International Business

Dr Nur Kamarul Hafiz bin Jamil

11-1
Chapter 9
The International
Monetary System

11-2
 What Is The International
Monetary System?
• The international monetary system refers to the
institutional arrangements that countries adopt to
govern exchange rates
• A floating exchange rate system exists when a
country allows the foreign exchange market to
determine the relative value of a currency
• the U.S. dollar, the EU euro, the Japanese yen, and the
British pound all float freely against each other
• their values are determined by market forces and
fluctuate day to day

11-3
 What Is The International
Monetary System?
• A pegged exchange rate system exists when a
country fixes the value of its currency relative to a
reference currency
• many Gulf states peg their currencies to the U.S. dollar
• A dirty float exists when a country tries to hold the
value of its currency within some range of a
reference currency such as the U.S. dollar
• China pegs the yuan to a basket of other currencies

11-4
 What Is The International
Monetary System?
• A fixed exchange rate system exists when countries fix their
currencies against each other at some mutually agreed on exchange
rate
• European Monetary System (EMS) prior to 1999

11-5
 What Was The Gold Standard?

• The gold standard refers to a system in which countries peg

currencies to gold and guarantee their convertibility
• the gold standard dates back to ancient times when gold coins were a
medium of exchange, unit of account, and store of value
• payment for imports was made in gold or silver

11-6
 What Was The Gold Standard?

• later, payment was made in paper currency which was linked to gold at a
fixed rate
• in the 1880s, most nations followed the gold standard
• $1 = 23.22 grains of “fine” (pure) gold
• the gold par value refers to the amount of a currency needed to purchase
one ounce of gold

11-7
 Why Did The
Gold Standard Make Sense?
• The great strength of the gold standard was that it contained a
powerful mechanism for achieving balance-of-trade equilibrium by all
countries
• when the income a country’s residents earn from its exports is equal to the
money its residents pay for imports
• It is this feature that continues to prompt calls to return to a gold
standard

11-8
 Why Did The
Gold Standard Make Sense?
• The gold standard worked well from the 1870s until 1914
• but, many governments financed their World War I expenditures by printing
money and so, created inflation
• People lost confidence in the system
• demanded gold for their currency putting pressure on countries' gold
reserves, and forcing them to suspend gold convertibility
• By 1939, the gold standard was dead

11-9
 What Was The
Bretton Woods System?
• In 1944, representatives from 44 countries met at
Bretton Woods, New Hampshire, to design a new
international monetary system that would facilitate
postwar economic growth
• Under the new agreement
• a fixed exchange rate system was established
• all currencies were fixed to gold, but only the U.S. dollar
was directly convertible to gold
• devaluations could not to be used for competitive
purposes
• a country could not devalue its currency by more than
10% without IMF approval

11-10
 What Institutions Were Established
At Bretton Woods?

• The Bretton Woods agreement also established

two multinational institutions
1. The International Monetary Fund (IMF) to
maintain order in the international monetary
system through a combination of discipline and
flexibility
2. The World Bank to promote general economic
development
• also called the International Bank for Reconstruction
and Development (IBRD)

11-11
 What Institutions Were
Established At Bretton Woods?

1. The International Monetary Fund (IMF)

• fixed exchange rates stopped competitive
devaluations and brought stability to the world trade
environment
• fixed exchange rates imposed monetary discipline on
countries, limiting price inflation
• in cases of fundamental disequilibrium, devaluations
were permitted
• the IMF lent foreign currencies to members during
short periods of balance-of-payments deficit, when a
rapid tightening of monetary or fiscal policy would
hurt domestic employment

11-12
 What Institutions Were
Established At Bretton Woods?

2. The World Bank

• Countries can borrow from the World Bank in two
ways
1. Under the IBRD scheme, money is raised through
bond sales in the international capital market
• borrowers pay a market rate of interest - the bank's cost of funds plus a margin
for expenses.
2. Through the International Development Agency, an
arm of the bank created in 1960
• IDA loans go only to the poorest countries

11-13
 Why Did The Fixed Exchange
Rate System Collapse?

• Bretton Woods worked well until the late 1960s

• It collapsed when huge increases in welfare programs and
the Vietnam War were financed by increasing the money
supply and causing significant inflation
• other countries increased the value of their currencies
relative to the U.S. dollar in response to speculation the
dollar would be devalued
• However, because the system relied on an economically well
managed U.S., when the U.S. began to print money, run high
trade deficits, and experience high inflation, the system was
strained to the breaking point
• the U.S. dollar came under speculative attack

11-14
 What Was The
Jamaica Agreement?
• A new exchange rate system was established in
1976 at a meeting in Jamaica
• The rules that were agreed on then are still in place
today
• Under the Jamaican agreement
• floating rates were declared acceptable
• gold was abandoned as a reserve asset
• total annual IMF quotas - the amount member countries
contribute to the IMF - were increased to $41 billion –
today they are about $300 billion

11-15
 What Has Happened To Exchange
Rates Since 1973?

• Since 1973, exchange rates have been more volatile and less
predictable than they were between 1945 and 1973 because of
• the 1971 and 1979 oil crises
• the loss of confidence in the dollar after U.S. inflation in 1977-78
• the rise in the dollar between 1980 and 1985
• the partial collapse of the EMS in 1992
• the 1997 Asian currency crisis
• the decline in the dollar from 2001 to 2009

11-16
 What Has Happened To
Exchange Rates Since 1973?
Major Currencies Dollar Index, 1973-2010

11-17
 Which Is Better – Fixed
Rates Or Floating Rates?
• Floating exchange rates provide
1. Monetary policy autonomy
• removing the obligation to maintain exchange rate
parity restores monetary control to a government
2. Automatic trade balance adjustments
• under Bretton Woods, if a country developed a
permanent deficit in its balance of trade that could
not be corrected by domestic policy, the IMF would
have to agree to a currency devaluation

11-18
 Which Is Better – Fixed Rates
Or Floating Rates?
• But, a fixed exchange rate system
1. Provides monetary discipline
• ensures that governments do not expand their money supplies at
inflationary rates
2. Minimizes speculation
• causes uncertainty
3. Reduces uncertainty
• promotes growth of international trade and investment

11-19
 Who Is Right?
• There is no real agreement as to which system is better
• We know that a Bretton Woods-style fixed exchange rate regime will
not work
• But a different kind of fixed exchange rate system might be more
enduring
• could encourage stability that would facilitate more rapid growth in
international trade and investment

11-20
 What Type of Exchange Rate
System Is In Practice Today?
• Various exchange rate regimes are followed today
• 14% of IMF members follow a free float policy
• 26% of IMF members follow a managed float system
• 22% of IMF members have no legal tender of their own
• ex. Euro Zone countries
• the remaining countries use less flexible systems such as
pegged arrangements, or adjustable pegs

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 What Type of Exchange Rate
System Is In Practice Today?
Exchange Rate Policies of IMF Members

11-22
 What Is A Pegged Rate System?

• A country following a pegged exchange rate system pegs the value of

its currency to that of another major currency
• popular among the world’s smaller nations
• imposes monetary discipline and leads to low inflation
• adopting a pegged exchange rate regime can moderate inflationary pressures
in a country

11-23
 What Is A Currency Board?

• Countries using a currency board commit to converting their

domestic currency on demand into another currency at a fixed
exchange rate
• the currency board holds reserves of foreign currency equal at the fixed
exchange rate to at least 100% of the domestic currency issued
• the currency board can issue additional domestic notes and coins only when
there are foreign exchange reserves to back them

11-24
 What Is The Role
Of The IMF Today?
• Today, the IMF focuses on lending money to countries in financial
crisis
• There are three main types of financial crises:
1. Currency crisis
2. Banking crisis
3. Foreign debt crisis

11-25
 What Is The Role
Of The IMF Today?
• A currency crisis
• occurs when a speculative attack on the exchange value of a currency results
in a sharp depreciation in the value of the currency, or forces authorities to
expend large volumes of international currency reserves and sharply increase
interest rates in order to defend prevailing exchange rates
• Brazil 2002

11-26
 What Is The Role
Of The IMF Today?
• A banking crisis refers to a situation in which a loss
of confidence in the banking system leads to a run
on the banks, as individuals and companies
withdraw their deposits
• A foreign debt crisis is a situation in which a country
cannot service its foreign debt obligations, whether
private sector or government debt
• Greece and Ireland 2010

11-27
 What Was The Mexican
Currency Crisis Of 1995?
• The Mexican currency crisis of 1995 was a result of
• high Mexican debts
• a pegged exchange rate that did not allow for a natural adjustment of prices
• To keep Mexico from defaulting on its debt, the IMF created a $50
billion aid package
• required tight monetary policy and cuts in public spending

11-28
 What Was The
Asian Currency Crisis?
• The 1997 Southeast Asian financial crisis was
caused by events that took place in the previous
decade including
1. An investment boom - fueled by huge increases in
exports
2. Excess capacity - investments were based on
projections of future demand conditions
3. High debt - investments were supported by dollar-
based debts
4. Expanding imports – caused current account deficits

11-29
 What Was The
Asian Currency Crisis?
• By mid-1997, several key Thai financial institutions
were on the verge of default
• speculation against the baht
• Thailand abandoned the baht peg and allowed the
currency to float
• The IMF provided a $17 billion bailout loan package
• required higher taxes, public spending cuts, privatization
of state-owned businesses, and higher interest rates

11-30
 What Was The
Asian Currency Crisis?
• Speculation caused other Asian currencies including
the Malaysian Ringgit, the Indonesian Rupaih and
the Singapore Dollar to fall
• These devaluations were mainly driven by
• excess investment and high borrowings, much of it in
dollar denominated debt
• a deteriorating balance of payments position

11-31
 What Was The
Asian Currency Crisis?
• The IMF provided a $37 billion aid package for
Indonesia
• required public spending cuts, closure of troubled banks,
a balanced budget, and an end to crony capitalism
• The IMF provided a $55 billion aid package to South
Korea
• required a more open banking system and economy, and
restraint by chaebol

11-32
 How Has The IMF Done?
• By 2010, the IMF was committing loans to 68
countries in economic and currency crisis
• All IMF loan packages require tight macroeconomic
and monetary policy
• However, critics worry
• the “one-size-fits-all” approach to macroeconomic policy
is inappropriate for many countries
• the IMF is exacerbating moral hazard - when people
behave recklessly because they know they will be saved if
things go wrong
• the IMF has become too powerful for an institution
without any real mechanism for accountability

11-33
 How Has The IMF Done?
• But, as with many debates about international
economics, it is not clear who is right
• However, in recent years, the IMF has started to
change its policies and be more flexible
• urged countries to adopt fiscal stimulus and monetary
easing policies in response to the 2008-2009 global
financial crisis

11-34
 What Does The Monetary
System Mean For Managers?

• Managers need to understand how the

international monetary system affects
1. Currency management - the current system is a
managed float - government intervention can
influence exchange rates
• speculation can also create volatile movements in
exchange rates

11-35
 What Does The Monetary
System Mean For Managers?

2. Business strategy - exchange rate movements

can have a major impact on the competitive
position of businesses
• need strategic flexibility
3. Corporate-government relations - businesses can
influence government policy towards the
international monetary system
• companies should promote a system that facilitates
international growth and development

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