International Monetary System

Introduction

The international monetary system facilitates economic transactions between countries through the use of national currencies. It provides a mechanism for setting currency exchange rates and enables cross-border flows related to trade, investment, and finance. An effective international monetary system is crucial for global economic growth and stability.

When the system functions smoothly, international trade and investment thrive. However, when it malfunctions or collapses, it can grind global economic activity to a halt. The international monetary system aims to mitigate risks and minimize disruptions that can ripple across borders.

At its core, the system exists to overcome the lack of globally accepted currencies. With countries using their own legal tender, exchanges are necessary to conduct business across borders. The prevailing exchange rates at any given time ultimately reflect the complex interactions between global supply and demand for currencies.

By establishing structures and guidelines for currency valuation and exchange, the international monetary system provides the foundation for international economic engagement. Its sound functioning facilitates cross-border transactions that increase global productivity and raise standards of living.

National Currencies and Exchanges

The international monetary system facilitates economic transactions and trade between countries with different national currencies. Unlike domestic transactions which use a single national currency, international transactions involve multiple currencies with fluctuating exchange rates.

For example, an exporter in Japan selling goods to the United States will be paid in US dollars, not Japanese yen. The exporter needs to convert the US dollars to yen to realize the value of the transaction in their home currency. This currency exchange allows international trade and investment to occur despite countries having unique legal tender currencies.

On a broader scale, the international monetary system provides a framework for currency valuation and exchangeability between nations. Without this system, cross-border economic activity would be severely hampered. The presence of multiple national currencies necessitates currency exchanges as part of international transactions. An effective international monetary system makes these exchanges orderly and straightforward.

Exchange Rates and Currency Fluctuations

Exchange rates play a critical role within the international monetary system. They represent the relative price of one currency in terms of another and fluctuate based on the supply and demand for currencies. This impacts both international trade and individuals in profound ways.

For international trade, exchange rates influence the prices of exports and imports. An appreciation in a country’s currency makes its exports more expensive and imports cheaper. This can reduce export competitiveness and domestic production while increasing import spending. Conversely, a depreciation makes exports cheaper and imports more expensive, potentially boosting exports and domestic industries competing with imports. As such, exchange rate changes can significantly impact a country’s trade flows and current account balance.

For individuals, currency fluctuations affect one’s purchasing power and wealth. If someone holds assets denominated in a foreign currency that appreciates, this increases their wealth and buying power for foreign goods and services. However, currency depreciation reduces real wealth and purchasing power. Significant devaluation can be devastating, wiping out savings and earnings. Even small daily fluctuations impact prices for imported consumer goods, overseas travel, studying abroad, and more. Individuals must closely monitor exchange rates for financial planning and decisions.

In summary, exchange rates have a multifaceted impact on international trade and individuals. Their fluctuations can confer advantages or impose hardships, making exchange rate policy an important and often controversial area for governments and central banks. Understanding these dynamics is key to navigating the modern global economy.

Fixed vs Floating Exchange Rates

The exchange rate system plays a critical role in the international monetary system and encompasses both fixed and floating exchange rate regimes.

Fixed exchange rates involve governments setting a fixed price for their currency relative to other currencies and then intervening in currency markets to maintain that fixed price. With a fixed exchange rate, the value of a currency is tied to another currency, often a major international currency such as the U.S. dollar. To maintain the fixed rate, the country’s central bank must buy and sell its own currency in response to shifts in supply and demand.

Under a fixed exchange rate system, exchange rates are stable, but the central bank loses control over domestic monetary policy. Also, if market conditions change substantially, the fixed rate may become unsustainable and have to be abandoned, as occurred when the Bretton Woods system collapsed in the early 1970s after the U.S. ended the convertibility of dollars into gold.

In contrast, with floating exchange rates, the value of a currency is allowed to move freely based on market forces of supply and demand without government intervention. Rates fluctuate from day to day and reflect the current market conditions and perceptions. Central banks have autonomy over monetary policy under floating rates.

Floating systems are more flexible and market-driven but can experience significant volatility and uncertainty in exchange rates. Examples of major currencies operating under a floating exchange rate regime include the U.S. dollar, Japanese yen, British pound, Australian dollar, and the euro. Managed floats allow periodic government intervention to influence currency values while letting rates be determined largely by the market most of the time.

Balance of Payments

The balance of payments is an accounting mechanism that tracks international transactions between one country and the rest of the world over a period of time. It consists of three main components:

• Current Account - This tracks trade in goods and services as well as income flows between a country and the world. The current account looks at trade balances for goods and services, income receipts such as interest and dividends, and transfer payments. A current account deficit indicates the country is a net borrower from the rest of the world.

• Capital Account - This records capital transfers and the acquisition or disposal of nonfinancial assets between a country and the world. It reflects things like migrants transferring funds into or out of a country, debt forgiveness, or one country acquiring property or infrastructure in another country.

• Financial Account - This tracks investment flows and transactions involving financial assets and liabilities between a country and the world. It includes foreign direct investment, portfolio investment, reserve assets like foreign exchange, and other investment assets and liabilities. Net flows reflect if a country is a net lender or borrower globally.

Together, these three accounts capture all economic transactions between a country and the rest of the world. By definition, they should net to zero - debits should equal credits. The balance of payments provides valuable data on a country’s external economic position and relationships.

Balance of Payments Adjustment

The balance of payments serves a crucial function in tracking the flow of transactions between one nation and the rest of the world. However, imbalances can occur which lead to balance of payments deficits. There are several mechanisms that can adjust and restore equilibrium to a country’s balance of payments.

When a country is running a deficit in its current account, meaning it is importing more goods and services than it is exporting, an automatic balancing process often takes place through changes to exchange rates. As the demand for foreign currency increases to pay for imports, the value of the domestic currency will decrease, making exports cheaper and imports more expensive. This can work to gradually eliminate the current account deficit.

Deficits in the capital account, stemming from more money flowing out of a country into foreign investments than is flowing back in, may lead to higher domestic interest rates. Higher interest rates can stem outflows of capital as assets in the home country become more attractive. Governments can also institute capital controls to restrict the flow of capital across borders in order to address imbalances.

More drastic measures to correct overall balance of payments deficits can include contractionary fiscal and monetary policies to reduce aggregate demand. This works to limit spending on imports while decreasing inflation which can improve export competitiveness. However, such measures also slow economic growth.

Currency devaluations, by suddenly lowering the value of a currency by decree, is another mechanism used by governments to abruptly eliminate deficits. By instantly making imports more expensive and exports cheaper, the balance of payments can be forced into equilibrium. However, competitive devaluations between trade partners can lead to instability.

In summary, exchange rate adjustments, higher interest rates, controls on capital, contractionary policies, and currency devaluations represent options to restore balance of payments equilibrium when countries are running substantial deficits. The methods vary in their degree of impact and potential for side effects. But correcting imbalances in international transactions is vital for macroeconomic health and stability.

Bretton Woods System: Aiming for Stability with Fixed Exchange Rates

In 1944, delegates from 44 nations met at the Bretton Woods conference in New Hampshire to establish a new post-war international monetary system. This led to the creation of the Bretton Woods System, which aimed to foster stability, free trade, and economic cooperation globally.

A key feature of the Bretton Woods System was its fixation on exchange rate stability. Participating countries agreed to peg their domestic currencies to the U.S. dollar, which in turn was pegged to gold at $35 per ounce. Governments were obligated to maintain fixed exchange rates within 1% of the agreed values by intervening in foreign exchange markets. Since most international transactions were denominated in dollars, the primary onus fell on the United States to keep the value of the dollar at an agreed level.

However, during the 1960s, the U.S. Federal Reserve expanded the domestic money supply and fiscal expenditures were high due to President Johnson’s social and military spending programs. This caused inflation to rise and a growing current account deficit due to increased imports from Europe and Asia. Gold reserves in the U.S. dwindled as countries began redeeming dollars for gold rather than holding dollars.

By the early 1970s, the fixed exchange rate system under Bretton Woods became unsustainable. On August 15, 1971, President Nixon announced the U.S. government would no longer redeem dollars with gold, and most major world currencies began to float freely against the dollar. This effectively ended the Bretton Woods system of stable exchange rates it had aimed to uphold.

The collapse of Bretton Woods had profound impacts, marking the transition to flexible exchange rates still dominant today. It demonstrated limitations of pegging exchange rates while disregarding fundamental economic factors like trade balances and monetary policy. The ideals of cooperation and managed stability under Bretton Woods remained influential, though the fixed exchange rate regime proved untenable in practice. Its demise ushered in a new era of floating currencies and more independent monetary policies among major economies.

1980s Developments

The 1980s saw a mix of conflict and cooperation in the international monetary system. The disruptions from the 1970s, like the collapse of the Bretton Woods system, prompted countries to reevaluate the existing financial institutions like the International Monetary Fund (IMF). There was conflict between countries over exchange rates and trade imbalances.

At the same time, there were also cooperative efforts between the major economies to try to address the imbalances and achieve greater currency stability. The Plaza Accord in 1985 was a notable example. The agreement between the US, Japan, West Germany, France, and the UK aimed to depreciate the US dollar and rectify trade imbalances through coordinated central bank intervention. This showed that despite clashes, the major economies could still cooperate on exchange rate policies amidst the challenges and changes happening in the international monetary system in the 1980s.

2000s Imbalances and Crisis

In the 2000s, growing global economic imbalances contributed to the onset of the great financial crisis of 2007-2009. These imbalances were linked to the economic policies and approaches taken by major economies like the United States, China, and Europe.

Some key factors that led to the imbalances included:

• The low interest rate policies and increased money supply in the US, which contributed to excessive risk taking in financial markets as investors searched for higher yields. This fueled the boom in housing prices that eventually collapsed.
• China’s focus on export-driven growth and accumulation of large trade surpluses, which it invested heavily in US assets like Treasury bonds. This influx of capital allowed the US to fund its deficits while keeping interest rates low.
• Oil-exporting countries also running large trade surpluses and investing funds in US assets.
• Loose financial regulation and oversight, especially in the US, which allowed excessive risk taking by banks and financial institutions. Derivatives trading accelerated without adequate supervision.

As these imbalances grew, the risks of a crisis mounted. When the US housing bubble burst in 2007, it triggered a financial crisis marked by the collapse of major financial institutions like Lehman Brothers, the seizing up of credit markets, stock market declines, and a global recession. The crisis exposed the flaws and fragilities in the international monetary system that allowed the imbalances to persist and grow in the years prior. It prompted new thinking on international policy coordination and regulations to prevent similar calamities in the future.

Exchange Rate Cooperation in the European Union

The European Exchange Rate Mechanism (ERM II) was introduced in 1999 as part of Economic and Monetary Union (EMU) to promote exchange rate stability between EU countries. ERM II helps to ensure stability between the euro and other EU currencies by monitoring exchange rate fluctuations between them.

The aims of ERM II are:

• To help non-euro countries prepare themselves for joining the euro area
• To provide exchange rate stability for current non-euro EU members
• To align non-euro currencies more closely to the euro

ERM II works through a fixed currency exchange rate with standard fluctuations bands. Central banks are required to intervene if the exchange rate approaches the limits. Countries also agree to coordinate economic policies closely to maintain exchange rate stability.

Joining ERM II is voluntary for non-euro EU members. Participating in the mechanism for at least two years without severe tensions is one of the convergence criteria for adopting the euro. As of January 2023, the Danish krone and the Bulgarian lev are the two currencies participating in ERM II.