CHAPTER 11 – THE INTERNATIONAL MONETARY SYSTEM
11.1 INTRODUCTION
• International monetary system → set of conventions, rules, procedures and
conventions that govern the conduct of financial relations between nations
• Background → development after second world war
11.2 THE BRETTON WOODS SYSTEM
• Initial talks about post-war international monetary system started in the US and UK
around 1941
o US – Harry Dexter
o UK – Keynes
• Motivation → to avoid the breakdown in international monetary relations
o Hyperinflation in Germany before war
• Nurkse → floating exchange rates discourage international trade
11.3 FEATURES OF THE SYSTEM
• Fixed but adjustable exchange rate
o Each currency was assigned a central parity against US dollar → but allowed
to fluctuates +- 1%
o The dollar itself was fixed to the price of gold at $35 per ounce → to provide
confidence in the system
o In case of fundamental disequilibrium → country could devaluate or revaluate
its currency
o Capital movements were destabilising
• The IMF and credit facilities
o IMF – International monetary fund → to oversee and promote international
monetary cooperation and growth of world trade
o Task: to ensure smooth functioning of exchange rate system
▪ Minimising the need of countries to devaluate/revaluate the
currencies
▪ By providing them with facilities which could help them to finance BoP
deficits
o Credit mechanism was set up → to help countries facing balance of payments
problems
11.4 A BRIEF HISTORY OF THE BRETTON WOODS SYSTEM
• In March 1947 – currencies were not freely convertible
• After world war 2
o USA ran healthy surpluses
o European economies large deficits
• Marshall aid – conditional on greater cooperation between European economies
• From early 1950s
, o US entered into deficits
o Some European countries and Japan started to have surpluses
• the move to floating exchange rate as a result of breakdown of fixed exchange rate
system
11.5 WHY DID THE BRETTON WOODS SYSTEM BREAK DOWN?
• Operated with relative success between 1947-1971
• The liquidity problems and lack of adequate adjustments mechanism
• The liquidity problems
o It was essential to keep confidence in the US dollar
o International trade grew and so did the demand for US dollars
o Created large deficits → the ratio of US dollar liabilities to gold held by FED
deteriorated
o US took measures to curb its deficits → shortage of world reserves →
deflationary pressure on world economy
o Known as Triffin dilemma
• An alternative interpretation of the demise of Bretton Woods
o Gresham’s law → there is a discrepancy between the official rate of exchange
between two assets and their private market rate of exchange
▪ The asset that is undervalued would disappear from circulation
▪ The asset that is overvalued would stay there
▪ ‘bad money drives out good money’
o Dollars had driven out gold
• Lack of adjustment mechanism
o Countries were extremely reluctant to devaluate/revaluate their currencies
▪ US could not devaluate their dollars in terms of gold
o In fixed exchange rate regime – the pressure is on debtors to undertake
economic adjustment
▪ Fall in their reserves required to defend the exchange rate
• The seigniorage problem
o USA was the major source of international liquidity
o To acquire reserves the rest of the world had to run surpluses while USA ran
deficits
▪ Means – rest of the world was consuming less than producing
▪ Only USA had the privilege to consume more than produce
▪ Some countries had to adopt deflationary policies (not USA) → USA
was under pressure to correct its deficits
11.6 THE POST-BRETTON WOODS ERA
• The first oil shock and its aftermath
o Return to floating exchange rates was viewed as temporary by CBs – until a
new monetary policy is established
o As a result of Arab-Israeli conflict in 1973 → oil companies quadrupled the
prices of oil
, ▪ Huge impact on economy
▪ Huge rise in oil prices
▪ Non-oil exporting developing countries particularly hit
• Rise in price of their imports → reduced their exports earnings
o Divergences in inflation rates
o Stagflation
o Recession
11.7 THE JAMAICA CONFERENCE OF 1976
• November 1975 – legitimizing the floating exchange rate regime → conference held
in Jamaica
o SDR should be the ‘principal reserve asset’
• The second amendment
o Gave countries a large degree of discretion in selecting their exchange rate
arrangements
o Defined the obligations and responsibilities of fund members
o Guidelines in 3 principles
▪ 1. A member small avoid manipulating exchange rates or the
international monetary system in order to prevent effective balance of
payments adjustment or to gain unfair competitive advantage
▪ 2. A member should intervene in the exchange market if necessary to
counter disorderly conditions → which can lead to disruptive short-
term movements
▪ 3. Members should take into account in their intervention policies that
interests of other members
o IMF could penalize the members that did now follow the guidelines
11.8 THE SNAKE AND THE EMS
• The member countries of EEC (European Economies Community) had been
concerned that their large degree of trading risk could threaten by exchange rate
instability
• Setting up Snake in 1972 (replaced by IMF in 1992)
11.9 THE SECOND OIL SHOCK
• Iranian revolution in 1978 → hike in oil prices
• Not as huge as the first one
• Adjustment of balance of payments deficits was quicker
11.10 THE DAZZLING DOLLAR, 1980-1985
• From January 1980 to May 1985 → appreciation of US dollar
• US authorities had tight monetary policy and relaxed fiscal policy
o Budget deficit was rising
o US interest rates rose compared to Europe
11.1 INTRODUCTION
• International monetary system → set of conventions, rules, procedures and
conventions that govern the conduct of financial relations between nations
• Background → development after second world war
11.2 THE BRETTON WOODS SYSTEM
• Initial talks about post-war international monetary system started in the US and UK
around 1941
o US – Harry Dexter
o UK – Keynes
• Motivation → to avoid the breakdown in international monetary relations
o Hyperinflation in Germany before war
• Nurkse → floating exchange rates discourage international trade
11.3 FEATURES OF THE SYSTEM
• Fixed but adjustable exchange rate
o Each currency was assigned a central parity against US dollar → but allowed
to fluctuates +- 1%
o The dollar itself was fixed to the price of gold at $35 per ounce → to provide
confidence in the system
o In case of fundamental disequilibrium → country could devaluate or revaluate
its currency
o Capital movements were destabilising
• The IMF and credit facilities
o IMF – International monetary fund → to oversee and promote international
monetary cooperation and growth of world trade
o Task: to ensure smooth functioning of exchange rate system
▪ Minimising the need of countries to devaluate/revaluate the
currencies
▪ By providing them with facilities which could help them to finance BoP
deficits
o Credit mechanism was set up → to help countries facing balance of payments
problems
11.4 A BRIEF HISTORY OF THE BRETTON WOODS SYSTEM
• In March 1947 – currencies were not freely convertible
• After world war 2
o USA ran healthy surpluses
o European economies large deficits
• Marshall aid – conditional on greater cooperation between European economies
• From early 1950s
, o US entered into deficits
o Some European countries and Japan started to have surpluses
• the move to floating exchange rate as a result of breakdown of fixed exchange rate
system
11.5 WHY DID THE BRETTON WOODS SYSTEM BREAK DOWN?
• Operated with relative success between 1947-1971
• The liquidity problems and lack of adequate adjustments mechanism
• The liquidity problems
o It was essential to keep confidence in the US dollar
o International trade grew and so did the demand for US dollars
o Created large deficits → the ratio of US dollar liabilities to gold held by FED
deteriorated
o US took measures to curb its deficits → shortage of world reserves →
deflationary pressure on world economy
o Known as Triffin dilemma
• An alternative interpretation of the demise of Bretton Woods
o Gresham’s law → there is a discrepancy between the official rate of exchange
between two assets and their private market rate of exchange
▪ The asset that is undervalued would disappear from circulation
▪ The asset that is overvalued would stay there
▪ ‘bad money drives out good money’
o Dollars had driven out gold
• Lack of adjustment mechanism
o Countries were extremely reluctant to devaluate/revaluate their currencies
▪ US could not devaluate their dollars in terms of gold
o In fixed exchange rate regime – the pressure is on debtors to undertake
economic adjustment
▪ Fall in their reserves required to defend the exchange rate
• The seigniorage problem
o USA was the major source of international liquidity
o To acquire reserves the rest of the world had to run surpluses while USA ran
deficits
▪ Means – rest of the world was consuming less than producing
▪ Only USA had the privilege to consume more than produce
▪ Some countries had to adopt deflationary policies (not USA) → USA
was under pressure to correct its deficits
11.6 THE POST-BRETTON WOODS ERA
• The first oil shock and its aftermath
o Return to floating exchange rates was viewed as temporary by CBs – until a
new monetary policy is established
o As a result of Arab-Israeli conflict in 1973 → oil companies quadrupled the
prices of oil
, ▪ Huge impact on economy
▪ Huge rise in oil prices
▪ Non-oil exporting developing countries particularly hit
• Rise in price of their imports → reduced their exports earnings
o Divergences in inflation rates
o Stagflation
o Recession
11.7 THE JAMAICA CONFERENCE OF 1976
• November 1975 – legitimizing the floating exchange rate regime → conference held
in Jamaica
o SDR should be the ‘principal reserve asset’
• The second amendment
o Gave countries a large degree of discretion in selecting their exchange rate
arrangements
o Defined the obligations and responsibilities of fund members
o Guidelines in 3 principles
▪ 1. A member small avoid manipulating exchange rates or the
international monetary system in order to prevent effective balance of
payments adjustment or to gain unfair competitive advantage
▪ 2. A member should intervene in the exchange market if necessary to
counter disorderly conditions → which can lead to disruptive short-
term movements
▪ 3. Members should take into account in their intervention policies that
interests of other members
o IMF could penalize the members that did now follow the guidelines
11.8 THE SNAKE AND THE EMS
• The member countries of EEC (European Economies Community) had been
concerned that their large degree of trading risk could threaten by exchange rate
instability
• Setting up Snake in 1972 (replaced by IMF in 1992)
11.9 THE SECOND OIL SHOCK
• Iranian revolution in 1978 → hike in oil prices
• Not as huge as the first one
• Adjustment of balance of payments deficits was quicker
11.10 THE DAZZLING DOLLAR, 1980-1985
• From January 1980 to May 1985 → appreciation of US dollar
• US authorities had tight monetary policy and relaxed fiscal policy
o Budget deficit was rising
o US interest rates rose compared to Europe
