The International Monetary System

Chapter Organization
 Macroeconomic Policy Goals in an Open Economy
 International Macroeconomic Policy Under the Gold
Standard, 1870-1914
 The Interwar Years, 1918-1939
 The Bretton Woods System and the International
Monetary Fund
 Internal and External Balance Under the Bretton
Woods System
 Analyzing Policy Options Under the Bretton Woods
System
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International Macroeconomic Policy
Under the Gold Standard, 1870-1914
 Origins of the Gold Standard
• The gold standard had its origin in the use of gold
coins as a medium of exchange, unit of account, and
store of value.

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 The Gold Standard, 1870-1914

 Gold Standard
• The fundamental principle of the classical gold
standard was that each country should set a par value
for its currency in terms of gold and then try to
maintain this value.
• In this system the exchange rate between any two
currencies was determined by their gold content.

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 The Gold Standard, 1870-1914

 Price Specie Flow Mechanism (Specie here means gold)

• This is mechanism to restore equilibrium

• When a country’s currency inflated to fast it looses
competitiveness in world market
• Deteriorating trade balance as IMP> EXP , which led
to decline in confidence of currency
• It led to withdrawn of gold from reserves and shipped
abroad to pay for imports
• It led to reduction in money supply and ultimately
results in slowdown, recession, unemployment.
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 The Gold Standard, 1870-1914

 Price Specie Flow Mechanism (Specie here means gold)

• This is mechanism to restore equilibrium

• When a country’s currency inflated to fast it looses
competitiveness in world market
• Deteriorating trade balance as IMP> EXP , which led
to decline in confidence of currency
• It led to withdrawn of gold from reserves and shipped
abroad to pay for imports
• It led to reduction in money supply and ultimately
results in slowdown, recession, unemployment.
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 The Gold Standard, 1870-1914

 Price Specie Flow Mechanism (Specie here means gold)

• If EXP>IMP the demand for its currency moves to gold

import point
• By more export country currency would be in more
demand to cater more demand country would increase
gold reserve which would lead to increase money supply.
• It would lead to rise in employment and ultimately
inflation so it would make import cheaper and exports
more costly and then BOP would become worse.

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 The Gold Standard, 1870-1914
 Decline of Gold Standard
• At the time of First World War the nations require expansion
in money supply for financing the war activities.
• The strained political relations impeded free flow of gold
• The countries increased the money supply and had to suspend
convertibility of currency into gold

• All this was deviation from the norms of Gold Standard

• UK was first to abandon the system due to its rigid structure as
no devaluation is possible
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 The Interwar Years, 1914-1944
 The Inter –war period was characterized by half – hearted attempts
and failure to restore the gold standard, economic and political
instabilities ,widely fluctuating exchange rates , bank failures and
financial crisis.
 With the eruption of WW-I in 1914, the gold standard was
suspended.
• The interwar years were marked by severe economic instability.
• The reparation payments led to episodes of hyperinflation in
Europe.
 The German Hyperinflation

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 The Interwar Years, 1914-1944
 The Fleeting Return to Gold
• 1919
– U.S. returned to gold
• 1922
– A group of countries (Britain, France, Italy, and Japan)
agreed on a program calling for a general return to the
gold standard and cooperation among central banks in
attaining external and internal objectives.

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 The Interwar Years, 1914-1944
• 1925
– Britain returned to the gold standard
• 1929
– The Great Depression was followed by bank failures
throughout the world.
• 1931
– Britain was forced off gold when foreign holders of
pounds lost confidence in Britain’s commitment to
maintain its currency’s value.

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 The Interwar Years, 1914-1944
 International Economic Disintegration
• Many countries suffered during the Great Depression.
• Major economic harm was done by restrictions on
international trade and payments.

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 The Interwar Years, 1914-1944
Figure 181: Industrial Production and Wholesale Price Index Changes,
1929-1935

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 The Bretton Woods System
and the International Monetary Fund
 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.
• It called for currency convertibility.

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 The Bretton Woods System
1945-1972
 Bretton Woods System-
• After depression of 1930s,followed by another was
had already affected the international exchange of
currencies.
• Revival of the system was necessary and the
reconstruction of the post war financial system began
with the Bretton Woods Agreement that emerged from
the International Monetary and Financial Conference
of the united and associated nations in July 1944 at
Bretton Woods , New Hemisphere.

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 The Bretton Woods System
1945-1972
 The negotiators at Bretton Woods made certain
recommendations in 1944:
• Each nation should be at liberty to us e macroeconomic
policies for full employment.
• Free floating exchange rates could not work. But the
extremes of both permanently fixed and free-floating rates
should be avoided.
• A monetary system was needed that would recognize that
exchange rates were both a national and international
concern.

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 The Bretton Woods System
1945-1972
 The negotiators at Bretton Woods made certain
recommendations in 1944:
• Each nation should be at liberty to us e macroeconomic
policies for full employment.
• Free floating exchange rates could not work. But the
extremes of both permanently fixed and free-floating rates
should be avoided.
• A monetary system was needed that would recognize that
exchange rates were both a national and international
concern.

.
 The Bretton Woods System
1945-1972
 The negotiators at Bretton Woods made certain
recommendations in 1944:
• Each nation should be at liberty to us e macroeconomic
policies for full employment.
• Free floating exchange rates could not work. But the
extremes of both permanently fixed and free-floating rates
should be avoided.
• A monetary system was needed that would recognize that
exchange rates were both a national and international
concern.

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 The External Balance
Problem of the United States
 The U.S. was responsible to hold the dollar price of
gold at $35 an ounce and guarantee that foreign
central banks could convert their dollar holdings into
gold at that price.
• Foreign central banks were willing to hold on to the
dollars they accumulated, since these paid interest and
represented an international money par excellence.
 The Confidence problem
• The foreign holdings of dollars increased until they
exceeded U.S. gold reserves and the U.S. could not
redeem them.
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 The External Balance
Problem of the United States
 Special Drawing Right (SDR)
• An artificial reserve asset
• SDRs are used in transactions between central banks
but had little impact on the functioning of the
international monetary system.

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 The External Balance
Problem of the United States
Figure 184: U.S. Macroeconomic Data, 1964-1972

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 The External Balance
Problem of the United States
Figure 184: Continued

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 The External Balance
Problem of the United States
Figure 184: Continued

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 The External Balance
Problem of the United States
Figure 184: Continued

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 New Exchange Rate System

 Flexible exchange rate system

 Fixed Exchange Rate System

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