history of international monetary system

Topics: Bretton Woods system, Monetary policy, Foreign exchange market Pages: 6 (1238 words) Published: September 23, 2013
CHAPTER 2 SUMMARIZED NOTES

A) THE EVOLUTION OF INTERNATIONAL MONETARY SYSTEM

1) THE CLASSICAL GOLD STANDARD ERA (1870-1914)

Characteristics:

All currencies are valued in terms of their gold equivalent and thus all currencies are linked together.

Eg: 1 ounce of gold = $20.67 1 ounce of gold = £4.25 so 1£ = (20.67 /4.25) = $4.87

Money has a value fixed in terms of commodity gold.

Since gold is costly to produce, governments could not easily increase their money supply. Supply of money is restricted by the supply of gold.

Advantages :

Controlling inflation and balance-of-trade equilibrium through money supply.

Eg: Country A Bal.of.Pay. Deficit Money Supply  Prices (Inflation) 

Country B Bal.of.Pay. Surplus Money Supply  Prices (Inflation) 

Explanation :
Country A imports more than it exports which in turn leads to net outflow of gold reducing money suppply and prices. Country B, on the other hand, exports more than it imports leading to net inflow of gold increasing its money supply and prices. As a result, Country A’s products become cheaper leading to an increase in exports reducing balance of payments deficit. On the contrary, Country B’s products become more expensive leading to decrease in exports and balance of payments surplus. This process helps achieve balance of payments disequlibrium.

Controlling the exchange rate volatility by establishing fixed exchange rates per gold.

Maintaining balance-of-payments equlibrium and price stable exchange rates help improve the growth of world trade.

2) THE INTERWAR PERIOD (1918-1939):

Characteristics:

It flourished as war related restrictions stopped gold flows and gold standard. Countries started printing money to finance their military expenditures causing hyperinflation.

Eg: By the end of 1923, Price Index in Germany was 1 trillion times higher than pre-war level.

US, UK, and France turned back to gold standard after I. World War but could not keep it for long due to the fast outflow of gold reserves resulting from the chronic balance-of-payment (export-import) deficits and lack of confidence in those countries’ currencies. UK, for instance, returned to gold standard by pegging gold to pound at the old prewar exchange rate. However, the prices had risen through war period which in turn caused pound to be overvalued. This in turn led to a sharp decline in exports.

Countries aimed at stimulating their economies by increasing exports and thus devalued their currencies

Economic and political instabilities, bank failures, capital flight across borders

Eg: Great Depression of 1929 in U.S.

3) BRETTON WOODS SYSTEM (Gold-Exchange Standard) (1945-1972) :

Characteristics:

IMF was founded as the major governing body to develop and monitor the rules of conduct for international monetary policies. World Bank was also found and was responsible for country development projects. IMF’s main task was to provide short-term loans to countries experiencing temporary balance-of-payments disequilibrium. These loans, however, were subject to IMF conditions imposing changes in domestic economic policy to restore equilibrium.

A fixed exchange rate system was established to prevent the devaluations that existed during Interwar period.

Each country fixed the value of their currency in terms of gold and established a par value relative to U.S. Dollar, which was pegged to gold at $35 per ounce and was the only currency convertible to gold.

Countries held U.S Dollars as well as gold for international means of payment.

Nations were committed to maintain their currencies value within 1% of parity

If a country could not keep the parity due to balance-of-payments disequilibrium, IMF would provide loans to restore that country’s economic stability. The system started collapsing after U.S itself started running huge balance-of-payment...
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