Chapter 2
The International Monetary System

FINA470 Concordia University Summer 2015

History of the International
Monetary System
 Exhibit 2.1 summarizes exchange rate regimes since 1860
 The Gold Standard, 1876-1913
 Countries set par value for their currency in terms of gold
 Exchange rates were in effect “fixed”
 Gold reserves were needed to back a currency’s value

 The gold standard worked until the outbreak of WWI, which interrupted trade flows and free movement of gold

FINA470

Concordia University Summer 2015

1-2

Exhibit 2.1 The Evolution of Capital
Mobility

FINA470

Concordia University Summer 2015

1-3

History of the International
Monetary System
 The Inter-War years and WWII, 1914-1944

 During this period currencies were allowed to fluctuate in





FINA470

terms of gold and each other
Increasing fluctuations in currency values became realized as speculators sold short weak currencies
In 1934, the U.S. dollar was devalued to $35/oz from
$20.67/oz
During WWII and its chaotic aftermath the US dollar was the only major trading currency that continued to be convertible

Concordia University Summer 2015

1-4

History of the International
Monetary System
 Bretton Woods and the IMF, 1944
 Allied Powers met in Bretton Woods, NH and created a post-war international monetary system

 The agreement established a US dollar based monetary system and created the IMF and World Bank

 Countries fixed their currencies in terms of gold but were not required to exchange their currencies

 Only the US dollar remained convertible into gold (at $35/oz with Central banks, not individuals)

FINA470

Concordia University Summer 2015

1-5

History of the International
Monetary System
 Therefore, each country established its exchange rate vis-à


FINA470

vis the USD and then calculated the gold par value of their currency Participating countries agreed to try to maintain the currency values within 1% of par by buying or selling foreign or gold reserves Devaluation was not to be used as a competitive trade policy and up to a 10% devaluation was allowed without formal approval from the IMF

Concordia University Summer 2015

1-6

History of the International
Monetary System
 The Special Drawing Right (SDR)
 Created by the IMF to supplement existing foreign

exchange reserves
 Used as unit of account
 Base against which some countries peg their currency
 Defined initially in terms of fixed quantity of gold
 Currently, it is the weighted average value of four major currencies  Individual countries hold SDRs as deposits at the IMF and settle IMF transactions through SDR transfers

FINA470

Concordia University Summer 2015

1-7

History of the International
Monetary System
 Fixed exchange rates, 1945-1973
 Bretton Woods and IMF worked well post WWII, but diverging fiscal and monetary policies and external shocks caused the system’s demise

 The US dollar remained the key to the web of exchange rates

 Heavy capital outflows of dollars became required to meet investors’ and deficit needs and eventually created a lack of confidence in the US’ ability

to convert dollars to gold

FINA470

Concordia University Summer 2015

1-8

History of the International
Monetary System
 This lack of confidence forced President Nixon to suspend official

purchases or sales of gold on Aug. 15, 1971
 Exchange rates of most leading countries were allowed to float in relation to the US dollar
 A year and a half later, the dollar came under attack again and lost 10% of its value
 By early 1973 a fixed rate system no longer seemed feasible and the dollar, along with the other major currencies was allowed to float

FINA470

Concordia University Summer 2015

1-9

History of the International
Monetary System
 Floating Era, 1973-1997
 Exchange rates became much more volatile and less predictable they





were during the “fixed” period
Several emerging market currency crises
EMS restructuring (1992) and introduction of