Global Monetary

System
Prof. Dhaval Bhatt
Session No: 05
  Introduction to Global Monetary System
 History of Monetary System
 Classical Gold Standards (Bimetallism) – 1850 to 1914
Session 

Interwar (Gold Standards) – 1918 to 1939
Bretton Woods System – 1944 to 1971
Outline  Current System (1971 – Present)
 Exchange Rate Mechanisms
 Fixed Exchange Rate
 Floating Exchange Rate
  Global monetary systems are sets of internationally agreed rules,
conventions and supporting institutions, that facilitate
Global international trade, cross border investment and generally there
allocation of capital between nation states.
Monetary  International monetary system refers to the system prevailing in
System world foreign exchange markets through which international
trade and capital movement are financed and exchange rates are
determined.
 Global  The International Monetary System is part of the institutional
Monetary framework that binds national economies, such a system permits
producers to specialize in those goods for which they have a
System comparative advantage, and serves to seek profitable investment
opportunities on a global basis.
(contd…)
  22nd June 1816, Great Britain declared the gold currency as official
national currency (Lord Liverpool’s Act). On 1st May 1821 the
convertibility of Pound Sterling into gold was legally guaranteed.
 Other countries pegged their currencies to the British Pound,
Classic Gold which made it a reserve currency. This happened while the British
more and more dominated international finance and trade
Standards relations.
 At the end of the 19th century, the Pound was used for two thirds
of world trade and most foreign exchange reserves were held in
this currency.
  Between 1810 and 1833 the United States had de facto the silver
standard. In 1834 (Coinage Act of 1834), the government set the
Classic Gold gold-silver exchange rate to 16:1 which implemented a de facto
Standards gold standard.
 In 1879 the United States set the gold price to US$ 20,67 and
(Contd…) returned to the gold standard. With the “Gold Standard Act” of
1900, gold became an official instrument of payment.
  From the 1870s to the outbreak of World War I in 1914, the world
benefited from a well integrated financial order, sometimes
known as the First age of Globalization. Money unions were
Classic Gold operating which effectively allowed members to accept each
Standards other's currency as legal tender including the Latin Monetary
Union and Scandinavian monetary union.
(Contd…)  In the absence of shared membership of a union, transactions
were facilitated by widespread participation in the gold standard,
by both independent nations and their colonies
  Each country defined the value of its currency in terms of gold.
 Exchange rate between any two currencies was calculated as X
currency per ounce of gold/ Y currency per ounce of gold.
Rules of the  These exchange rates were set by arbitrage depending on the
system transportation costs of gold.
 Central banks are restricted in not being able to issue more
currency than gold reserves.
  The growth of output and the growth of gold supplies needs to be
closely linked. For example, if the supply of gold increased faster
than the supply of goods did there would be inflationary pressure.
Arguments Conversely, if output increased faster than supplies of gold did
against Gold there would be deflationary pressure.
 Volatility in the supply of gold could cause adverse shocks to the
Standard economy, rapid changes in the supply of gold would cause rapid
changes in the supply of money and cause wild fluctuations in
prices that could prove quite disruptive
 Arguments  In practice monetary authorities may not be forced to strictly tie
against Gold their hands in limiting the creation of money.

Standard  Countries with respectable monetary policy makers cannot use

monetary policy to fight domestic issues like unemployment.
(Contd…)
  The years between the world wars have been described as a
period of de-globalization, as both international trade and capital
flows shrank compared to the period before World War I. During
World War I countries had abandoned the gold standard and,
Interwar except for the United States.
Period  The onset of the World Wars saw the end of the gold standard as
countries, other than the U.S., stopped making their currencies
convertible and started printing money to pay for war related
expenses.
  After the war, with high rates of inflation and a large stock of
outstanding money, a return to the old gold standard was only
possible through a deep recession inducing monetary contraction
as practiced by the British after WW I.
Interwar  The focus shifted from external cooperation to internal
Period reconstruction and events like the Great Depression further
illustrated the breakdown of the international monetary system,
bringing such bad policy moves such as a deep monetary
contraction in the face of a recession.
  British and American policy makers began to plan the post war
international monetary system in the early 1940s.
 The objective was to create an order that combined the benefits of
Bretton an integrated and relatively liberal international system with the
freedom for governments to pursue domestic policies aimed at
Woods promoting full employment and social wellbeing.
 The principal architects of the new system, John Maynard Keynes
and Harry Dexter White
  In 1944, 44 countries met in New Hampshire
 Countries agreed to peg their currencies to US$ which was
convertible to gold at $35/oz.
Bretton  Agreed not to engage in competitive devaluations for trade
Woods purposes and defend their currencies.
 Weak currencies could be devalued up to 10% w/o approval.
 IMF and World Bank created.
  The features of the Bretton Woods system can be described as a
“gold-exchange” standard rather than a “gold-standard”. The key
difference was that the dollar was the only currency that was
Features of backed by and convertible into gold. (The rate initially was $35 an
ounce of gold).
Bretton  Other countries would have an “adjustable peg” basically, they
Woods were exchangeable at a fixed rate against the dollar, although the
rate could be readjusted at certain times under certain conditions.
System  The IMF was created with the specific goal of being the
multilateral body that monitored the implementation of the
Bretton Woods agreement.
  Each country was allowed to have a 1% band around which their
currency was allowed to fluctuate around the fixed rate. Except on
the rare occasions when the par value was allowed to be
Features of readjusted, countries would have to intervene to ensure that the
currency stayed in the required band.
Bretton  Its role was to hold gold reserves and currency reserves that were
Woods contributed by the member countries and then lend this money
out to other nations that had difficulty meeting their obligations
System under the agreement.
(contd…)  Currencies had to be convertible: central banks had to exchange
domestic currency for dollars upon request.
  The borrowing was classified into tranches, each with attached
Features of conditions that became progressively stricter. This enabled the IMF to
force countries to adjust excess fiscal deficits, tighten monetary policy
Bretton etc, and force them to be more consistent with their obligations under
the agreement.
Woods  Although the adjustable exchange rate system meant that countries
System that could no longer sustain the fixed exchange rate vis-a-vis the dollar
would be allowed to devalue their currencies, they could only do so
(contd…) with the consent of the other countries and the auspices of the IMF.
  In a world with N currencies there are only N-1 exchange rates against
the reserve currency. If all the countries in the world are fixing their
currencies against the reserve currency and acting to keep the rate
Features of fixed, then the reserve country has no need to intervene.

Bretton  Reserve currency country can use monetary policy for its own
domestic policy purposes while other countries are unable to use
Woods monetary policy for domestic policy purposes. Therefore a decrease
in the reserve country’s money supply would cause an appreciation of
System the reserve currency and force the other central banks to lose
external reserves.
(contd…)  So the reserve country can affect both the output in its country as
well as output in other countries through changes in its monetary
policy.
  In the early post-war period, the U.S. government had to provide
dollar reserves to all countries who wanted to intervene in their
currency markets. Lead to problem of lack of international
liquidity.

Fall of Bretton  The increasing supply of dollars worldwide, made available

through programs like the Marshall Plan, meant that the
Wood System credibility of the gold backing of the dollar was in question. U.S.
dollars held abroad grew rapidly and this represented a claim on
U.S. gold stocks and cast some doubt on the U.S.’s ability to
convert dollars into gold upon request.
  Domestic U.S. policies, such as the growing expenditure
associated with Vietnam resulted in more printing of dollars to
Fall of Bretton finance expenditure and forced foreign governments to run up
holdings of dollar reserves. Although they pursue this for a while a
Wood System few countries began to become growingly less keen on holding
dollars and more keen on holding gold.
(contd…)  In 1971, the U.S. government “closed the gold window” by decree
of President Nixon.
  The world moved from a gold standard to a dollar standard from
Bretton Woods to the Smithsonian Agreement. Growing increase
Fall of Bretton in the amount of dollars printed further eroded faith in the system
Wood System and the dollars role as a reserve currency.
 By 1973, the world had moved to search for a new financial
(contd…) system: one that no longer relied on a worldwide system of
pegged exchange rates.