A Primer on International Monetary Systems
"neither a state nor a bank ever has had unrestricted power of issuing paper money, without abusing that power; in all States, therefore, the issue of paper money ought to be under some check and control; and none seems so proper as that of subjecting the issuers of paper money to the obligation of paying their notes, either in gold coin or bullion." 

Just as an efficient capital market and a stable money supply is at the core of every advanced, industrial economy, a precondition for the widespread expansion of international transactions is the development of a stable international financial system. The key role of the international capital market in the economy, and its interrelationship with the other important aggregate markets, is evident in the circular flow diagram. Individuals and firms come to the international capital market to finance their purchases of foreign goods, services and assets. For example, you would need access to an international capital market to buy a SONY VCR produced in Asia, stock in BMW, land in France, or a home on Mykonos in the Greek islands. Similarly, a Japanese investor buying MGM stock, a German investor buying US government securities, or a Hong Kong business buying a Microsoft Excel program would also need access to the international capital market.  In all instances there would be a need to convert one currency into another - convert dollars into marks when Americans buy a German BMW or yen into US dollars when Japanese investors buy MGM stock.  It is the international financial system that facilitates the flow of funds between buyers and sellers of the various markets and stimulates international exchange.

At the center of the international financial system is the international monetary system that will provide for an international money, something which can be used as a medium of exchange and store of value. What differentiates the domestic from the international markets is that the international transactions involve multiple currencies.  There are three requirements that must be satisfied by any international monetary arrangements_{. (Williamson and Milner)}  First, there must be an exchange rate regime to determine the relative prices of individual currencies. How many Japanese yen will be needed to buy one US dollar? The international monetary system must supply an answer to this question.

Second, there must be a reserve regime defining the assets which will be transferred when there is an imbalance. What happens if the US imports more from Asia than it exports to the region?  What are the Asians going to receive in exchange for the trade imbalance?  The international monetary system must supply an answer to this question.

Third, there must be an adjustment obligation defining what actions will be taken to correct persistent imbalances and who should initiate the actions. What happens if the US continues to run the trade deficits?  There needs to be a mechanism that corrects this imbalance. 

Gold Standard

We will pick up our story of the evolution of the international monetary system in the last few decades of the 19th century. By that time the gold standard had emerged as the international monetary standard. The beauty of the gold standard was its simplicity. Each country established a gold price for its currency, what we would call an exchange rate. For example, an ounce of gold could be purchased for 35 US $s or 17.5 English £s. If you happened to find yourself with $35, you could turn it back to the US government and receive an ounce of gold for it. You could also exchange the 35 US dollars for 17.5 English £s, so the exchange rate was 2 dollars per £ (or 1/2 £ per dollar).

The gold standard was thought to have one additional advantage. The ability on the part of the holders of any currency to convert their currency into gold was viewed as a constraint on the government's ability to print money. As you could see in the opening quote by David Ricardo, there was a well placed fear that governments had a tendency to oversupply money when they were given any control over the printing presses.  We saw governments' abuse the power of manufacturing money in Germany in the 1930s, Yugoslavia in the 1990s, in Rome during the height of the Roman Empire's power, and in other situations too numerous to mention.   In the section on money we will briefly examine the evolution of money and monetary systems.

The gold standard provided a built-in constraint on the behavior of policy makers. If monetary authorities printed too much money, then prices in the country would rise, making imports more attractive and exports less attractive. The situation is described in the diagram below.  Let's assume a country is currently running a trade surplus.  The resulting trade imbalance would generate a net inflow of gold into the country which would, because of the direct link between the supply of gold and the supply of money, bring about an increase in the money supply. The increase in the money supply would translate into higher prices as people tried to spend the new dollars.  The higher prices would make the goods more expensive, which would lower the level of exports and raise the level of import spending.  The final result would be a reduction of the trade surplus - a process that would continue until the trade surplus was eliminated. 

In emergencies, countries would periodically be forced off the gold standard, most often as a result of financing a war. This was certainly the case during WW I.  After the war there was an attempt to return to return to the old standard, led by Great Britain's return in 1925, but the system rapidly unwound after the Crash of 1929. Capital exports from the US to Germany virtually ceased, as did US imports from Europe as a result of the depression and the Smoot-Hawley tariff of 1930. The decline in capital inflows prompted Germany to end reparation payments which upset the European financial system.  England finally devalued the pound in 1931, and the dollar was devalued in 1933-34. The world had entered a period of 'beggar-thy-neighbor' policies as countries attempted to use commercial policies, exchange controls, and devaluations to improve their individual situations.

Bretton Woods

To avoid a continuation of the chaos of the 1930s a new international financial order needed to be established? In an effort to create a new monetary system to facilitate the growth of international exchange once the war was over, the US and England entered into negotiations soon after America's entry into WW II in 1941. Based on the successes of these preliminary negotiations, a meeting for all the allies was convened in July 1944 in Bretton Woods, New Hampshire.  What emerged from the meeting were the outlines of a new monetary system - the Bretton Woods system. The gold standard was dead. There was simply not enough gold to finance world economic growth and back the world's currencies that had been inflated during the war. The gold standard was to be replaced by the dollar standard, a result undoubtedly of the fact the US emerged from WW II with nearly 75 percent of the world's gold supply. England, led by Keynes, had wanted the establishment of an international central bank with the authority to force changes in domestic policies to move toward international balance.  This was unacceptable to the US, however, as policy makers worried about the loss of control of their domestic policies. Exchange rates were to be fixed within a + / - margin of 1 percent and the par values of the currencies were to be expressed in terms of gold.  More importantly, dollars were to be accepted as a medium of exchange for international transactions and as international reserves. If France had a balance of payments surplus with Germany, then the Germans could pay for the imbalance by using US US $s accepted as means of payment.

Out of the Bretton Woods meeting also emerged a quasi-international central bank, the International Monetary Fund (IMF). The IMF was established to help provide discipline in international transactions and to provide loans to countries experiencing balance of payments problems. The system lacked any explicit adjustment mechanism, although there was certainly an implicit set of principles. A temporary imbalance should be financed, a small persistent imbalance should be addressed with monetary and fiscal policies if this did not involve internal 'hardship', and devaluation was to be used as a last resort if the imbalance was large and persistent. Destabilizing capital flows, meanwhile, could be controlled by controls on the flow of money.

There were, however, some fundamental problems with the Bretton Woods system which began to emerge in the 1960s.  Robert Triffin was one of the first to point out the logical inconsistency in the system.  Knowing full well the mathematics of the quantity theory of money, he knew the expansion of world trade was possible only if there was an expansion of the world money supply. Because the world money supply was tied to US $s, this could only happen if the US ran deficits to provide the world with $s. A trade deficit would result in an outflow of dollars that would expand the world money supply and facilitate desired increases in international trade.  The problem was at some point the flood of dollars would raise questions about the US's commitment to sustain their exchange rate at $35 an ounce. At some point there would be more dollars in circulation in the world than there was gold to back the dollars.  Either there would be a liquidity problem as the US reduced its trade deficit to reduce the number of dollars circulating in the world, or a confidence problem if the US deficits continued to mount and too many dollars circulated. There was also an adjustment problem. With countries committed to full employment and devaluation ruled out in all but the most critical cases, there was no real mechanism to correct trade imbalances.

The weaknesses of the system became apparent in the 1960s. During this period the US continued to run large trade surpluses, but now the foreign grants and investments more than offset the trade surplus so dollars began to accumulate outside of the US.  The system finally began to unravel in 1967 when the £ was devalued after repeated assurances that it would not happen. In the next few years there were a series of speculative crises which eventually led to a run on the dollar. In the twenty years ending in 1970, the value of US gold reserves had fallen from $25 billion to $10 billion, while the dollar claims against the US dollar had risen from $5 billion to $70 billion. Anyone with a minimal amount of mathematical reasoning can see the potential problem, the US would soon run out of gold if a widespread effort was taken to convert dollars into gold. This possibility of a run on gold was abruptly halted on August 15, 1971 when Richard Nixon ended convertibility of the dollar. The Bretton Woods system was now all but finished, but what was to replace it?  A debate on the outlines of a new system had already been underway for a number of years.

In fact, there had already been action on some of the policy proposals. At an annual meeting of the IMF in 1967, a new reserve asset was created, the SDR (Special Drawing Rights). The first SDRs were distributed in 1970 by simply being credited to the accounts of the member countries in proportion to their quota. Their value was initially set at 1/35th of an ounce of gold and then in 1974 they were revalued as a market basket of 16 currencies. The SDRs were to be sold by deficit countries to strong currency countries in exchange for foreign currencies which could be used for intervention.

What finally emerged was a non system legalized by the IMF in January 1976. The IMF Articles would now allow countries to either float or peg their currencies. Since that time a number of countries have pegged their currencies to the dollar, some have pegged their currency to a basket of currencies, and some, including the US, have allowed their currency to float.

Flexible exchange rate system

The first two solutions relied heavily on the Visible Hand of government to regulate prices and force the appropriate adjustments.  It should come as no surprise there was also a system based on the "Invisible Hand" of the market system.  At the heart of the new system is a 'model' explaining exchange rates movements in terms of shifts in supply and demand for the currency.  We have all been conditioned to know instinctively that a decline in price can be caused by either an increase in supply or a decrease in demand.  All we need to understand the basics of the flexible exchange rate system is translate it into this supply-demand model of prices.

First, however, we need the ground rules.

• the price of the dollar, what some would refer to as the value of dollar or the exchange rate, is the number of units of a foreign currency needed to buy a dollar (ex. 97 ¥ per US $).
• people want to be paid in their domestic currency.  German workers want to be paid in German marks while the US government will want US dollars when it sells Treasury securities to English investors.
• the exchange rate is set in the international money market, something very much akin to the US stock market.  In that market there are buyers and sellers of currencies and the exchange rate is determined by the interaction of the buyers and sellers.  People will need to come to the international money market when they are involved in an international transaction.
• demand for dollars is generated every time someone anywhere in the world wants to buy US goods, services or US assets. To pay for the export of US rice to Japan in 1997 Japanese consumers needed to convert their ¥  into $s to pay the US farmers producing the rice.  These foreign buyers will need to go to the international money market and demand (buy) US $s to pay their bills for the rice and mortgages.
• supply of dollars is generated every time someone in the US tries to buy goods, services and assets from abroad.  When Americans buy Japanese cameras they will need to convert their $s for Japanese ¥ so workers that produced the camera can be paid in yen.  The America consumers will need to go to the international money market where they will supply US dollars to the money market. 

The supply - demand model presented graphically below should look very familiar to anyone who has seen a supply-demand model.  All that we will do now is make a few modifications in the traditional model and we will have a model of exchange rates.

Exchange Rate

We will begin with the questions: why do the curves have the familiar slopes?  Why is the demand curve downward sloping and the supply curve upward sloping?  A simple example will help.  Let's assume that there is a $1,000 computer produced in the US and a 50f bottle of French wine.  What will these goods cost if they are exported?  The prices of the goods in each country when the exchange rate is 5f per $ are presented in the table below.  At this exchange rate the computer costs 5,000f in France and the wine costs $10 in the US. 

Prices at exchange rate of 5f per $

What happens when the exchange rate falls - a movement that is called either a depreciation or devaluation.  The table below has prices when the exchange rate has fallen to 2f per $.  It now costs fewer francs to buy a US dollar so we would say the dollar has depreciated.  At this exchange rate the computer costs 2,000f and the wine costs $25 in the importing country.  If you assume demand is downward sloping for the two goods, then you should expect the higher price for the wine in the US to lower demand for wine.  If we have lower demand for wine then we will have fewer people supplying US $s to exchange them for French francs.  The decrease in the price of the dollar generates a decrease in supply of dollars - the price of dollars and the supply of dollars tend to move in the same direction.  This positive relationship is reflected in the positively sloped supply curve.

Prices at exchange rate of 2f per $

As the exchange rate falls, we also find the price of the computer in France has fallen which should result in increased demand for computers.  The increased demand for imported computers should increase demand for dollars as more foreigners convert their currency to US $s to buy the computers.  In this case we see the decrease in the exchange rate creating additional demand for US $s and thus we have a negative relationship between the price of a dollar and demand for dollars.  This is why we have a negatively sloped demand curve in the diagram.

Now we were ready for the our theory of exchange rates. We know that in the spring many students head to Cancun, Mexico for their spring break.  Before leaving for break, these students have to 'buy' pesos which they use while in Cancun to pay for their hotels, restaurant, and bar bills.  Many will have 'bought' the pesos at their local bank with dollars their bank will then take to the international money market.  At the market the local bank will sell the dollars in order to buy the pesos needed by the students. But as we saw above, any decrease in the demand, or increase in the supply of dollars, will drive down the price of the dollars.  In this case the increase in supply would be reflected in an outward shift in the supply curve, and the price of the dollar would drop. 

It should come as no surprise, however, that this is not the only 'theory' of the dollar's decline to have paraded before the American people in recent years.  A few of the alternatives that have been proposed at various times over the years are listed below, but as we will see, they are variations on the same theme.

• Deterioration in the balance of trade deficit: to pay for the increase in imports that produces the trade deficit, Americans must sell dollars to buy the foreign currency necessary to pay for their imports. [supply curve shifts out]
• Rapid growth in foreign stock markets: US investors, seeking the highest rate of return on their money, are increasing their supply of dollars to purchase foreign currency which they need to finance their purchase of stock on foreign stock exchanges. [supply curve shifts out]
• Low interest rates in the US: foreign investors, seeking the highest rate of return on their money, are not buying US government securities and buying foreign securities which generates a decrease in the demand for US dollars. [demand curve shifts in]
• Kobe earthquake: demand for dollars by Japanese investors to buy US assets will decline as some of the investors decide to use their funds to help rebuild Kobe rather than buy US government securities [demand curve shifts in].
• Loss in 'confidence' in the dollar: demand for dollars in the post W.W.II era remained high as foreign investors and central bankers preferred to hold their cash as dollars, but the rise of new economic super powers Japan and Germany has prompted both investors and central bankers to diversify their cash portfolio by selling their dollars to buy Japanese yen and German marks. [demand curve shifts in].

The result of the move to flexible exchange rates can be seen in the diagram below.  Since the US $ was allowed to float in 1971, its price has changed rather sharply.  The trade-weighted index is the average value of the dollar when weighed against the currencies of the countries that the US trades with.   By the early 1980s the dollar had lost about one-third of its value (120 to 80) and then nearly doubled by 1985 (80 to 160). 

Before leaving our discussion of the flexible exchange rate system, let's look at the exchange rate of Thailand's bhat.  This was the first currency to be hit by the Asian crises and the exchange rate graph demonstrates quite clearly the magnitude of the crash.  It also points out one of the advantages of the fixed exchange rate system - these wide fluctuations would be avoided.  Before the bhat was allowed to float freely in mid 1997, its value was pegged to the dollar so that there was very little variation in the value of the bhat.  Any contracts made in 1990 could have been made in bhats or dollars and there would have been little difference by early 1997.  By late 1997, however, the situation changed dramatically as the bhat dropped sharply.  [The exchange rate is expressed in terms of dollars so a strengthening of the US dollar means a weakening of Thailand's bhat]  Virtually overnight the value of the bhat dropped by nearly 50 percent - where it once took 25 bhat to buy one US dollar, it now took 55 bhat to buy one US dollar.  Those Thai businesses and individuals with debt denominated in dollars - they owed people loans in dollars - found that the size of their debt doubled. This is what drove many into bankruptcy and raised again the question of the costs and benefits of flexible exchange rates.   

 The future

Where do we go from here?  There are many possibilities and we will revisit this issue in our discussion of the 1990s.  What we can expect is to see movements in a number of directions. One direction will be to free up some exchange rates - this is what Thailand did in the aftermath of the Asian currency crisis.  Others have moved to control the international flow of currency - Malaysia being the best example.  And then there is the movement to fixed exchange rates - the direction in which Europe is moving.  In the midst of the move toward floating exchange rates, Europe is returning to a more formal fixed-exchange rate regime. For the US, at least, it seems reasonably certain that the current floating exchange rate regime will be retained.