History of the International Monetary System

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Introduction

The major fundamentals of the International Monetary System are the purpose of currency preferences and rate of exchange mechanism; the exchange rate mechanism is the most important among the two elements (Cooper 33). The IMS has rules and principles that oversee the financial relationships between nations and is a vital element of global relations. When the monetary system does well all other economies follow the same trend and when it is in bad shape all the other economies follow too. Therefore, the monetary relationship has an enveloping weight on international and domestic advancement and throughout history is spotted with instances of monetary failure resulting in political and economic disruption.

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In the past substantial disorder in International monetary association has worsened the relationships between Japan, America and Europe; for this reason, monetary relationships should be ordinary and elements of setting in a well-running system should be allowed (Cooper 34). This paper explores the working of the IMS at length and the evolution of the present international monetary system (IMS) as it is known today. It has also reviewed the role played by the International Monetary Fund as one of the institutions established in Bretton Woods to supervise the international monetary system.

History

Bimetallism (Before 1875)

During this period the nations used “double standard” that is silver and gold as a legal tender, several countries used the gold standard and others were on silver standard and few countries used both standards (Forex.in.rs).

The silver and gold were used to determine the foreign exchange rate and as a mean of settling the debt; Gresham’s Law entailed that “it would be the least valuable metal that would tend to circulate” (Forex.in.rs). In 1816 the Napoleonic Wars finished and the British assembly accepted the law of using gold coins as the only legal tender and removed silver coins in their system (Eiteman 2).

Bimetallism in the United States started in 1792 after passing the Currency Act and became the majority law; before the passing of the Act each State used dissimilar notes from dissimilar banks and the gold coins were distributed without restraint using Spanish doubloons (Forex.in.rs). This became a disaster since there were different types of money; as a result, the congress removed the silver dollar in 1873 from list of coins already imprinted (Forex.in.rs) and the silver price collapsed in 1874. On the other hand, France adhered to bimetallism until 1878 while China, Germany, India and Holland remained on silver standard (Forex.in.rs).

This was the situation of the International Monetary System before 1870 where silver and gold were used to make payments for both exports and imports (Forex.in.rs). The Sterling pound (gold standard) exchange rate around 1870 and French Franc (Bimetallic standard) was determined by the gold of the two country currencies while the exchange rate of German Mark (silver standard) and French Franc was founded by silver coins (Forex.in.rs).

Political commotion and wars resulted in loss of value of the countries’ exchange rate around 1848-1879; therefore, as a result, the International Monetary System was in chaos until the 1870s (Forex.in.rs).

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Classical Gold Standard (1876-1913)

The gold standard is categorized into different standards such as coin vis-à-vis other, legal vis-à-vis effective, and domestic vis-à-vis international (EH.net). It is the most celebrated monetary system to have ever existed is the gold standard; countries joined and adhered to the gold standard at different periods in the lifetime of this monetary standard (EH.net). In general, the gold standard affected the money supply of those countries that adhered to it. The world war began in 1914 when the classical standard ended; this was pursued by interwar standards which functioned between World War I and World War II (that is in the 1920s-30s) (EH.net).

Countries joined and opted out of the gold standard at different times of the year. The coming together of different countries mirrors the significance of nations to organize and preserve the standard; Britain especially played a major role in the life of classical standard and United States in the life of Interwar standard (EH.net). These two nations were crucial to adoption of this standard. Germany and France together with the United States convinced other nations to take up the standard at the time of classical standard (EH.net).

The most commonly used type of gold standard was the coin and exchange, but the exchange system was used by a few countries at the time of classical standard (EH.net). These countries (Canada, Ceylon, and Australia) used the coin, while the British colonies and the Dominions used coin and exchange for India only (EH.net). Western Europe, Scandinavia, Eastern Europe, the Middle East (Egypt and Turkey), Mexico and Central America, and South America used coins. Africa and Asia (except Japan) used the exchange system (EH.net).

Gold Standard characteristics

Types of Gold Standard

Mixed and Pure Coin Standards

Domestic standards do not rely on networks with other nations and are usually grouped into two, namely; pure coin and mixed standards (EH.net). The mixed standard involves the use of paper and coin and the two standards share common traits such as definite and predetermined gold content of the local monetary unit (EH.net). They have an unrestricted legal-tender authority which means that classified parties have no limitation on the utilization of gold, and the central bank can convert privately held gold bars to gold coins in unrestricted amounts (EH.net).

Pure coin standard uses gold as the only money while mixed standard adds paper notes to the basket which are issued by the commercial banks, central bank and the government and are translatable to a gold coin. During the gold Standard regime a pure coin standard did not prevail, since it reduced from approximately one-fifth of the total global currency supply in 1800 to 17% in 1885 as a result of the introduction of silver coins (EH.net). International standards logically call for more nations to be on gold since private persons are allowed to export and import gold with no limitation and foreign-exchange operations must exist (Eiteman 3).

Gold bars (Bullion) and Exchange standards

Countries were free to choose any of the global gold standards; “gold-bullion, pure coin, gold-exchange and mixed standards” (EH.net). The coin did not flow as money and was also not used as reserves by commercial banks and the government did not coin the gold in gold-bullion standard since the central bank was ready to do business with persons selling or buying gold bars using its notes and a common least amount of transaction was specified (EH.net). The fiscal authority of the nation on the gold exchange bought and sold a country’s currency that was in the form of a gold coin (EH.net).

Gold import/Export and Gold Points

A fixed-rate of exchange on the standard is a generalization that is made but it normally deceives. The cost of importing and exporting gold such as insurance, interest on currency, freight, risk premium and normal profit is expressed as a proportion of invested amount and gold points are obtained which are then used as the exchange rate for exporting gold (Eiteman 3).

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The private segment obtained foreign currency by taking advantage of the difference between the exchange rate and the gold-point when they export; the foreign currency was also sold at a certain exchange rate and therefore they (arbitrageurs) made profit comparative to divergence of the gold-point and consequently, the actions of arbitrageurs brought about equilibrium in the market (Eiteman 4). The private segment was motivated by profit; trust in the monetary system (in setting a rigid gold price and independence in gold and foreign exchange transactions); the gold-point spread is the variation of the gold points; the points and spread can be articulated as a proportion of parity (Eiteman 5).

Rule of the Game

The rule of the game was applied from 1876 to 1913 by those countries that were playing the part which was supposed to set an authorized price of gold and permit free translation between domestic legal tender and gold at this rate (Eiteman 5). The importation and exportation of gold were not to be restricted and it was to be used freely for global transactions. The country’s currency issue was to be backed with gold and nothing else. The central bank was to lend to local banks at a higher rate of interest in case there was short-term liquidity problem in relation to gold outflows. In case there was provisionally suspension to set up an authorized price for gold and free translation of currency to gold by each country, the nations were expected to reinstate convertibility at basis rate as soon as possible (Eiteman 9).

A nation experiencing a trade discrepancy loses gold and the currency supply decreases involuntarily and by rule in harmony with Rules of the Game. As a result, the income and price from money contracts fall and this reduces imports and increases exports. On the other hand, a country running a surplus account gains gold, its currency supply increases, income increases, level price increases, imports increase, and exports decrease; in both cases, the balance-of-payments is reinstated back to equilibrium through the use of current account (Eiteman 36). This is referred to as the “Price Specie-flow Mechanism” (Eiteman 36). The capital account can reinstate the balance by the use of interest rate, an increase in interest rates of the country running a deficit account bring about capital inflow and reduction in real investment and thus imports and real income is attained (Eiteman 37).

Likewise, a decrease in the interest rate of the nation with a surplus account draws out capital outflow and a rise in real investment, import, and income, thus the current-account inequalities are corrected (Eiteman 6).

An example of a gold standard is when you think of a planet with only two nations represented by X and Y and assume that state X operates a Balance-of-trade surplus, that is, its exports surpass its imports. State X imports gold and export services and goods, its cash supply raises, which lead to increase in the prices of services and goods. While in state Y the reverse takes place, the prices increase in X and decrease in Y will ultimately put right the trade discrepancy (Eiteman 43).

Interwar Period (1915-1944)

From 1915 to 1944 (World War I) the gold standard came to an end after the operation of the gold standard was postponed after the breakout of World War I in 1914 (Cooper 36). The European nations had been interconnected directly, however they were abruptly separated from union by the war; the nations moved away from the union and industrialized at different rates during this period of War (Cooper 41). Eventually, the war ended in mid-1918 and the rate of inflation diverged to great extent, since many countries had printed a lot of money to fund the War (Cooper 41). In 1917 the Russian Revolution took place, but the global economies structure was intensely altered by the year 1918 (Cooper 46).

The countries attempted to gain an advantage in the global export market by varying the exchange rate using “predatory” devaluation of their domestic currency. As a result the countries attempted to reinstate the gold standard even though the members did not have the political willpower to pursue the “Rules of the Game”; the consequences of the global trade were deeply detrimental (Eiteman 25).

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It was obvious that the foreign exchanges rates could not be reinstated; this resulted in to delay in fixing an official face value of the currencies; this meant that the countries permitted their currencies to float less or more freely in the exchange market (Econ.iastate.edu). They did not recognize that floating rates were not the only feasible remedy; as alternative, there was widespread anticipation that the exchange floating rates regime was provisional, and nations would immediately go back to gold standard. The question that was left to be answered was at what parities the countries would reinstate the gold standard (Econ.iastate.edu).

In 1918 after the war the United States instantly broadcasted that it will uphold the dollar gold price back to what it was before the war (Econ.iastate.edu). This meant that the British state credit was at risk; failure to reinstate the gold parity before the war would weaken the trust in the pound and Britain opted for a deflationary policy (1920-1925) (Econ.iastate.edu). In 1997 (Asian Financial Crisis), South Korea opted for the same policy which led to a stunning rise in the unemployment rate (Econ.iastate.edu).

The Gold Standard Act was enacted in 1925 and led to price decrease with unemployment rates of over 10% (Econ.iastate.edu). By April of the same year, Winston Churchill broadcasted that the notes will be exchanged for gold by the Bank of England and went back to the gold standard that it had before war parity (Econ.iastate.edu).

At the same time Britain tried to decrease wages and prices to hold an overvalued Sterling pound this lead to a wide-ranging strike (Econ.iastate.edu).

In this system, the countries held to dollar or gold or pound as asset reserve, as a result of restricted gold supply. The system was planned to decrease the gold quantity that was required on the country reserve; the Great Britain and the US held on the gold as asset reserve and their currencies became the main currencies reserve. Other countries were requested to hold the pound and dollar as asset reserves instead of gold since currencies were exchangeable to currencies reserve at a fixed parity. Pounds and dollars were easily exchangeable into gold by the central bank, although not for the common public. The majority of the nations that were using silver standard fixed silver to the US dollar with exception of Hong Kong and China (Econ.iastate.edu).

In the gold standard exchange, nations opted for the traditional method of devaluing the local economy in case of chronic deficits. At the start of World War II, the countries opted for this policy, specifically Great Britain. Although small number of countries’ currencies were exchangeable for gold, the rules makers considered that gold should be used to support currencies and they freely accepted deflationary policy following War World I (Econ.iastate.edu).

In 1930s the nations had 3 alternatives to avoid gold outflow, nations attempted to administer the flexible rates of exchange by way of interest rate increase although it did not avoid the capital outflow (Econ.iastate.edu). A number of counties undervalued their currencies without success others forced exchange control when experiencing capital flight (Econ.iastate.edu).

The Gold Standard Act was amended in 1931, Britain postponed the gold payments and this ended the ineffective attempt to reinstate the gold standard (Econ.iastate.edu). Numerous countries copied Britain and deserted the relation to gold; for instance, Japan deserted gold exchangeable in 1931, after it attacked Manchuria (Econ.iastate.edu). In 1934, President Franklin Roosevelt increased the gold price to $35.00 from $20.67 per ounce, this lead to 40% undervaluation of the dollar (Econ.iastate.edu).

Bretton Woods and IMF (1944)

The Bretton Woods System is usually understood to stand for International Monetary Regime that succeeded the end of World War II; the name Bretton Woods was taken from the name of the place that the conference was held (Driscoll 20) and it was at this particular conference that the World Bank and International Monetary Fund (IMF) institutions were formed(Driscoll 20).

The conference’s aim was to preside over currency affairs among independent states. In theory, the system was intended to amalgamate binding lawful obligations with many-sided resolution carried out through global administration IMF capable with restricted supranational power (Driscoll 20). In practice however, the initial system and its consequent development and decisive downfall were directly reliant on the policies and preferences of the United States which was the most influential member (Driscoll 29).

The World Bank and the IMF are known jointly as the Bretton Woods Institutions and were established in the year 1944, and their main function is to facilitate global economic development and economic order structure (Driscoll 35). The IMF and the Bank show many common traits as they are both owned and run by the member nation’s governments; the institutions are concerned with economic problems and focus more on lengthening and underpinning the economies of the members.

The two institutions usually hold combined annual meetings; regardless of these similarities the IMF and the Bank remain different and their basic difference is that “the IMF is a cooperative institution that seeks to maintain an orderly system of payments and receipts between nations” (Cohen 132). Each one of these institutions has a different structure and purpose; the financing of operations comes from dissimilar sources, gives aid to dissimilar member category and endeavors to attain different objectives in their own way of operations (Cohen 32).

Role of the IMF

The IMF was founded in order to resolve the financial struggle instrumental in starting and prolonging the Great Depression of the 1930s; unexpected, erratic disparity in the exchange rates country’s currency and extensive reluctance amongst the government to permit their legal tender to be traded with a foreign currency (Driscoll 72). Set up as a cooperative and charitable institution, the institution catches the attention of its partisanship countries that are ready to renounce some gauge of national independence by abjuring traditions detrimental to the welfare of their colleague member country (Driscoll 68).

The IMF proffers short-term supports to the member nations attempting to protect their domestic currencies. It also gives aid to nations facing structural business troubles if they undertake ample procedures to correct these issues.

The IMF enhances existing exchange reserves through a global asset reserve referred to as “Special Drawing Right” (Driscoll 23).

Bretton Woods Agreements “The Rule of the Game”

IMF’s Articles of Agreement was signed by the member countries and contains the Code of Conduct; the code is very simple as it requires all member States to fix a rate for their legal tender (currency) in terms of gold (Cohen 13). In the short-term, they are supposed to maintain their currency rate within 1% of the nation’s currency face value and leave the long-term rate open and allow free translation of the Current Account while utilizing the Capital Controls to restrict speculation (Cohen 23). Make up for short-term discrepancies through the utilization of IMF credits and official reserves and disinfect the effect of foreign exchange market interference on the local money supply.

The countries were supposed to allow general macroeconomic independence (employment and price level), permit their legal tender to be traded for a foreign legal tender freely and without limitations, to update the IMF on changes they think of in monetary and financial policies that will have an effect on the member country’s economies and to the most likely degree amend policies on recommendation from the IMF to house the needs of the member community as a whole (Cohen 13).

To assist countries put up with the Code of Conduct, the IMF manages a pool of cash that lends money to the member countries in case of problems. The institution is not above all a loan provider institution as is the World Bank and is primarily a supervisor of exchange rate and monetary policies of its members and custodian of the Code of Conduct (Cohen 87). It frequently receives reports on member nations’ economic prospects and policies, which it discusses, puts some remarks and communicates to all members so that other countries may take action with full know-how of the reality and apparent understanding of how the home policies may impact other nations (Driscoll 65). IMF is certain that an essential proviso for global success is a monetary system that is orderly and which supports trade, enlarges economic production, creates jobs and improves the standards of living all over the world (Cohen 53). In fact, based on its charter the IMF is obligated to supervise and uphold this system, no less and no more (Cohen 37).

Size and Structure

The IMF has approximately 2,300 employees distinct from the World Bank and has no subsidiaries; generally, most employees operate from its head office in Washington, D.C., even if three of its small workplace is located in Geneva, United Nations in New York and Paris and its human resources comprise of professionals who are financial and economic experts (Cohen 13).

Sources of funding

The IMF receives its funds from quota subscriptions by member countries (182 in number) and each member country makes a payment to the common pool-specific amount of cash in proportion to the size of its economy and strength. IMF is similar to a credit union, where members have the right to use the common pool of cash to help them in periods of need (Driscoll 30).

Fixed Exchange Rates,1945-1973

Fixed Exchange Rate was a Bretton Woods System that progressed to a fixed-rate standard of the dollar which was designed and supervised by the IMF; it operated very well after the World War II the age of restoration and growth in the global trade but the system was affected by diverging inflation rates and shocks from a variety of currency leading to the system failure (Eiteman, Stonehill and Moffet 32). The United States dollar happened to be the major currency reserve held by most Central Banks, following-on was a constant balance-of-payment deficit in the United States which was heavily funded by Capital outflows of US dollars while other countries accumulated enormous US dollar reserves and they at long last lost trust in the capability of the United States to translate dollars to gold (Eiteman et al 32).

Due to lack of trust required, President Richard Nixon made a decision to postpone official sales and purchases of gold by the United States Treasury in 1971 and as a result, the dollar was devalued and most nations were permitted to float their currencies and let the market forces of demand and supply play its part, on March 1973 (Eiteman et al 33).

An Eclectic Currency Arrangement (1973-Present)

In the year 1972, the US dollar was undervalued for the first time while the second instance was in 1973 which occurred to allow currency floatation in the market and since then, the foreign exchange rate turned out to be a lot more flexible and less convectional than in the fixed currency time (Eiteman et al 33). In the last 30 years there have existed significant and numerous global currency events (Eiteman et al 33).

After the collapse of the Bretton Woods System of exchange, the IMF selected the committee of 20 which proposed a variety of alternatives for the rate of exchange agreement and the amended Article of Agreement in 1976 which was then implemented in 1978 incorporated different ways of determining the rate of exchanging (Eiteman et al 33). The first one was the floating Rate System that used the market forces of demand and supply to establish the rate of exchange for two country currencies. Two arguments were put forth, that is, the rate of exchange should vary automatically to reflect changes in macroeconomic factors, as consequence no space between the nominal and real rate of exchange while the other is that, the scheme processes lining properties that will protect the currency from shocks will originate from other nations (Meissner 19).

Currency pegging was established as a fixed rate of exchange resulting in a stable payment for imports or exports. However, doing business with other nations pegging will not apply and thus currency pegging is not advisable for a diversified country doing business with many nations (Meissner 23). On the other hand, Crawling peg permits the fixed rate to change after some time to reflect changes in the economy which reflect advanced methods of both flexible and fixed-rate systems, therefore it can facilitate eradication of too much volatility and rigidity (Meissner 23).

Time Zone Arrangement is another determinant of exchange rates in which countries fix intra-zone rates of exchange, for example, the Euro (established in European Monetary Union) while other countries prefer to have one currency (for example the Euro, Western Africa Economic and Monetary Union, Eastern Caribbean Currency Union and Central African Economic and Monetary Community) (Meissner 23). Lastly, other methods may include; one, Currency Board Arrangement which is supported by a legislative obligation to exchange local currency for a particular foreign currency at pegged rate while the second is, is dollarization, where some countries opt to use US dollar as a legal tender of the nations (Meissner 23).

Conclusion

It is clear that, the developed economies have used two types of global exchange rate systems after the end of World War I, namely; the flexible and the fixed exchange rate schemes. The fixed-rate allows a country to set a rigid rate that is agreed upon by two countries, this rate is used to exchange currencies at the international market while floating rates of exchange are allowed to establish their own rate through the use of market forces. Most of the time nations do not allow their local currencies to determine a market rate of exchange, individually or as a group they intervene in the International market of Currency Exchange several times after the beginning of the floating-rate of exchange system, as a way of manipulating the rate of another or more nations.

Work cited

Cohen, B. “Bretton Woods Systems”, 2010, Web.

Cooper, R. “Prolegomena to the choice of an international monetary system”, International Organisation, 29(1975):32-42 Print.

Driscoll, D. “The IMF and the World Bank: How do they differ”, 1996, Web.

Econ.iastate.edu. “Gold standard”, 2010, Web.

Eiteman. “The international Monetary system”, 2004, Web.

Eiteman, Stonehill and Moffet. “Multinational Business Finance: the International Monetary system ”, 2010, New York: Person Prentice Hall.

EH.net. “Gold Standard”, 2010, Web.

Forex.in.rs. “Old Bimetallism before 1875”, 2010, Web.

Meissner, C. “The Evolution of the International Monetary System: A Long-Run Perspective on Exchange Rate Regime Choice”, 2006, Web.

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