There followed a period of competitive devaluations as
each nation tried to "export" its unemployment.
 This, together with the serious trade restrictions
imposed by most nations cut international trade
almost in half.
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10 Cont’d…
3. The Bretton Woods System ( 1944 - 1971)
 After the abandonment of the gold standard, there was
no generally accepted exchange rate regime. Some
countries formed themselves into "currency blocs",
most notably the "Sterling era" (the U. K. plus the
commonwealth, but excluding Canada, Egypt, some
Scandinavian countries, and for some time Japan), and
a "dollar bloc" centered on the United States.
 In 1944, representatives from the United States, the
United Kingdom, and 42 other nations met at Bretton
Woods, New Hampshire, USA, to decide on what
international monetary to establish after the war.
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11 Cont’d…
 The system devised at Bretton Woods called for the
establishment of the International Monetary Fund
(IMF) and the World Bank (WB).
 The IMF was established for the purposes of :
 Overseeing that nations followed a set of agreed
rules of conduct in international trade and finance,
and
 Providing borrowing facilities for nations in
temporary balance of payments difficulties.

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12 Cont’d…
 The Bretton Woods system was a gold-exchange
standard which is an international monetary system
where the price of one currency (say, the dollar) is tied
to gold but all other currencies are tied to the value of
that currency the dollar).
 The United States was to maintain the price of gold
fixed at $35 per ounce and be ready to exchange on
demand dollars for gold at that price without
restrictions or limitations.
 Other nations were to fix the price of their currencies
in terms of dollars (and thus implicitly in terms of
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gold).
13 Cont’d…
The Collapse of the Bretton Woods (1967 - 73)
 The beginning of the events that led to the breakdown
of the Bretton Woods is usually identified as the
devaluation of the pound Sterling in 1967, which
could not be averted even with substantial help from
the United States and other countries.
 The problem was aggravated by oil price increases of
1973 - 74, increases in commodity prices, deterioration
of terms of trade of oil importing countries, and
appreciation of US dollar.

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14 Cont’d…
 The fundamental cause of the collapse of the Bretton
Woods is related to:
 Adjustment problem: that is, lack of adjustment
mechanism. Individual countries had prolonged balance of
payments deficits or surpluses. This was particularly true
for the United States (deficits) and West Germany
(surpluses).
 Liquidity problem: that is, unavailability of
international reserves, and
 Confidence problem: that is, balance of payments
deficits persisted and this undermined confidence in the
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15 Cont’d…
4. The Present (1973 onwards)- Managed Floating
/Hybrid System
• Allow the currency to float, but intervention in foreign
exchange markets by monetary authorities to smooth
out short term fluctuations without attempting to affect
the long run trend in exchange rates.
• In other words, the exchange rates are flexible (through
the forces of demand and supply) with occasional
intervention to stabilize the rates.

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16 Key International Financial Institutions
1. The International Monetary Fund (IMF)
• IMF was formed in 1944 at the Bretton Woods Conference
primarily by the ideas of Harry Dexter White and John
Maynard Keynes, and came into formal existence in 1945
with 29 member countries.
• Currently it has 198 member countries and its headquarter
is based in Washington, D.C.
• It main aims are to foster global monetary cooperation,
secure financial stability, facilitate international trade and
sustainable economic growth, and reduce poverty around
the world while periodically depending on the World Bank
for its resources.
• It now plays a central role in the management of balance of
payments difficulties and international financial crises.

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17 Cont’d…
2. The World Bank (WB)
 WB is an international financial institution that provides loans and
grants to governments of poor countries for the purpose pursuing capital
projects.
 It was also formed in 1944 with IMF at the Bretton Woods Conference
an it’s also headquartered in Washington, D.C.
 The WB comprises two institutions: the International Bank of
Reconstruction and Development (IBRD), and the International
Development Association (IDA).
 The WB is the component of the World Bank Group which is an
extended family of five international organizations, and parent
organization of the WB, the collective name given to the first two listed,
IBRD and the IDA. The additional three are International Finance
Cooperation (IFC), Multilateral Investment Guarantee Agency (MIGA),
and International Center for Settlement of Investment Disputes (ICSID)
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18 International Capital Flows and Multinational Corporations
 The traditional literature has long assumed that
factors of production are mobile within countries, but
immobile between countries. However, today there is
a movement of resources from one country to
another.
 We shall also focus on multinational corporations (or
multinational enterprises or transnational
corporations/enterprises) since they are important
vehicles for the movement of foreign direct
investment (FDI).
 These terms all refer to the same phenomenon –
production is taking place in plants located in two or
more countries but under the supervision and general
direction of the headquarters located in one country.
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19 Cont’d…
 Multinational corporations are firms that own, control
or manage production and distribution facilities in
different countries; they are the major providers of
FDI.
 We need to distinguish between “foreign direct
investment” and “foreign portfolio investment.” FDI is
real – investment in factories, capital goods, land, and
inventories. It involves ownership and control.
 Portfolio investments are investments in financial
assets such as bonds and stocks. Such investments take
place primarily through financial institutions like
banks and investment funds.
 Although direct investments may be made by
individuals or partnerships, most FDI is undertaken by
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20 Cont’d…
 Direct investment is typically industry- specific taking
two forms: horizontal and vertical integration. Large
corporations integrate horizontally by opening new
subsidiaries in various parts of the world. In other
words, it is the production abroad of a differentiated
product that is also produced at home.
 Vertical integration is the expansion of the firm
backwards or forwards. Expansion backwards involves
the supply of its own raw materials and intermediate
products; while expansion forwards involves the
provision of its own sales and distribution networks.
One reason for vertical integration is to reduce risk.

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21 Cont’d…
 The basic motive of both direct and portfolio
investments is to earn higher returns with a lesser risk.
For example, the theory of portfolio diversification
postulates: portfolio diversification and risk
diversification.
 Portfolio diversification is investing in different
financial assets; while risk diversification is investing in
different nations and currencies. In other words: “Do
not put all your eggs on one basket.”

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22 Cont’d…
 What are other reasons for international movement
of capital?
 In response to large and rapidly growing markets in the
recipient country,
 In response to a high per capita income (a higher
purchasing power) in the recipient country,
 To secure access to mineral or raw material deposits to process
and sell them in more finished forms,
 In response to tariffs and non-tariff barriers which can induce
an inflow of FDI,
 In response to low relative wages in the host country,
 For defensive purpose to protect market share, and
 As a means of risk diversification.
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23 The Concept of Dutch Disease
 Dutch disease is an economic term for the negative
consequences that can arise from the spike in the value of a
nation’s currency.
 It is primarily associated with the new discovery of exploitation
of a valuable natural resource and the unexpected repercussions
that such a discovery have on the overall economy of a nation.
 It has two major economic effects resulting from a higher local
currency:
 It decreases the price competitiveness of exports of the
affected country’s manufactured goods
 It increases imports
 In the long run, these factors can contribute to unemployment, as
manufacturing jobs move to lower-cost countries. Meanwhile,
non- resource-based industries suffer due to the increased wealth
generated by the resource-based industries.

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24 Cont’d…
 The term Dutch disease was coined by the Economist
magazine in 1977 when the publication analyzed a
crisis that occurred in the Netherlands after the
discovery of vast natural gas deposits in the North Sea
in 1959.
 The newfound wealth and massive exports of oil caused
the value of the Dutch guilder to rise sharply, making
Dutch exports of all non-oil products less competitive
on the world market. Unemployment rose from 1.1% to
5.1%, and capital investment in the country dropped.
 Dutch disease become widely used in economic circles
as a shorthand way of describing the paradoxical
situation in which seemingly good news, such as the
discovery of large oil reserves, negatively impacts a
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25 Issues on Foreign Aid and International Debt Crises
 On 12 August 1982, the Mexican government
announced that it could not meet its forthcoming debt
repayments on its $80 billion of outstanding debt to
international banks (The Mexican Moratorium).
 This was the first sign of the international debt crisis.
Other countries also followed suit.
 The debt crisis encompasses a wide set of countries
from low income developing nations to middle income
countries.

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26 Cont’d…
Factors For LDCs Debt Problem
Oil Price Increases of 1973 – 74 and 1979 – 81
 The two “Oil Shocks” resulted in huge oil import bills of
many LDCs. This necessitated borrowing to finance the
additional import expenditures. Much of the borrowing
was from industrialized countries’ commercial banks,
which were recycling dollars deposited in them by
members of Organization of the Petroleum Exporting
Countries (OPEC).
Recession in the Industrialized Countries
 The oil shocks resulted in recession in developed
countries which in turn affected exports by LDCs.
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27 Cont’d…
The Behavior of Real Interest Rates
 The real interest rate was low and thus encouraged
LDCs to undertake new loans.
The Decline in Primary – Product Prices:
 The terms of trade of oil – importing countries
deteriorated and this necessitated additional borrowing
in order to finance needed imports for development.
Domestic Policies within the LDCs
 The loans were used for consumption rather than for
productive investment, thus repayment prospects were
poor and new borrowing was needed.
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28 Cont’d…
Capital Flight
 A factor associated with increasing indebtedness was capital
flight from LDCs. In Latin American countries, in particular,
inflation was taking place and many domestic citizens sent funds
to industrialized countries’ banks.
Loan Pushing
 It refers to the practice where lenders, particularly international
financial institutions, aggressively encourage or persuade
borrowers (often governments or corporations in developing
countries) to take on loans, even when those loans may not be in
the borrower’s best interest or sustainable in the long term. and
thus, loans were made available and did not adequately take risk
factors into account.
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29 Cont’d…
The Role and Viewpoints of the Actors in the Debt
Crisis
 There are different views on how to manage the crisis.
First, who are the actors in the debt crisis? The actors
are:
 International Banks – Commercial Banks
 The Authorities of the Developed Nations
 International Institutions – IMF and WB
 Debtor Nations

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30 Cont’d…
 Commercial Banks: argue that the debt problem is a
temporary liquidity problem, so give the debtor nations
some time. Commercial banks preferred rescheduling
debt repayments and at the same time ensuring that
additional interest are paid on the postponed principal
repayments.
 They are opposed to granting debt forgiveness arguing
that:
 Granting debt forgiveness for one country would lead
other debtors to seek similar relief,
 Debt relief might discourage the debtors from taking
the measures necessary to improve their economic
performance.
 The banks have also been keen to treat each debtor on a
“Case by Case” approach because each debtor faces
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different circumstances.
31 Cont’d…
 National Authorities (of the lender): Their concern is to
avoid the collapse of their banking system. Because of their
strategic and economic interests, the authorities are prepared
to allow some concessions/reductions.
 International Institutions (IMF and WB): The IMF wants
the debtor countries to accept an IMF sponsored adjustment
package (IMF Conditionality), for example, reduction of
government budget deficits and money supply, devaluation,
elimination of government subsidies, elimination of
distorted price controls, and allowing markets to function.
The WB has been concerned about the costs in terms of
slower development that debt repayments impose upon
debtor nations.
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32 Cont’d…
 The Debtor Nations: They claim that the debt issue is
not their making, but due to a combination of external
factors beyond their control. They felt that the creditor
banks should consider the possibility of debt
forgiveness.

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33 Cont’d…
 There are three sets of proposals:
 Alter the structure and nature of the debt (Commercial
banks view) – e.g., lengthening the time horizon to make it
more manageable for repayment of the debt.
 Economic reform in the debtor nations (IMF and WB view)
The argument is that the reforms will improve the debtor
nations’ ability to service their debts.
 Debt forgiveness – Write off part of the debts the debtors
owe by:
 Reducing the principal owed,
 Reducing the interest payments below the market rates,
 Mixture of the above two.

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34 The Paris Club
 In response to Argentina’s debt problems and the
difficulties being encountered by developing countries
in repaying their external debts, creditor governments
formed what is known as the Paris Club in 1956.
 The Paris Club is a consortium of industrialized
countries’ governments, whose objective is to provide a
framework for rescheduling debt repayments to official
creditors.
 Any creditor government may apply for membership of
the Paris Club which conducts negotiations between a
debtor government and the creditor governments and
meetings are usually chaired by a senior French
Treasury Official.

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35

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