TOPIC 2: THE INTERNATIONAL MONETARY SYSTEM (IMS)
2.1: AN OVERVIEW OF THE EVOLUTION OF MODERN INTERNATIONAL MONETARY SYSTEM
MNCs operate in a global market, buying/selling/producing in many different countries. For example, GM
sells cars in 150 countries, produces cars in 50 countries, so it has to deal with hundreds of currencies.
The international monetary system which prevails today has evolved over a period of more than 150 years. In
the process of evolution, several monetary systems came into existence, which either collapsed due to their
inherent weakness or were modified to cope with the changing international economic order.
International Monetary System - is Institutional framework within which:
1. International payments are made
2. Movements of capital are accommodated
3. Ex-rates are determined
An international monetary system is required to facilitate international trade, business, travel, investment,
foreign aid, etc. For domestic economy, we would study Money and Banking to understand the domestic
institutional framework of money, monetary policy, central banking, commercial banking, check-clearing, etc.
To understand the flow of international capital/currency we study the IMS. IMS - complex system of
international arrangements, rules, institutions, policies in regard to ex-rates, international payments, capital
flows. IMS has evolved over time as international trade, finance, and business have changed, as technology
has improved, as political dynamics change, etc. Example: evolution of the European Union and the Euro
currency impacts the IMS.
Simply, the international monetary system refers primarily to the set of policies, institutions, practices,
regulations and mechanisms that determine the rate at which one currency is exchanged for another.
2.1.1: BIMETALLISM (pre-1875)
Commodity money system using both silver and gold (precious metals) for int'l payments (and for domestic
currency). Why silver and gold? (Intrinsic Value, Portable, Recognizable, Homogenous/Divisible,
Durable/Non-perishable). Why two metals and not one (silver standard or gold standard vs. bimetallism)?
Some countries' currencies in certain periods were on either the gold standard (British pound) or the silver
standard (German DM) and some on a bimetallic (French franc). Pound/Franc exchange rate was determined
by the gold content of the two currencies. Franc/DM was determined by the silver content of the two
currencies. Pound (gold) / DM (silver) rate was determined by their exchange rates against the Franc.
Under a bimetallic standard (or any time when more than one type of currency is acceptable for payment),
countries would experience "Gresham's Law" which is when "bad" money drives out "good" money.
The more desirable, superior form of money is hoarded and withdrawn from circulation, and people use the
inferior or bad money to make payments. The bad money circulates, the good money is hoarded. Under a
bimetallic standard the silver/gold ratio was fixed at a legal rate. When the market rate for silver/gold
differed substantially from the legal rate, one metal would be overvalued and one would be undervalued.
People would circulate the undervalued (bad) money and hoard the overvalued (good) money.
Examples: a) From 1837-1860 the legal silver/gold ratio was 16/1 and the market ratio was 15.5/1. One oz of
gold would trade for 15.5 oz. of silver in the market, but one oz of gold would trade for 16 oz of silver at the
, legal/official rate. Gold was overvalued at the legal rate, silver was undervalued. Gold circulated and silver
was hoarded (or not minted into coins), putting the US on what was effectively a gold standard.
b) Later on, France went from a bimetallic standard to effectively a gold standard after the discovery of gold
in US and Australia in the 1800s. The fixed legal ratio was out of line with the true market rate. Gold became
more abundant, lowering its scarcity/value, silver became more valuable. Only gold circulated as a medium of
exchange.
2.1.2: THE CLASSICAL GOLD STANDARD (1875-WWI).
For about 40 years most of the world was on an international gold standard, ended with First World War
(WWI) when most countries went off gold standard. London was the financial center of the world, most
advanced economy with the most international trade.
Classical Gold Standard is a monetary system in which a country's government allows its currency unit to be
freely converted into fixed amounts of gold and vice versa. The exchange rate under the gold standard
monetary system is determined by the economic difference for an ounce of gold between two currencies.
The gold standard was mainly used from 1875 to 1914 and also during the interwar years.
Gold Standard exists when most countries:
1. Use gold coins as the primary medium of exchange.
2. Have a fixed ex-rate between ounce of gold and currency.
3. Allow unrestricted gold flows - gold can be exported/imported freely.
4. Banknotes had to be backed with gold to assure full convertibility to gold.
5. Domestic money stock had to rise and fall with gold flows
The creation of the gold standard monetary system in 1875 marks one of the most important events in the
history of the foreign exchange market. Before the gold standard was implemented, countries would
commonly use gold and silver as means of international payment as explained earlier. The main issue with
using gold and silver for payment is that their value is affected by external supply and demand. For example,
the discovery of a new gold mine would drive gold prices down.
The underlying idea behind the gold standard was that governments guaranteed the conversion of currency
into a specific amount of gold, and vice versa. In other words, a currency would be backed by gold. Obviously,
governments needed a fairly substantial gold reserve in order to meet the demand for exchanges. During the
late nineteenth century, all of the major economic countries had defined an amount of currency to an ounce
of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange
rate for those two currencies. The use of the gold standard would mark the first use of formalized exchange
rates in history. However, the system was flawed because countries needed to hold large gold reserves in
order to keep up with the volatile nature of supply and demand for currency.
Under a gold standard, exchange rates would be kept in line by cross-country gold flows. Any mis-alignment
of ex-rates would be corrected by gold flows. Payments could in effect be made by either gold or banknotes.
If market exchange rates ever deviated from the official ex-rate, it would be cheaper to pay in gold than in
banknotes.
2.1: AN OVERVIEW OF THE EVOLUTION OF MODERN INTERNATIONAL MONETARY SYSTEM
MNCs operate in a global market, buying/selling/producing in many different countries. For example, GM
sells cars in 150 countries, produces cars in 50 countries, so it has to deal with hundreds of currencies.
The international monetary system which prevails today has evolved over a period of more than 150 years. In
the process of evolution, several monetary systems came into existence, which either collapsed due to their
inherent weakness or were modified to cope with the changing international economic order.
International Monetary System - is Institutional framework within which:
1. International payments are made
2. Movements of capital are accommodated
3. Ex-rates are determined
An international monetary system is required to facilitate international trade, business, travel, investment,
foreign aid, etc. For domestic economy, we would study Money and Banking to understand the domestic
institutional framework of money, monetary policy, central banking, commercial banking, check-clearing, etc.
To understand the flow of international capital/currency we study the IMS. IMS - complex system of
international arrangements, rules, institutions, policies in regard to ex-rates, international payments, capital
flows. IMS has evolved over time as international trade, finance, and business have changed, as technology
has improved, as political dynamics change, etc. Example: evolution of the European Union and the Euro
currency impacts the IMS.
Simply, the international monetary system refers primarily to the set of policies, institutions, practices,
regulations and mechanisms that determine the rate at which one currency is exchanged for another.
2.1.1: BIMETALLISM (pre-1875)
Commodity money system using both silver and gold (precious metals) for int'l payments (and for domestic
currency). Why silver and gold? (Intrinsic Value, Portable, Recognizable, Homogenous/Divisible,
Durable/Non-perishable). Why two metals and not one (silver standard or gold standard vs. bimetallism)?
Some countries' currencies in certain periods were on either the gold standard (British pound) or the silver
standard (German DM) and some on a bimetallic (French franc). Pound/Franc exchange rate was determined
by the gold content of the two currencies. Franc/DM was determined by the silver content of the two
currencies. Pound (gold) / DM (silver) rate was determined by their exchange rates against the Franc.
Under a bimetallic standard (or any time when more than one type of currency is acceptable for payment),
countries would experience "Gresham's Law" which is when "bad" money drives out "good" money.
The more desirable, superior form of money is hoarded and withdrawn from circulation, and people use the
inferior or bad money to make payments. The bad money circulates, the good money is hoarded. Under a
bimetallic standard the silver/gold ratio was fixed at a legal rate. When the market rate for silver/gold
differed substantially from the legal rate, one metal would be overvalued and one would be undervalued.
People would circulate the undervalued (bad) money and hoard the overvalued (good) money.
Examples: a) From 1837-1860 the legal silver/gold ratio was 16/1 and the market ratio was 15.5/1. One oz of
gold would trade for 15.5 oz. of silver in the market, but one oz of gold would trade for 16 oz of silver at the
, legal/official rate. Gold was overvalued at the legal rate, silver was undervalued. Gold circulated and silver
was hoarded (or not minted into coins), putting the US on what was effectively a gold standard.
b) Later on, France went from a bimetallic standard to effectively a gold standard after the discovery of gold
in US and Australia in the 1800s. The fixed legal ratio was out of line with the true market rate. Gold became
more abundant, lowering its scarcity/value, silver became more valuable. Only gold circulated as a medium of
exchange.
2.1.2: THE CLASSICAL GOLD STANDARD (1875-WWI).
For about 40 years most of the world was on an international gold standard, ended with First World War
(WWI) when most countries went off gold standard. London was the financial center of the world, most
advanced economy with the most international trade.
Classical Gold Standard is a monetary system in which a country's government allows its currency unit to be
freely converted into fixed amounts of gold and vice versa. The exchange rate under the gold standard
monetary system is determined by the economic difference for an ounce of gold between two currencies.
The gold standard was mainly used from 1875 to 1914 and also during the interwar years.
Gold Standard exists when most countries:
1. Use gold coins as the primary medium of exchange.
2. Have a fixed ex-rate between ounce of gold and currency.
3. Allow unrestricted gold flows - gold can be exported/imported freely.
4. Banknotes had to be backed with gold to assure full convertibility to gold.
5. Domestic money stock had to rise and fall with gold flows
The creation of the gold standard monetary system in 1875 marks one of the most important events in the
history of the foreign exchange market. Before the gold standard was implemented, countries would
commonly use gold and silver as means of international payment as explained earlier. The main issue with
using gold and silver for payment is that their value is affected by external supply and demand. For example,
the discovery of a new gold mine would drive gold prices down.
The underlying idea behind the gold standard was that governments guaranteed the conversion of currency
into a specific amount of gold, and vice versa. In other words, a currency would be backed by gold. Obviously,
governments needed a fairly substantial gold reserve in order to meet the demand for exchanges. During the
late nineteenth century, all of the major economic countries had defined an amount of currency to an ounce
of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange
rate for those two currencies. The use of the gold standard would mark the first use of formalized exchange
rates in history. However, the system was flawed because countries needed to hold large gold reserves in
order to keep up with the volatile nature of supply and demand for currency.
Under a gold standard, exchange rates would be kept in line by cross-country gold flows. Any mis-alignment
of ex-rates would be corrected by gold flows. Payments could in effect be made by either gold or banknotes.
If market exchange rates ever deviated from the official ex-rate, it would be cheaper to pay in gold than in
banknotes.
