History of the International Monetary System

The international monetary system establishes the rules by which countries value

and exchange their currencies. It also provides a mechanism for correcting

imbalances between a country’s international payments and its receipts. Further,

the cost of converting foreign money into firm’s home currency-a variable critical to

the profitability of international operations depends on the smooth functioning of

the international monetary system.

The history of monetary system started when in ancient time (seventh century

B.C.1) tribes & city-states of India, Babylon & Phoenicia used gold & silver as media

of exchange in trade. The total history of international monetary system is discussed

below in a chronological order.

1.

The Gold Standard, 1876-1913

The gold standard created a fixed exchange rate system. Countries set par value for

their currency in terms of gold. This came to be known as the gold standard and gained

acceptance in Western Europe in the 1870s.The US adopted the gold standard in

1879.The “rules of the game” for the gold standard were simple

• Example: US$ gold rate was $20.67/oz, the British pound was

pegged at £4.2474/oz

• US$/£ rate calculation is $20.67/£4.2472 = $4.8665/£

Because governments agreed to buy/sell gold on demand with anyone at its own fixed

parity rate, the value of each currency in terms of gold, the exchange rates were therefore

fixed. Countries had to maintain adequate gold reserves to back its currency’s value in

order for regime to function. The gold standard worked until the outbreak of World War

I, which interrupted trade flows and free movement of gold thus forcing major nations to

suspend operation of the gold standard

The Gold Standard variously specified how the gold backing would be implemented,

including the amount of specie per currency unit. The currency itself is just paper

and so has no innate value, but is accepted by traders because it can be redeemed

any time for the equivalent specie. A US silver certificate, for example, could be

redeemed for an actual piece of silver5.

Starling-Based Gold Standard: From 1821 until the end of 1918, the most

important currency in international commerce was the British pound sterling

because of the United Kingdom’s large territory due to dominant economic and

military power. So, most of the people relayed on pound that time. As a result

international monetary system during this period is also called starling-based gold

standard. Because of the international trust London became a dominant

international center in the 19th century, a position it still holds8.

World War I: During World War 1, the sterling-based gold standard unraveled.

With the outbreak of war, normal commercial transactions between the Allies

(France, Russia, and the United Kingdom) and the Central Powers (Austria-Hungary,

Germany, and the Ottoman Empire) ceased. The economic pressures of war caused

country after country to suspend their pledges to buy or sell gold at their currencies'

par values.

Example of the Gold Standard

Consider a world with two countries denoted A and B and Suppose that Country A

runs a balance of trade surplus, i.e. its exports exceed its imports. Country A exports

goods and imports gold. Its money supply increases, which increases the price of its

goods and services.

The reverse occurs in B

The increase in A’s prices and the decrease B’s prices will eventually correct the

trade imbalance.

The Inter War Year and World War II, 1914-1944

During World War I, currencies were allowed to fluctuate over wide ranges in terms of

gold and each other, theoretically, supply and demand for imports/exports caused

moderate changes in an exchange rate about an equilibrium value. The gold standard has

a similar function. In 1934, the US devalued its currency to $35/oz from $20.67/oz prior

to World War I. From 1924 to the end of World War II exchange rates were theoretically

determined by each currency's value in terms of gold. During World War II and

aftermath, many main currencies lost their convertibility. The US dollar remained the

only major trading currency that was convertible

Competitive Devaluation of Currencies & Increased Tariff Rate: After the United

Kingdom abandoned the gold standard, a "sterling area” emerged as some countries,

Primarily members of the British Commonwealth, pegged their currencies to the

Pound and relied on sterling balances held in London as their international

Reserves. Other countries tied the value of their currencies to the U.S. dollar or the

French franc. Some countries (United States, France, United Kingdom, Belgium,

Latvia, the Netherlands, Switzerland & Italy) were deliberately & artificially

devaluating their official value of currencies to make their goods cheaper in the

international markets, which is stimulating its exports and reducing its imports. But,

none were getting the benefit due to competitive devaluation at almost same

percentage that is each currency's value relative to the other remains the same.

Most countries also raised the tariffs they imposed on imported goods in the hope of

protecting domestic jobs in import-competing industries. Nations adversely affected

by trade barriers of any kind are quite likely to impose retaliatory or reciprocal

tariffs.

Effect of beggar-thy-neighbor policies (World War II): As more and more

countries adopted beggar-thy-neighbor policies like devaluation of currencies and

increasing the tariff rate on imported goods, international trade contracted that hurt

employment in each country's export industries. More ominously, this international

economic conflict was soon replaced by international military conflict that was the

outbreak of World War II in 1939.3.

Bretton Woods and the International Monetary Fund, 1944

Allied powers met in Bretton Woods, NH and created a post-war international monetary

system. The agreement established a US dollar based monetary system and created the

IMF and World Bank.Under original provisions, all countries fixed their currencies in

terms of gold but were not required to exchange their currencies.Only the US dollar

remained convertible into gold (at $35/oz with Central banks, not individuals).Therefore,

each country established its exchange rate vis-à-vis the US dollar and then calculated the

gold par value of their currency.Participating countries agreed to try to maintain the

currency values within 1% of par by buying or selling foreign or gold

reserves.Devaluation was not to be used as a competitive trade policy, but if a currency

became too weak to defend, up to a 10% devaluation was allowed without formal

approval from the IMF

Post-War Situation: World War II created inflation, unemployment and an instable

political situation. Every country was struggling to rebuild their war-torn economy.

Bretton Woods Conference: Not to repeat the mistakes that had caused World War

II, to promote worldwide peace & prosperity and to construct the post war

international monetary system representatives of 44 countries met at a resort in

Bretton Woods, New Hampshire in 1944.

Decisions & Outcome of the Bretton Woods Conference: The Bretton Woods

Conference has presented the world two historic agreements. These are as follows:

A. Agreement of conferees to renew the gold standard on a modified basis.

B. Agreement to create two new international organizations to assist the rebuilding

of the world economy and the international monetary system. These area.

International Bank for Reconstruction and Development (IBRD)

b. International Monetary Fund (IMF)

Fixed Exchange Rates, 1945-1973

Bretton Woods and IMF worked well post World War II, but diverging fiscal and

monetary policies and external shocks caused the system’s demise. The US dollar

remained the key to the web of exchange rates heavy capital outflows of dollars became

required to meet investors’ and deficit needs and eventually this overhang of dollars held

by foreigners created a lack of confidence in the US’ ability to meet its obligations

The IMF today is composed of national currencies, artificial currencies (such as the

SDR), and one entirely new currency (Euro).All of these currencies are linked to one

another via a “smorgasbord” of currency regimes , countries would prefer fixed exchange

rates. Fixed rates provide stability in international prices for the conduct of trade. Fixed

exchange rates are inherently anti-inflationary, requiring the country to follow restrictive

monetary and fiscal policies. Fixed exchange rates regimes necessitate that central banks

maintain large quantities of international reserves for use in occasional defense of fixed

rate. Fixed rates, once in place, may be maintained at rates that are inconsistent with

economic fundamentals. The US$ was the main reserve currency held by central banks.

Persistent deficits in the U.S. balance of payments had to be financed by heavy capital outflows of dollars. Foreigners, having accumulated huge reserves of US$, eventually lost confidence in the ability of the U.S. to convert dollars to gold.